THE NUB

In the boom-time clamour to make money, the basics of investing often were set aside.

The sharemarket crash was a reminder that -- good times or bad -- we must never lose sight of the relationship between risk and return. The potential for high returns necessarily comes with high risk.

Blessed are the meek, for they shall inherit the Earth. But in the boom-time clamour to gear up, chase yield and leap into exotic investments those people following a more traditional path must have felt occasional doubt.

Then came the bolt of lightning that was the global financial crisis. Wealth no longer multiplied like the loaves and fishes, the Bernie Madoffs of this world were exposed as false gods, and we had to be reminded – again – that greed is not good but one of the seven deadly sins.

There were some harsh lessons as the Australian sharemarket plunged 55 per from its November 2007 peak to the trough in March this year.

The losses have been even more devastating for those caught up in disasters such as Westpoint, Opes Prime, Storm Financial and this year’s managed investment scheme collapses. It was as if a plague of locusts had stripped them bare.

Given the biblical nature of the crisis, perhaps it’s time to ask what might have been written on the tablets of stone had Moses conferred on Mt Sinai with the Great Financial Adviser in the sky.

We consulted more widely, and with those more worldly, to come up with this set of 10 Commandments to keep you out of the investing wilderness.

1. Remember the relationship between risk and return; keep it Holy.

“If there’s an immutable law in investing it’s that high returns always mean higher risk – always,” says ipac’s national manager for advice strategy, John Dani, emphasising that last word.

Unfortunately, people start to covet the higher returns promised in advertising or boasted by friends, whether the risk associated with chasing those returns matches their investment profile or not. They bite into the apple. “That’s when it all becomes unstuck,” Dani says.

Determining your risk profile and therefore what’s an appropriate investment involves thinking about why you’re putting this money away and when you’ll need it again, Announcer Financial Planning advisers Phil Sgangarella and Michael Sik say.

The sharemarket is not the place to park a home loan deposit you’ll need in the next 12 months, but it’s an appropriate place if you’re saving for retirement and have enough time to recover from the inevitable negative year – or two – along the

way.

2. Thou shalt remember that leverage is a double-edged sword.

It wasn’t that long ago that people looked at you sideways if you weren’t geared up to the eyeballs, but leverage is the highest risk you can take, HLB Mann Judd wealth management partner Jonathan Philpot (ed: correct) says.

Borrow to increase your investing power and the pressure’s now on you to achieve an even higher return just to offset the interest cost.

This strategy might suit a young professional who’s got the time and the cash flow to ride through market cycles, but a retiree probably shouldn’t take such risks with their life savings.

Debt in the form of margin loans was central to both the Opes Prime and Storm Financial collapses. Storm’s highly leveraged clients were left owing something like a combined $20 million more than the value of their portfolios after the market plunge.

Worse still, some of them were “double geared”, says Announcer’s Sgangarella – they borrowed against borrowings against their home.

The lesson: just as leverage amplifies your gains in a rising market, it also amplifies your losses in a falling one.

3. Thou shalt diversify.

The people who have suffered the most are those who had a lot, even all, of their money in the one place ­– the wrong place, as it turned out. For their sins, they may have lost the lot.

“Things can go wrong, the unexpected can happen,” says Strategy Steps director Louise Biti. That’s why it pays to diversify across and within asset classes, to spread your risk.

Rather than investing 100 per cent in Australian shares you could invest also in fixed-interest assets and property. Within your share portfolio, rather than having just resources stocks you could also hold banks, retailers and utilities.

If one investment should go horribly wrong you might lose 5 per cent of your money, but not everything.

“The lessons of diversity have been learned the hard way by investors who put all their money into one asset that was giving the highest returns at the time, such as debentures of companies that have now failed,” HLB Mann Judd’s head of wealth management, Michael Hutton, says.

“It never makes sense to put all one’s capital in one asset class, no matter how attractive it may seem at the time, whether it’s equities, high-yielding debentures, property or the perceived safety of cash.

“With a diversified portfolio it doesn’t matter so much if some investments underperform as long as they don’t make up the majority of the portfolio and other assets continue to perform well.”

4. Honour thy asset allocation

Having decided on an appropriate mix of investments, stick with it. When greed takes over, people start to forget about risk profiles and time horizons and pile into the “next big thing”, regardless of how it fits with their investment strategy.

Leverage only increases their exposure. As a result they find themselves with too much money in relatively risky assets when the inevitable downturn happens.

When fear kicks in, investors jump the other way, abandoning well thought out strategies in the flight to cash. But with cash offering such low returns at the moment – you’re lucky to get 4.5 per cent in a high-interest account or term deposit these days – there’s the “opportunity cost” versus better-performing assets as well as the risk of capital erosion through inflation, Hutton of HLB Mann Judd says.

Light a candle for those poor souls who capitulated in early March, selling their shares and crystallising their losses at what analysts say is likely to have been the bottom of the cycle.

5. Thou shalt not invest in anything thou doth not understand.

During the boom years investors’ hunger for yield took them into exotic terrain – whether they realised it or not. The high yield promised by product promoters often was generated by exposure to opaque, engineered products such as collateralised debt obligations. While ordinary investors may not have put their money directly into such instruments, they were unwittingly exposed to them through things such as supposedly AAA-quality “enhanced cash” vehicles. The word “cash” made people feel safe but these products were juiced up by mixing high-grade fixed interest products with toxic debt such as the subprime mortgages that triggered the global financial crisis.

Louise Biti says there’s no such thing as a stupid question when it comes to placing your money. “If you don’t get it, it’s your right to ask,” she says.

Warren Buffet never invests in anything he doesn’t understand – nor should you.

6. Thou shalt not buy tree investments – money does not grow on trees.

There’s no point abstaining from tax only to lose your savings, ipac’s national manager for advice strategy, John Dani, says. “Where people lose their way is by being hypnotised by tax,” he says. “But a tax deduction should only ever be regarded as a fringe benefit to a viable underlying investment.”

No tax deduction makes up for a poor investment. Just ask the people who were in the Great Southern and Timbercorp managed investment schemes when they collapsed this year.

7. Thou shalt pay heed to fees and taxes.

In the end, you have no control over how investment markets are going to behave, Morningstar communications manager Phillip Gray says. “But what you can control is the money you pay for access to those investment markets.”

Investors falter when they don’t investigate precisely how much they’re paying and what for.

“When investors are getting returns of 18 to 20 per cent in an up market they’re probably not going to pay any attention to the fact they’re paying 1.5 to 2 per cent out of that in fees. But if they’re getting minus 20 per cent and they’re still paying 1.5 to 2 per cent people start to pay much more attention,” Gray says.

Potentially, you could be paying up to half a dozen different types of fee, from management fees, platform fees and annual service charges through to performance fees and a trailing commission to your adviser.

A “sleeper” issue is the impact a fund manager’s practices have on the tax people have to pay. A fund with high turnover of stocks, for instance, can generate unwanted capital gains tax liabilities for the end investor.

So, consider what your return is after both fees and tax. Unfortunately, in Australia there’s no requirement for managers to report performance on an after-tax basis and only a handful do so.

8. Thou shalt discern an adviser from a salesperson.

Failures such as Westpoint and the timber schemes, where advisers took commissions of 10 per cent, and perhaps as much as 18 per cent, have only highlighted the longstanding concerns about whether such payments colour financial planners’ advice. The Australian Securities and Investments Commission says on its fido consumer website (www.fido.gov.au) that important clues as to whether an adviser is dodgy or dedicated are whether they make you feel comfortable about asking questions, encourage you to take your time and want to understand your situation thoroughly. “Being talked at, put under pressure or told there’s only one right way to do things is not a good sign,” ASIC says. “You’re looking for an adviser, not a salesperson.”

So far 22 licensed advisers, four unlicensed advisers and one corporate entity have been banned by ASIC in relation to advice around Westpoint products.

By the same token if you’re lucky enough to have found a good financial planner, make use of them.

9. Thou shalt not worship false gods.

Funnily enough, Bernie Madoff didn’t like to answer questions. The Wall St financier guaranteed a sizzling return in all markets but wasn’t keen to talk to people about how he achieved that. Those who got through the door to ask the right questions were the ones who said “thanks, but no thanks”. The wonder is

Madoff took $50 billion before his Ponzi scheme – whereby funds from new investors were used to cover “returns” to old investors – was uncovered. Last month he was sentenced to the maximum 150 years’ jail for defrauding investors.

10. Thou shalt not expect bull runs – or bear markets – to last forever.

Everyone’s an optimist when returns are high and they invest on the basis that the good times will last forever. The trouble is that’s an unrealistic expectation. Analysis of nearly three decades of data by fund manager Dimensional Australia shows that the average bull run in fact lasts about two and a half years.

By the same token, everyone’s a pessimist when returns are poor, let alone negative. Yet the average bear market lasts about 10 months.

Not even the professionals are able to consistently pick the turning points – all the more reason to follow the 10 commandments of investing.

THE NUB:

• We're living longer, so our retirement savings have to last longer - 20 years on average ... but for many people, even longer.
• Yet we started taking risks with our retirement savings, lured by juicy sharemarket returns that have since evaporated.
• Now the Henry tax review is considering whether we should be encouraged -- even compelled -- to put, say, 25-30 per cent of our super into some sort of 'lifetime' annuity product or longevity insurance.
• If we're happy to take the tax benefits of the superannuation system, surely we have a responsibility to husband that money?

By Lesley Parker
Sydney Morning Herald, August 5, 2009

Australians may finally have to come to grips with longevity risk - the danger they'll last longer than their retirement money - as superannuants count the cost of the financial crisis and the Henry tax review considers whether people should be forced to buy long-lasting retirement income streams.

It's been obvious for some time that the fact we're living longer means our retirement dollars will have to stretch further.

On top of that, recent investment losses in super funds have left some retirees in a financial position from which they may never fully recover. Retirees who were previously self-funded have had to go back work, while others have started drawing a part or even full government age pension, or will do so earlier than they might have done otherwise.

Meanwhile, the Henry tax review's interim report into the retirement income system has flagged that its final recommendations, due in December, will address the ability of people to use their super to manage longevity risk - so they don't just use the age pension as a 'put' option - once the money runs out.

''While super generates assets for retirement, current arrangements do little to ensure that those assets can be used for income purposes throughout the years of retirement,'' the review panel says in the interim report. ''As people live longer, there is a growing risk that individuals will exhaust their assets before they die.''

The chief executive of Challenger Financial Services Group, Dominic Stevens, says that, technically, after 40 years of compulsory contributions to super, a retiree could withdraw the lot and put it on red at the casino.

''A lot of that money will be the benefits of the tax breaks,'' Stevens says. ''But if you put it on red and lose, the taxpayer will end up supporting you.''

The Henry review's interim report describes a lack of products to insure against longevity risk as a structural weakness in the retirement income system, which was set up to relieve the fiscal burden of the Government pension as the population ages.

It says it will look at whether people should be forced, or merely encouraged, to use some of their retirement savings to buy an income stream and mentions the 'interactions' with the Centrelink means tests and the tax system in this regard.

Superannuation industry body ASFA the 'Voice of Super' suggested in its submission to the Henry review that one option would be to compel people to put, say, 25 per cent of their retirement savings towards buying some form of ''longevity insurance''.

ASFA chief executive Pauline Vamos says that could be an actual insurance policy, a product such as a lifetime annuity or some new combination of the two. Challenger, which has a foot in each camp with insurance and funds management arms, has proposed a mandatory 30 per cent be quarantined for an income stream.

Currently, longevity insurance isn't widely available in Australia and lifetime annuities have plunged in popularity since the Howard Government removed the means test exemption for complying income streams in 2007. They were a 'hard sell' anyway, at a time when prevailing interest rates, to which they're linked, were low but returns from investment markets were tantalisingly high, says Ipac Securities' head of technical services, Colin Lewis - who nevertheless believes that after pocketing super's tax benefits people have a moral obligation to make that money last.

Annuities provide guaranteed income streams and ''lifetime'' annuities or pensions provide payments for the rest of your life. The income isn't linked to market movements but contracted at the outset and the money can't be withdrawn as a lump sum. If you die earlier rather than later, the provider keeps the balance of a lifetime annuity, unless you've paid extra for the option of the payments reverting to your spouse.

The Australian chief executive of Lazard Asset Management, Rob Prugue, notes that when the US introduced its social security system in the late 1930s, life expectancy was 62 years but the age pension didn't kick in until 65.

Today, he says, even hard-living souls, like Keith Richards from the Rolling Stones, make it to 65 and the healthiest specimens can make a century.

But the trouble is that in recent years the super system has been more about 'wealth creation' and not so much about funding the liability of a potentially long retirement.

''Many of us have been lured by robust returns rather than trying to properly build a portfolio that could actually meet our financial obligations ... portfolios with true long-term objectives,'' he says.

Vamos says ASFA's research shows that people do like the idea of a long-term income stream - that Australians aren't just going out and blowing their lump sums on an Audi instead of an annuity. ''But somewhere along the line, perhaps, people aren't going to have enough money,'' Vamos says. ''They need to think about part of their money being set aside to manage longevity risk.''

Modelling by researcher Towers Perrin for the Challenger Financial Services Group found, for instance, that someone who retires at age 60 and uses $500,000 in retirement savings to buy a market-linked allocated pension could quite possibly deplete those funds by age 84 - just short of the life expectancy for an Australian man. This is based on the person withdrawing a 'comfortable' income of $37,452 a year.

ASFA feels there may need to be a new type of product that combines insurance and funds management, rather than forcing people to choose between the certainty of a low-return lifetime annuity and the potential for capital growth in a market-linked product that could help their money go further. Other options it has suggested include applying mandatory minimum and maximum withdrawals to a broader range of pension products.

Stevens says Challenger's view is that between the ages of 20 and 65, retirement savings are all about return but from 65 it's all about risk and you don't earn a big enough premium over the safety of government bonds to take on the risk of equities at this later stage in life.

The trouble with an allocated pension - and the relatively high exposure in Australia to equities - is that, in essence, people are acting as ''their own little life insurance company'', self-insuring against the risk they'll live longer than the average, he says.

''Do you have the skills, the understanding, the administrative ability to do all that?" Stevens asks. "If you get it wrong, can you go to the equity market and recapitalise.''

The recent sharemarket crash showed how devastating a negative year can be for someone just entering retirement, he says (see tables for growth and equity options).

''If you have a 13 per cent fall in the first year of your retirement, the statistic is that you have north of an 80 per cent chance of not meeting your [retirement] goals," he says. "If you have a bad year in the first two or three years, it massively affects the way your retirement pans out. We're saying there should be some form of incentive, or requirement, to put some money towards a more riskless strategy, like an annuity, so they don't get into these problems.''

A recent OECD report into pensions says equities should remain part of people's retirement savings strategy but it promotes the concept of ''life-cycle investing'' - moving from riskier assets to less risky assets, such as deposits and government bonds, as people near retirement (see also page 15).

''Governments should at least encourage people to choose this strategy but it may be necessary to go further,'' the report says, suggesting they mandate that a 'life-cycle' investment option be the default option within super funds.

Most members never exercise investment choice and thus would be covered by this option.

Welcome

Welcome to Folio Media, the blog of journalist Lesley Parker.

I specialise in personal finance ... consumer finance ... how to keep your budget, your credit card, your home loan, your insurance, your retirement savings under control.

You'll see my work in Sydney Morning Herald Money ... and here ...