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Ol' Bob's Financial Resilience

I put this workshop together in 2021 for some friends, it's focussed on sensible long-term investing for Australians.

Ol’ Bob is not a financial professional and is definitely not qualified to give financial advice.

Simple rules:

How to invest without having to think about it.

You don’t need to know any more than this to be very successful at investing, you will outperform the vast majority of Australian investors with this strategy.

A basic understanding of investing.

Compounding

Investing takes advantage of the power of compounding. Most of us have an idea of what compound interest is but humans are very bad at visualising exponential growth. We tend to overestimate the growth in the short term and massively underestimate the growth in the long term.

Would You Rather Have $1 Million or a Penny That Doubles Daily for 30 Days?

https://grow.acorns.com/compounding-interest-example/

Let's mess around with the compound interest calculator:

https://moneysmart.gov.au/budgeting/compound-interest-calculator

(note: historic stock market returns are around 7%)

Management Fees

The effect of management fees when combined with the power of compounding is maybe even less intuitive.

Let’s say Alice and Ned each receive an inheritance of $100,000. Alice manages their own investment, while Ned pays a manager 2% to manage their money. After 30 years with 7% compounding returns here is what we see:

Alice (paid $0 fees): Alice has $761,226
Ned (paid a manager 2%): Ned has $418,974, his manager has $342,252!

Have a mess around with the managed fees calculator here:

https://moneysmart.gov.au/managed-funds-and-etfs/managed-funds-fee-calculator

As you can see when we’re talking about long term investments it pays to be very conscious of the fees we are paying. (In fact it’s almost the only thing we can actually control!).

Trading Costs

When we buy or sell shares with our broker each trade costs money.

Different brokers will have different trading costs. The cheapest broker in Australia at the moment is SelfWealth, each trade costs ~$9.

It costs $9 whether you buy $1 worth of shares or $1M worth of shares, so making lots of small trades will be much more expensive than saving up and making a couple of big trades per year.

This is one of the many reasons why day trading is not a good long term strategy.

It is worth noting that brokers make way more money from people that make lots of small trades than those that make few large trades.

SelfWealth actively encourages users to make many small trades, you have to ignore their stupid rating system and advice to follow top traders of the week. Sadly that’s the price of cheap trading costs.

Asset Classes

Stocks

A ‘stock’ is a share of a business that you can buy. By owning a stock you are part owner of the underlying business. If the business makes money, your share of the business will be worth more. If the business loses money your share will be worth less. If the business goes broke, your share will be worth nothing.

This is why investing in stocks involves ‘risk’.

The share price of a business takes into account not only what the business is currently worth but also what shareholders (or potential shareholders) perceive it will be worth in the future.

Stocks can sometimes pay ‘dividends’, this is money that is regularly paid to its shareholders. Whether or not to pay dividends is completely up to the business and a dividend payment can be adjusted at the businesses whim.

Whether or not a stock pays dividends is largely irrelevant as the underlying value of the shares decreases by the amount of dividend getting paid out.

Dividends do however have some tax implications that we will discuss later.

Bonds

A Bond is a loan that pays a fixed interest rate.

For the moment when we talk about bonds we will be talking about a loan to a government.

Buying Australian or US treasury bonds provides a (small) fixed return. Because Australian and US governments can print their own money they in theory can never fail to pay back their debts.

This is why government bonds are considered ‘risk free’. They also have low volatility which will become important later.

Inflation

Inflation is the decline of purchasing power of a given currency over time.

Let’s say we have a savings account with our bank that is paying us 2% annually.

We will see the dollar amount in our bank account growing at 2% per year... looks ok, seems safe.

However if we take into account that the Australian dollar has an inflation rate of 2% we might notice that although the amount of money in our account is growing, our spending power is staying exactly the same.

Now let’s imagine that we didn’t put our money in a savings account, instead we stuffed it in a mattress, now we are losing 2% of our purchasing power per year.

Let’s have a look at the inflation rate history in Australia, have a think about how historical inflation rates might have affected investment and spending habits at the time:

https://www.rba.gov.au/inflation/measures-cpi.html

Risk

There are several types of risk involved with investing, some we will learn to avoid, others will become valuable tools.

The risk of not taking enough risk

When we take into account inflation it becomes obvious that what may have seemed like the safest place for our money (in the mattress), is actually not safe at all. As the purchasing power of our currency declines with time, keeping money in the mattress guarantees a loss.

The risk of total loss

When we get involved with investing one of the most concerning risks is ‘losing it all’.

If we invest in a single business and that business goes broke we run the risk of losing all our money.

This risk can be almost completely removed using diversification. If we invest in many businesses across many industries and in many countries we can ensure that with the exception of complete global collapse we will be safe from total loss.

Volatility

Once we have discovered that diversification solves our risk of total loss, our main risk is volatility.

When financial professionals talk about risk they most often mean volatility.

If we have a highly volatile investment the worth of the shares may be steadily increasing in value over time but they may also be fluctuating large amounts from year to year or even day to day.

The risk here is that if you want to sell some of your shares at a particular time (because you lost your job or face a financial emergency etc.) they may be worth less than you’d hoped.

We can minimise this risk by:

Ensuring we are properly diversified.

Having a long time horizon. It is for this reason that we should not be investing money in the stock market that we are going to need in the next 5 years.

Add a percentage of low volatility assets (Bonds).

When we are young we can invest with a long (30+ year) time horizon, this protects us from high volatility. But as we get older our time horizon gets shorter. We need to find another way to reduce volatility.

Shares have a high volatility and also a high expected return.

Bonds have a low volatility and a low expected return.

We can mix and match shares and bonds to ‘tune’ our portfolio to a level of volatility that we find acceptable.

Diversification

Hopefully by now we should be able to see that diversification solves many of the pitfalls involved in investing. In fact diversification solves so many issues it is often described as “the only free lunch” in investing.

So if diversification is so great how much diversification do we need? Should we buy shares in hundreds of businesses?

We know that everytime we buy shares with our broker we pay a trading fee. Surely buying shares in hundreds of even thousands of businesses is going to mean we’re spending all our money on trading fees right? Thankfully no, let’s introduce index funds.

Indexes and Index funds

Traditionally an Index has been used to visualise the performance of an entire stock market.

The S&P500 index tracks the 500 largest companies on the US stock exchange.

The ASX200 index tracks the 200 largest companies on the Australian stock exchange.

Let’s take a look at the S&P500 index graph

https://www.cnbc.com/quotes/.SPX

Because these indexes contain a list of companies that are thought to be well diversified enough to represent the market as a whole they became the basis for a set of index funds.

These funds own shares in every one of the businesses in the index. Shares of these funds are then made available to investors. This provides us with several benefits:

A single share of an S&P500 index fund provides the same amount of diversification as buying 1 share of each of the 500 companies tracked by the index.

We pay only the brokerage fee for 1 trade rather than 500 trades.

Because the companies in the fund are automatically selected from the index there is little human involvement so management fees can be kept very low.

Vanguard offers an index fund that tracks the MSCI WORLD index.

This provides global diversification and is often used as the backbone of an index portfolio.

Let’s look at this index fund paying attention to management fees and underlying holdings.

https://www.vanguard.com.au/personal/products/en/detail/8212/Overview

Realised vs unrealised gains/losses

It is worth mentioning here the difference between realised and unrealised gains and losses.

If you make a gain or loss in the sharemarket, that gain or loss is ‘unrealised’ until the point that you cash out your shares.

For example:

You invest $100,000 in a well diversified index portfolio, the next week a pandemic breaks out and the stock market crashes by 30% you now have only $70,000 in the stock market, but at this point your loss is ‘unrealised’ what do you do?

A. Sell your shares, investing turned out to be too stressful. (You’re out. You now have 0 shares invested and a ‘realised’ loss of $30,000.)

B. Nothing, you have a long term investment plan and you’re sticking to it.

Let’s have a look at the MSCI world index around the period of April 2020.

(https://www.cnbc.com/quotes/.WORLD)

If you had done nothing within 5 months of the crash you had made your money back. Within a year you had made a 15% profit.

A year after the crash you now have $115,000. This is an ‘unrealised gain’ of $15,000.

If you then sold your $15,000 worth of shares you would have a ‘realised’ gain of $15,000 and still have $100,000 invested.

A note on tax:

The tax man doesn’t care how much you gain or lose in the sharemarket until those gains or losses become ‘realised’, then you have to pay tax on them like any other earning.

Taxes

As mentioned above, expect to pay income tax on ‘realised’ gains. (You can also use ‘realised’ losses to offset tax from other income.)

Also expect to pay taxes on any dividends you might get paid.

An index fund probably will contain some companies that pay dividends and some that don’t, even if you choose to reinvest your dividend payout (which you should) you will still be asked to pay taxes on this amount.

In Australia we get a tax break for owning shares in Australian businesses, and in particular dividend paying Australian businesses. It is for this reason that we may want to consider owning a slightly higher percentage of Australian companies than a globally diverse index fund might offer.

To achieve this we might add a second index fund of only australian businesses:

https://www.vanguard.com.au/personal/products/en/detail/8205/Overview

In Australia we also get large tax advantages by keeping money in our Superannuation account. Because of these tax advantages making the most of your pre-tax super contributions can have a huge effect on the amount of tax you pay over your lifetime.

In Australia we also get a tax break if we have held an asset for over 12 months.

Rebalancing

So reviewing what we have learned we can see that we might need a portfolio that requires something like the following.

40% Australian Shares

40% Global Shares

20% Bonds

Over the course of a year some of these assets will outperform others and you will no longer have your desired allocations. It will be necessary to sell the over performing asset and buy the underperforming asset.

For example:

Let’s say after 1 year Australian shares have done very well but Global shares have done poorly and your allocation now looks like this:

44% Australian Shares (VAS)

36% Global Shares (VGS)

20% Bonds

In order to keep our portfolio balanced at the desired allocations we need to sell 4% of our Australian Shares and Buy 4% more global shares. This can be hard mentally as we can see that the Australian shares have made us more money!

However by not rebalancing we make a fundamental error, we would be essentially buying high and selling low and at the same time sacrificing diversity.

There are now funds that hold multiple index funds and rebalance for you. They usually have slightly higher fees but you may find that the convenience of owning just 1 single fund is worth the slightly higher fee. Especially when you take into account the trading costs when rebalancing.

See VDGR (https://www.vanguard.com.au/personal/products/en/detail/8220/portfolio)

Psychology

Managing your own portfolio of shares can be very simple, most of the work is convincing yourself that you shouldn’t do anything. Here are a few mental tricks I have found useful.

Think of your shares as doing a job, when the share market is down your shares are ‘working’ when the share market is up your shares are getting paid. Your shares need to regularly go to work to get paid.

Learn to enjoy periods when the share market is down. During these periods any money you are investing has more buying power.

When things look bad and people are panicking, sit on your hands. Your job is to refuse to act. If you are investing for the long term you will see several periods like this in your life.

Keep a diary of all your major financial decisions and actions, describe why you have made those decisions. This way you can keep track of your financial decisions over time and ensure you are sticking to your long-term plan.

A good decision doesn’t guarantee a good result, and you will hear plenty of stories of people who made terrible decisions and got amazing results (think the lotto winner). It is important to be happy you made a good decision even if the outcome wasn’t ideal.

Discussion topic: Ethical Investing

Resources

Youtube:

Ben Felix:

https://www.youtube.com/channel/UCDXTQ8nWmx_EhZ2v-kp7QxA

The Plain Bagel:

https://www.youtube.com/channel/UCFCEuCsyWP0YkP3CZ3Mr01Q

Passive Investing (documentary):

https://www.youtube.com/watch?v=zqa-jSuXmYw

Podcasts:

The Rational Reminder (pretty dense)

Books:

Your Complete Guide to Factor-Based Investing: The Way Smart Money Invests Today (Andrew L. Berkin and Larry E. Swedroe)

The Index Card: Why Personal Finance Doesn't Have to Be Complicated (Helaine Olen)

The Barefoot Investor 2020 Update (Scott Pape)

Rollplay - basic shares

Let's say our friend Alice gets given a $1000 car and starts a delivery business, they hire a driver to make the deliveries.

After 1 year of operation the business pays the driver a wage and has $1000 profit left over.

At this stage Alice owns business that is worth $2000:

1 x Car -  $1,000
Cash - $1,000

Alice wants to expand and buy another car, so she decides to sell half her business, she approaches her friend Betty

A: “Hey Betty, I have a business worth $2000, 
last year we made a $1000 profit and I think we could make even more next year with some investment money, 
would you be interested in buying a 50% share?”.


B: “Sounds good I’m in, here’s $1000”. (gives money to Alice)

Alice takes Betty’s money and buys a second $1,000 car and hires a second driver.

The next year after paying the drivers wage the business has $2000 profit left over.

At this stage Betty owns 50% and Alice owns 50% and the business is worth $4,000:

2 x Cars - $2,000 
Cash - $2,000

Betty wants to go on a holiday to the bahamas, they need the money they have invested in Alice’s business:

B: “Hey Alice, it’s been a good year, looks like my investment has doubled! I’d like to sell my shares”
A: “Ok that’s cool but you will need to find a buyer”

Betty starts asking around her friends to see if anyone would be interested in buying her share of Alice’s business.

Her friends Phil and Lil both say they might be interested (especially after Betty says she has doubled her money investing in Alice's business).

Phil offers Betty $2000 for her share in Alice’s business.

But Lil sees that Alice’s business is growing and thinks that she wants that share more than Phil, she offers Betty $2500 for the share.

Phil is shocked! The underlying business assets are only worth $2000 but he will lose the chance to double his money if he passes this up, he counter offers $3000.

A bidding war has begun! (This is price discovery)

Lil’ says “Damn it Phil, you win, I think $3000 is too much to pay.”

Phil buys Betty’s 50% share for $3000. (Betty is shocked and buys extra cocktails on her holiday)

Alice sees that Betty has sold her share for $3000 and realises that her share must also be worth $3000.

Now the business looks like this:

At this stage Alice owns 50% and Phil owns 50% and the business is worth $6,000:

2 x Cars - $2,000 
Cash - $2,000

As you can see the total value of the business is now worth more than the underlying assets. This is because Phil & Lil saw the future potential of the business and drove the price up.

This is what happens in the stock market (everyday the New York Stock Exchange trades between 2 billion and 6 billion shares).

It is important to realise that the stock market is “future looking”. Millions of traders, automatic algorithms and artificially intelligent software entities are constantly trading and these trades set the price of shares using supply and demand.

An ‘efficient’ market is one where the prices are reacting so quickly to any available public information that there is no-longer any ‘bargains’ to be had. Stock markets have been shown to behave in a way that is very close to perfectly efficient.

The Efficient Market Hypothesis can be the topic for another more nerdy discussion.

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