20
Mar 2015

Follow your feelings or fortunes?

Follow your feelings or fortunes?

Written by a Hudson Adviser

Human emotions rarely follow the most rational path and when we are talking about money this is even more so. Quite a large amount of research has gone into how people react when making financial decisions and it seems the results confirm we humans make decisions that are more influenced emotionally than perhaps common sense should indicate.

Let’s look at a simple experiment run by Professors Daniel Kahneman and Amos Tversky. Kahneman and Tversky presented several groups of subjects with a number of problems.

The first group of subjects were presented with this problem:

“In addition to whatever you own, you have been given $1,000. You are now asked to choose between:

A. A sure gain of $500.
B. A 50% chance to gain $1,000 and a 50% chance to gain nothing.”

Unsurprisingly 84% chose option A.

However the next group of subjects was presented with another problem:

“In addition to whatever you own, you have been given $2,000. You are now asked to choose between:

A. A sure loss of $500
B. A 50% chance to lose $1,000 and a 50% chance to lose nothing.”

In this instance 69% of the subjects chose option B.

The two problems are identical in terms of net cash to the subject, however the phrasing of the question causes the problems to be interpreted differently.

From their research (which resulted in a Nobel Prize for Kahneman) it was deduced that people placed different weights on gains and losses and on different ranges of probability. They found that individuals are much more distressed by prospective losses than they are happy by equivalent gains. Some economists have concluded that investors typically consider the loss of $1 dollar twice as painful as the pleasure received from a $1 gain. They also found that individuals would respond differently to equivalent situations depending on whether it is presented in the context of losses or gains. Further research has also found that people are willing to take more risks to avoid losses than to realize gains. Faced with a sure gain, most investors are risk-averse, but faced with a sure loss, investors become risk-takers.

While this research may end up as a tool for marketers, my point was that humans certainly do not act rationally when presented with influences such as fear of regret for poor decisions. This fear often results in humans tending to follow the crowd and/or conventional wisdom to avoid the possibility of feeling regret in the event that their decisions prove to be incorrect. Many investors find it easier to buy a popular stock and rationalize it going down since everyone else owned it and thought so highly of it. Buying a stock with a bad image is harder to rationalize if it goes down. Additionally, many believe that money managers and advisors favour well-known and popular companies because they are less likely to be fired if they underperform.

So it’s proven we have a tendency to be “crowd followers”, even though it doesn’t make sense.

Keeping in context with the research I just described, it is easy to understand why a good number of investors have capitulated and sold down their investments as they have fallen into despondency; making it much easier for them is the fact that almost everyone is in the same boat as they are, so the shame is mitigated somewhat. To exacerbate the problem, the capitulators indirectly cause the bottom point to fall even lower than it might have been otherwise.

The rewards for those who have steadfastly remained disciplined is that they are now approaching the Point of Recovery and need to hold their line, and for new investors, they are now at the Point of Maximum Financial Opportunity going forward. Once momentum begins to gather it won’t take long for the crowd to start moving. Better to be a crowd leader than a follower.

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20
Mar 2015

Direct shares v managed funds

Direct shares v managed funds

Written by Hudson Advisers

I've recently heard from at least three Hudson members who plan on reducing their direct share exposure, primarily because they are at the end of their tether in trying to keep up with them.

These are precisely the types of investors that would benefit from a managed fund portfolio, rather than a direct share portfolio – and yet still have a similar stock exposure, albeit without direct ownership.

The main differences I see in the direct shares versus managed funds debate are as follows:

Administration

The not so good - Buying into direct shares means a bi-annual statement for each stock held. If you hold 10 stocks, that’s 20 statements per annum that require filing.

The Good - Managed funds reduce the administration dramatically. Investors can access a range of funds under the one platform, effectively capping the paperwork to 2 statements per annum. This may seem trivial, but if you are like me and absolutely abhor filing, it is so very appreciated.

Taxation

Not too bad - most shares and managed funds provide dividends/distributions through the year, which go towards an investor’s assessable income that is ultimately taxed (regardless of whether the dividends/distributions are taken as cash or reinvested).

Much better - Managed funds go one step further and actually distribute realised capital gains through the year also, which are taxed at the investor level as per normal capital gains. This is due to the fund managers buying and selling stock on your behalf as they see fit.

Not so good - With direct shares on the other hand, capital gains tax is only applicable when the investor sells some of his direct ownership of the stock.

A way to avoid realised capital gains being passed on from managed funds is to invest in an index or passive fund. These funds simply follow benchmarks so there is no active buying and selling (and subsequent realised gains/losses) of underlying assets.

Fees – fees apply to both direct shares and managed funds.

One-Off - Direct shares attract brokerage on entry and exit.

Ongoing - Managed funds attract entry fees as well as an ongoing annual management fee.

The matter of fees is quite subjective – for example, I personally am happy to pay the ongoing management fees on my managed funds if it means minimal paperwork! For other more fee-sensitive investors, this can be a major hurdle in accepting managed funds.

Regular Savings Plan – The Good thing is for investors wishing to capitalise on a more regular method of investment and compounding returns (rather than simply reinvesting dividends), managed funds can offer an automatic way of picking up additional stocks every month.

Setting up a regular investment plan is a way to enforce saving. The majority of my members admit to being horrible savers, but terrific bill payers. So, like all bills, once the commitment is made, the funds are always made available to pay (and more importantly, are rarely even missed!).

MANAGED FUNDS

PROS - Diversification | Low start up costs | Expert management | Regular investment options | Potential to earn income or reinvest | Potential for high returns | Low administration.

CONS - Entry fees | Ongoing fees.

DIRECT SHARES

PROS - Low start up costs | Potential for high returns | High degree of control | Potential to earn income or dividend reinvestment.

CONS - Limited ability to diversify its small capital amount | Subject to market forces | Subject to higher risk | Brokerage.

There has been a move toward recommending managed funds of late for a couple of reasons:

Intellectual diversification: - It is not in an investors best interests to have a direct portfolio based on one person's intellect.

This is what you get if you use a broker(one) or yourself (one). Utilising managed funds you can spread micro decision making (which stocks) across several entities (for the same cost as using just one entity). NO one individual person, broker or fund manger will top the performance charts year after year – so spreading the intellectual decision making reduces the risk of your portfolio under performing the market.

 

Asset class diversification – By our very nature direct share investors invest in Australia almost 100% (just 3% of the world). Our Australian sharemarket is over-represented by banks and the resource/energy sector (according to an article by Eureka Report) almost double that on the global scale. Investment in Managed funds is the simplest and easiest way to diversify into other asset classes. It should be noted that since the GFC global markets have outperformed Australian markets as a whole.

In recent years (post GFC for instance ) Australia has under performed the rest of the world (eg Aus index v USA S&P 500 index).

In Australia 53% of our markets are made up of banking and resource/energy stocks. Compared to 26% elsewhere.

 

Composition of StocksInValue international coverage by sector vs Australian Stock Exchange as measured by Thomson Reuters industry classifications. Source: Thomson Reuters Datastream

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20
Mar 2015

Is a residential property a good asset to hold in retirement?

Is a residential property a good asset to hold in retirement?

Written by Hudson Adviser Michal Park

Hudson has long recommended residential property as a sound growth asset suitable for most members’ portfolio during their working lives when they are earning a taxable income and are looking for growth from their asset base.

Property provides good growth prospects over time, reasonable yield, tax effective investing, bank friendly financing and ease of understanding. So all round it is a good asset class to include in most portfolios. 

But it is not a particularly attractive asset to hold in retirement. 

Why? Well, the attributes listed above that make it an attractive growth asset during a person’s working life, making it – relatively speaking – less attractive in their post working life.

In retirement, you are seeking an asset base that provides:

  • A good yield and;
  • Some growth (to fight inflation that erodes the purchasing power of your capital) and;
  • Tax effective income and;
  • Liquidity and divisibility and;
  • Low maintenance costs

.........And, mostly in the above order.

1 - Residential property provides a moderate level of “gross income” in the order of 4 to 5% of the underlying capital value. This is a relatively poor yield in comparison to dividends from shares, interest from cash and distributions from commercial property trusts (listed and un-listed).

2 - Well located residential property will provide good growth over the cycle but in retirement, growth assumes less importance than these other attributes. As the old saying goes ‘You can’t eat growth’.

3 - The rental income from an un-geared residential property with limited tax deductions is pure income in the hands of the owner. Compare this with franked dividend income or tax-free income derived from an allocated pension, derived from Super money (for those over 60).

4 - Residential property is illiquid – it takes 30 days to sell (at best), comes with extremely high transaction costs, and it is not divisible as other preferable retirement assets are (such as shares or fixed interest investments). Remember you can’t sell a room in a house – you have to sell the whole house.

Ongoing costs associated with residential property can be high and detract from income returns in retirement. Think body corporate fees, council rates, management fees and maintenance fees. These are particular to property and do not apply to other preferable retirement asset classes.

So, residential property is an excellent growth asset to be held during your working life when growth is paramount, tax deductions are extremely helpful and cash flow from earned income is present.

However, residential property is not the preferable asset class to hold into retirement and members should be looking to consolidate and reduce their exposure to this asset class in or approaching retirement in a tax effective manner (i.e. sell when income is lower and over a few financial years).

The proceeds can then be used to contribute into Super or buy other more highly liquid higher yielding (and growth) asset classes that will provide the appropriate balanced portfolio with the tax effective yield required for your retirement income needs. 

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