What Investment Options Do You Have?
You’ve made up your mind to start investing. The next question you ask is – Where? A quick Google search throws up two main options – Investing in Property or Investing in Shares.
We’ve all grown up hearing of the Great Australian Dream. Get a job, make some money, put down a deposit on your dream home and then live happily ever after. This was the grow-rich-scheme that worked for our parents and their parents. But today’s world is very different.
Property vs Shares
Property is at an all-time high, some would even say that it’s enveloped in a bubble. That means that you have to put together a lot of equity just to be able to enter the market. And if you’re looking to buy in Sydney or Melbourne, the upfront payments for a good property are even more formidable. Then of course there is the aspect of taking out a home loan and paying interest on the borrowed money. Ongoing maintenance expenses on the property in the form of Strata Fees, Council Fees, etc. apart from actively dealing with tenant management also take up a fair bit of time, effort and money. And if you want to divest, property is not that easy to sell, making it an illiquid asset.
Property investments of course can feel more secure being bricks and mortar, have a high emotional value and their value can be less volatile.
The other option then is investing in Shares. But you don’t know anyone who invests in shares. Your parents didn’t do it, your friends don’t do it and neither does your neighbour. Warren Buffett is perhaps the only investor you know of. The only time that you ever sit up and notice the share market is either when it’s touching newer heights or when it’s tanking. And how do you even invest in shares?!
These are all great questions and while they seem intimidating, but they are all very surmountable. Most people in FI invest at least some, if not all, of their portfolio in shares. Here’s why.
Shares or units of corporations are nothing but a small portion of their ownership.
When a business starts out, its shares are typically held by the founders and perhaps some employees. As it grows, its need for capital grows and it starts to add more and more investors who provide it with more and more capital.
When you buy a share of an entity, you effectively become an owner of the enterprise, albeit a small one. This entitles you to the profits that the corporation generates. There are two ways that these profits are passed onto the shareholders. It is either distributed in the form of Share Dividends or is reinvested into the company for growth which leads to an increase in the share price leading to overall Capital Growth.
When a business becomes large enough and its need for capital becomes big enough, it can go ‘public’. This means that new shares of the business are issued and sold to the public for cash. These public shares are then listed and traded on stock exchanges such as the Australian Securities Exchange (ASX), New York Stock Exchange (NYSE), etc. Listing with an exchange comes with a lot of compliance requirements and public oversight, significantly reducing the associated level of risk. The price at which these shares are traded is dependent on the demand-supply of the shares which effectively is dependent on the health of the business, the sector in which it is in and the economies in which it operates.
Investing with Shares
Getting Started is Easy
It is pretty easy to get started with investing in shares. All you have to do is register with a share broker and you’re set. Brokers come in all shapes and sizes, starting from low-cost online brokers like Pearler & Self-Wealth, to online robo-advisors such as StockSpot & Raiz, to more traditional brokerages such as CommSec, NAB Trade, etc. The entry barrier to share investing is also pretty low. You can start buying shares with as little less as a few thousand dollars especially with low-cost online brokers & robo-advisors. The entry barrier is a bit higher with traditional brokerages.
What makes investing in shares unlike anything else is that the income you derive from them in the form of Dividends is completely passive income. Meaning that all you’ve had to do is provide capital to the corporation. Once you do that, the corporation’s hardworking employees start working for you, with their sole motive being shareholder value growth, while your own involvement is completely non-existent.
The biggest differentiator that share investing offers is that depending on your choice, you could invest in any asset class such as bonds, gold, equities and even real-estate. You could get exposure into any industry in the world, ranging from Oil & Gas to Pharma to Tech. Geographic limitations don’t apply to you either. Sitting in Australia, you could invest anywhere in the world; in developed economies such as the US and Europe and even emerging economies such as Asia, South America & Africa.
Because these shares are publicly traded on the stock exchanges, you can liquidate and exit at any time. This allows for a tremendous amount of flexibility in the management of your portfolio and even cashing out if for some reason you require funds urgently.
|Ease of Starting||High||Low||High|
Share Investment Strategies
Just like diet fads, a new type of share investing strategy emerges every few years, but almost all of them fall within the following four major categories.
The basic premise of value investing is that stock markets are irrational and that there are good companies on the market that are currently undervalued. Value investing requires considerable fundamental and technical research on the part of the investor who is looking to unearth these hidden jewels. Once found, the value investor invests significantly into these undervalued companies with the expectation that in time the markets will correct themselves and these undervalued companies will start trading at their real value. Value investors therefore rely on getting a great deal when buying. Our good, old Warren Buffett falls within this category.
Growth investing has been traditionally seen to be the diametric opposite of Value investing. It relies on finding stocks that have the greatest growth potential in the future. Growth investors also spend a lot of time determining which industries will see the greatest growth and which companies within those industries are poised to be the driving engines. At the time of investing, a growth investor is not bothered about whether the shares are undervalued, overvalued or right-valued. They are only looking at the future. Most tech investors that got into the likes of Apple, Facebook, Netflix, etc. would fall within this category.
This is a strategy in which the investors buy stocks that have historically offered high dividends, in order to create a regular revenue stream from dividends. These stocks typically belong to well-established companies that distribute their profits back to their shareholders. A lot of retirees prefer this type of investing strategy.
In contrast to value, growth & dividend investing which require active stock-picking, Index investing offers a much more passive approach. Investors attempt to generate returns similar to a broad market index such as the ASX 200, S&P 500 or even specific currencies such as the USD or commodities such as Gold. Exchange Traded Funds (ETFs) have been the flag-bearers of this methodology. ETFs are financial products that trade on the market and provide exposure to underlying shares and other assets such as bonds, commodities, real estate, etc.
Index investing is a particular favourite for Financial Independence, not only because it is hands-off, but also because many studies have shown that over the long term index investing almost always outperforms most stock-picking strategies. Even Warren Buffett touts the advantages of low-cost index investing over stock-picking for smaller investors when he says “By periodically investing in an index fund, for example, the know-nothing investor can actually outperform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.”
However, if you are more inclined to go with Value, Growth or Dividend Investing but do not want to spend the time researching and picking, you could choose to invest in a Managed Fund. Managed Funds pool money from different investors which is then invested by an experienced fund manager. Many different types of Managed Funds exist in the market with different types of investment themes to satisfy almost every type of investor.
|Value Investing||Growth Investing||Dividend Investing||Index Investing|
|Share Attributes||Under-valued||High-growth||High dividend yield||Index|
Taxation & Franking Credits
FI is all about maximizing your saving rate. That can be done either through increasing your income or minimizing your expenses. One key component of expenses which a lot of us fail to consider is taxation.
Whenever you earn any income, be it through labour or through capital, the government will take its pound of flesh, but what’s interesting is that income from labour is generally taxed at a much higher rate than income from wealth. What does that mean? In simple words, it means that your salary attracts a higher tax than the returns that you make on investments.
Another key nuance of taxation which is very typical to Australia is Franking Credits, which further helps in reducing the tax on capital income. And as we learnt from the 2019 Aussie elections, franking credits can make or break governments.
Here’s a quick primer on how each component of your income is taxed.
Income from Salaries
This is the one that you would already be most familiar with. At the end of every financial year (FY), you provide a summary of what you earned to the ATO and they calculate how much income tax would be levied on you. The rate of taxation depends on your income bracket and the rate that you get charged is called the marginal tax rate. For a yearly income of more than $90,000, your marginal tax rate would fall somewhere between 32.5% – 45%.
Income from Dividends
The dividends that you receive from your investment in shares are also considered a part of your Income for that FY and are required to be taxed at your marginal tax rate. But that’s where Franking Credits come in. Franking Credits are a mechanism to avoid double taxation of profits. So when a company pays corporate taxes, it gets an equivalent amount of franking credits, which it can pass on to its shareholders along with any dividends that it pays them. The shareholders will show this Dividend received as an income in their tax returns but will also be able to show the franking credits as a deduction, meaning that they will effectively be required to pay taxes only on the unfranked portion of the received dividend.
Capital Gains/ Losses
Capital Gains arise when you sell an asset such as a property or shares at a price that is higher than what you bought it at. If however you sell your capital assets at a lower price, it is considered to be a Capital Loss. Capital Gains are also taxed at your marginal tax rate, but if you have held onto your capital asset for any more than 12 months, your Capital Gains Tax is automatically reduced by 50%. In case you’ve made a Capital Loss, then you are allowed to set it off against any other Capital Gain that you would have made that year or else you are allowed to carry that loss forward to future years.
Key Fundamentals of Investing With Shares for Financial Independence
Investing with shares can seem somewhat daunting when you’re starting out. When do you enter the market? How often should you invest? Which shares/ ETFs should you buy? What if the markets are volatile, what should you do then?
There are some key fundamentals for FI that would make this whole process simple and streamlined.
Develop an Investment Plan
This is perhaps the most critical step to any form of investing. Understand your cashflows. Determine what your investment horizon is and how much risk you are comfortable taking. This will help you narrow down to the asset allocation that is ideal for you. That asset allocation will help you determine what percentage of your total investment should be investing into shares along with what type of share investment strategy would be best for you. It will also help you define how you should look after your investments over time.
Minimize Investment Costs
A key goal for FI is increasing the savings rate. It is therefore imperative that in your decisions regarding share investments, you keep this key fundamental firmly in mind. When choosing a stock broker, critically evaluate their brokerage charges and overheads. Often it is best to choose low-cost online brokers or robo-advisors. The same factor should also come into play when selecting between different ETFs, Managed Funds, etc. Not only should you choose a product that has performed well historically, but take into consideration their management fees. A higher management fee could significantly dent the returns that you can stand to make over the long term.
It is easy to fall into the trap of wanting to time the market to make the most of your investments. But that almost never happens. It’s impossible to determine when the markets are at their top or when the next downturn is coming. The strategy that works best with share investments is that of consistency. So chalk out how often you can invest in the market. It could be weekly, fortnightly or even monthly and then keep that timetable. What consistency does is that it allows you to take the benefit of dollar-cost averaging, which will let you ride through the market volatility mostly unscathed.
Diversify Your Investments
Diversification is a risk management strategy that helps you reap more stable returns from your investments. It’s good to have exposure to all major asset classes such as equities, bonds, gold and real estate. Given how globally connected we all are now, it also makes sense to diversify your assets geographically. Diversification balances your investment portfolio, which means that you’re never overly reliant on a particular type of investment. And because some of these assets classes are inversely correlated to one another, meaning when one goes up, another goes down, it’ll leave you squarely in the middle with stable returns.
Be in it For the Long Term
Share markets are volatile and investor biases abound. Every decade or so, the global economy and in turn the share market goes through a slump. So in your investment lifetime you will see a lot of ups and downs. But don’t let these scare you. Keep your head down and continue investing. Remember you’re in it for the long term. Whatever may happen in the short term, there is no better way to grow capital in the long term than investing in the share market.
This chapter is a part of the Aussie FIRE e-book.