This article appeared in the February 2011 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
Although Australians love shares, it has not always been that way. After property investment, we have traditionally directed any leftovers into investments that are considered safest, such as savings accounts, term deposits and debentures.
Plenty of people still do and it is probably wise to keep some of your money available in interest-bearing assets most of the time. But even though these investments are about as safe as you can get - you are very unlikely to lose all or even part of your money - they carry other less obvious risks.
The biggest is that interest-bearing investments alone may not help to increase your buying power, because they do not always provide enough protection against the two key "capital gobblers" - inflation and tax.
While most investors spend their lives worrying about day-to-day fluctuations in share prices, housing prices and so on, a much bigger problem for most people over the years has been the awesome corrosive power of inflation.
Albert Einstein may have claimed that compound interest was the greatest human invention but, when it comes to inflation, the compounding is working against you - all those 2 and 3 per cents per annum really add up.
Even at relatively low levels, inflation's effect on buying power over extended periods of time can be catastrophic.
In 1960, a standard postage stamp cost 5 pence, or 4.2 cents in decimal currency. Today it costs 60 cents. That is an increase of almost 1329 per cent in 50 years, which is roughly the length of the average working life.
From this one piece of information, we can already draw two very important lessons:
- Prices can't help but spiral upward over time,
- The value of your investments has to rise quicker than prices for you to get ahead in order to increase your buying power. And that is before we even think about paying the tax office and other nasty surprises.
Let us look at an example.
Beating inflation and the tax office
Say you put $5000 into a cash management trust that pays 4 per cent interest each year. At the end of year one, your $5000 has increased to $5200, just enough interest to buy a top-of-the-range pair of running shoes.
Say prices are currently rising by about 2 per cent each year, so we have to include this in working out how much your buying power has actually increased. It turns out that the real gain on your $5000 capital, taking inflation into account, is not 4 per cent but 2 per cent, or $100. But don't spend it just yet.
Next, the tax office wants a cut. Income from interest-bearing investments is taxed just like salary, at your marginal tax rate. Here's the real sting: you don't pay tax on your $100 real gain, you pay it on your $200 nominal gain, even though half of it disappears in higher prices.
If your marginal tax rate is 30 per cent, you will pay $60 tax (30 per cent of $200), and make a $40 real gain.
If you are on the top marginal tax rate (47 per cent), you will pay $94 tax. Your net increase in buying power is reduced to $6.
At least you have not lost ground, but if inflation had been any higher, or your return any lower, your buying power may well have fallen.
So should you put the $5000 into a cash management trust or not? And the answer is: we don't have enough information to know.
Clearly, the potential rate of return is only one of the variables you need to consider before making an investment. Cash management trusts (CMTs) play a valuable role for most investors and if, for instance, you need ready access to the cash, a CMT may well be a good choice. If, however, you are investing the money for a long time, it is almost certainly not the way to go.
For now, what is important is this simple principle: to increase your buying power over time, you need to earn a rate of return significantly higher than the rate of inflation.
Sounds simple, but you may be surprised to learn that ignoring inflation is still one of the most common investment mistakes.
Shares offer the benefits of a higher prospective real return over time - although the risks over short time periods are higher too - and far more favourable tax treatment than the more "traditional" investments.
The two key foundations of sharemarket investing
Newcomers to the sharemarket often assume that successful investing is all about picking winners - those shares that will perform magnificently over the years, delivering both big rises in price and generous dividend cheques along the way.
Although this is what many investors aim for, it is by no means the only way to do well and is often a triumph of hope over experience.
Even for professional investors, "wonder stocks" are the exception rather than the rule. And until you really know what you are doing, even attempting to outsmart the market by relying on one or two "hot" picks can be a good way to land in the poorhouse.
Similarly, although things are changing, plenty of would-be investors are still deterred from shares by the belief they are taking on too much risk, and may in fact lose all their money. This is an attitude often developed with experience of the speculative market, or a cursory reading of newspaper headlines surrounding the latest corporate collapse or share price plunge.
Whenever you make an investment it is important to understand the risks you are taking. This way, you can base your decisions on the most likely outcomes and consider carefully how they may affect your personal situation.
For now, we will concentrate on two key foundations that provide a useful entry point for our understanding of the sharemarket.
Key foundation one: the sharemarket naturally tends to rise over time
It is easy to forget this first foundation when the market is in free-fall, as it will be from time to time, But the sharemarket has a natural tendency to rise.
Not that the sharemarket will not be hit and hit hard by a crisis. But it always recovers in the end. Although it is entirely natural to be jittery when newspaper headlines scream "market meltdown", it is useful to keep this first principle in the back of your mind.
All this really means is that, even before you start playing, the rules of the game are stacked in your favour. The sharemarket is one of the few things that defies Sir Isaac Newton's law of gravity: what goes up, keeps on going up. Remarkable, when you think about it!
Hundreds of influencing factors
Share prices overall do tend to go upwards over time, but the pattern they trace out along the way is anything but predictable. Hundreds of factors influence the prices of individual shares from one day to the next and, as any watcher of the evening news will tell you, finance reporters dream up any number of convenient but unsatisfying explanations, including "profit taking", "sentiment change" and even "taking a break".
Students of finance sometimes refer to the path that share prices follow as a "random walk" - an expression that presumably arose because it is similar to the path taken by a Wall Street drunk.
Not only does the market itself tend to rise over time, but individual shares tend to move more or less together as well. This is simply because many of the same forces are acting on the performance of all shares, and on the companies behind those shares, at any particular time.
Dozens of factors slug it out every trading day in the battle to influence investor sentiment toward the sharemarket. For example, the performance of the domestic economy, global economic factors, the market for interest-bearing securities (particularly interest rates), the state of the property market, commodity prices, and even changes in government legislation. All affect the relative attractiveness of shares.
It should be no surprise, then, that when National Australia Bank (NAB) shares are rising to new highs, there is a reasonable chance that shares in other blue-chip banks such as the Commonwealth Bank of Australia (CBA), and other leading companies will be doing all right as well.
Of course, it is also true that market trends are generally made up of opposing but unequal forces. So although shares tend to move together through time, at any particular time some shares will be rising far more quickly, while some will be falling far more heavily than others. What this means is that a rising sharemarket may be propelled by a large number of shares (a broad-based rise), or a small number of shares (a concentrated rise, or "bad breadth" as some describe it).
Rest assured that the natural tendency of the sharemarket is to work with you, rather than against you. And here is the best piece of news you will hear all day: the sharemarket will generally work harder for you than other more traditional investment markets - our second key foundation of sharemarket investing.
Key foundation two: shares tend to rise more strongly than traditional investments
Although all the economists in the world laid end-to-end may never reach a conclusion, they must certainly agree on this one historical fact: over time, shares tend to outperform other more traditional investments.
Of course, there are good reasons why shares tend to produce higher returns than other investments over time, the most obvious being that the risk of losing money through shares is generally higher than from cash or other interest-bearing assets. And we all need an incentive to place our capital at risk.
While banks and savings institutions in Australia rarely go broke, companies can and do. But not only can you adopt strategies to reduce the risk of events such as corporate collapses affecting you, the first key foundation established that the sharemarket is more inclined to rise than to fall.
So as long as your money is spread widely enough, one poor investment decision (everyone makes them) should not have a devastatingly bad effect on your portfolio.
Let's get it clear right from the outset, however, that there is absolutely nothing wrong with having some bonds and other fixed-interest securities in your overall investment portfolio. In fact, it is a smart idea for most people and adds to your diversity of holdings. It is just that over most long periods of time, there is a good chance they will not perform as strongly as a well-managed share portfolio.
You are a money lender, not a business builder, and even if the money you lend is used to build the next National Australia Bank, you will receive no more than your original loan plus interest.
In buying shares, however, you participate in a company's growth and get corporate Australia working for you, instead of the other way around.
About the author
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