Tuesday 25th November 2008
The Financial Fortnight That Was
In This Issue
Quote for Consideration
Financial Topic Demystified - Income Planning
Fascinating Financial Fact - The CommSec iPod Index
Market News
Where are we on the business cycle?
Case Studies
3 Factor Model in Action - Updated Dimensional Trust Performance Graphs
Quick Links
 
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Greetings! 
 

Welcome to the latest edition of The Financial Fortnight That Was.

In this edition we consider the basics of income planning, take a look at CommSec's iPod Index, provide a summary of the movements in markets over the past fortnight and look at the link between the economic cycle and share market returns.

 

We are also pleased to continue with the new section looking at case studies this week looking at a couple with $1 million to invest.

 

We hope that you find the material informative and relevant!

A Quote for Consideration 

"We can extrapolate from the study that for the long term individual investor who maintains a consistent asset allocation and leans toward index funds, asset allocation determines about 100% of performance."

Roger Ibbotson, Ibbotson Associates

The True Impact of Asset Allocation on Returns

2001

 
Financial Topic Demystified 
Income Planning
 

Earlier this week we sent out an email to all of our clients.  In it we made some brief comments about the current market conditions.  Included with this email was our rationale for continuing to hold equities within an investment portfolio.  In our conclusion we reminded clients of what we consider an absolute key consideration when building investment portfolios - holding enough cash and fixed interest assets to cover income needs for the medium term while still exposing portfolios to growth assets to take advantage of the long term returns from these assets.   We call this income planning and wanted to take the time to remind readers of this concept by providing an extract from our book "A Clear Direction - Being a Successful CEO of Your Life" covering this topic.

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Once you are retired (whether this be 40 for some or a little later for others), the aim is to replace your 'personal exertion income' (i.e. your income from your job) with your investments - possibly supported by some Centrelink benefits such as the age pension.
 
A great way to look at this process is using 'income planning'.  This involves construction of your investment portfolio with your income needs being a critical part of this process.
 
Let us consider 'income planning' by looking at a case study.
 
The couple in question are 65 years of age, retired, with $600,000 in superannuation and a further $50,000 in 'lifestyle assets' that Centrelink assess for the sake of the assets test (things like their furniture and car).  They own their own home.
 
As a couple they are eligible for approximately $7,500 of the age pension (based on pension levels at September 2008). 
 
Clearly this is not enough to live on, so they decide to draw on their superannuation portfolio at the rate of approximately 5% a year, or $30,000 a year.
 
So the couple needs to plan for an income of $30,000 a year to be provided from their $600,000 superannuation portfolio.
 
In the investment world there are two key types of investments.  The first are often referred to as 'Defensive' investments, such as cash accounts and term deposits - as well as other high quality fixed interest investments like bonds.  These offer very reliable short term returns, usually with easy access to the money.  Their downside is that they don't offer very good long term returns compared to shares and property (average defensive returns over a period might be 6% a year; where shares and property might be 12% a year).
 
The other investments are 'growth' investments, such as shares and property.  In the short term they offer volatile returns - however in the long run (7 to 10 years) they offer returns higher than defensive investments.
 
A reasonable conclusion to draw from this is that defensive investments offer a great short term option, and growth investments offer a great long term option.
 
This hardly sounds profound, yet sits as the basis for 'income planning'.
 
The couple in the case study, with $600,000 in superannuation and looking to draw on this at the rate of $30,000 a year, can plan to keep the money that they need in the short term in defensive investments, with the remainder in growth assets.
 
They might set aside 5 years ($150,000) in cash and fixed interest investments - to be sure that they have at least 5 years of living costs set aside.  This should allow them to sleep soundly at night - they know where their next 5 years of income comes from.
 
The remainder is invested in growth assets - such as shares and property investments - which benefit from the higher returns that growth assets provide that cash.  These assets are volatile (may rise and fall in value) - however the couple don't have to be concerned with that because they know that they have the money to fund their next 5 years of living costs.
 
Over the 5 years, there will also be interest received from the cash and fixed interest investments, dividends from the shares, distributions from the property and so on.  In fact, it is not unreasonable to think that a well put together portfolio of $600,000 will pay gross income (including the tax benefits of franking credits) of at least 5% a year - so there is a further $30,000 a year being received by the portfolio.  Because some of this income comes from share and property investments, it will grow over time, helping the portfolio provide an income that will keep up with inflation.
 
Given that 5 years of living costs are set aside in cash and fixed interest investments, and the portfolio is generating a growing income stream of at least $30,000 a year, then the couple seem to be in a really strong position to fund their retirement - using defensive investments to provide short term certainty and growth assets (shares and property) to provide the higher long term returns.

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How Do We Apply This?

 

We use income planning in conjunction with risk profiling to come to a conclusion on the ideal amount of cash and fixed interest assets a client should hold or aim to hold when they commence drawing income from their investments.  In times like now it provides a deal of re-assurance that you can ride out down turns in growth asset prices without needing to sell investments to pay for your cost of living.
Fascinating Financial Fact

The CommSec iPod Index

 

Some readers may be aware of The Economist magazine's Big Mac Index which compares the price of Macdonald's Big Mac burgers across the world.  In January 2007 CommSec launched their iPod Index as a modern day variant of the same concept.  CommSec state that the index is a way of looking at issues such as the impact of currency changes on consumer spending, globalization and retail margins.
 
The most recent data, as of October 2008, shows that of the 62 countries investigated Australia is the cheapest place in the globe to buy an Apple iPod 8gb nano music player when measured in US dollar terms at $131.95.  Australia is followed by Indonesia ($138.47) and Canada ($138.73).  This is compared to being ranked 14th cheapest in July.
 
It just goes to show that the falling Australian dollar exchange rates actually have provided some other good news along with the benefit to holders of unhedged international investments.
 
If you would like more information regarding the index please click on the following link - CommSec iPod Index.

 
Market News
 

ASX P/E Ratio and Dividend Yields
 

The P/E ratio is a common broad indicator of the price of shares.  It is a calculation of the price of shares compared to expected earnings.   A higher ratio indicates that share prices are more expensive.  The historical P/E ratio for the ASX has been between 14 & 15.  The dividend yield is the calculation of dividend payments divided by the market capitalisation of the company or index.  The historical average in Australia is around 4%.

 

As of November 18th the P/E ratio for the S&P/ASX 200 was 8.44.  The dividend yield was 6.44%.

 

Market Indices


Since our previous edition, all growth asset classes have fallen in value.  The S&P ASX200 Index has fallen by 15.67% from 7th to the 21st of November.  It is now down 46.49% from the same time last year and down 46.11% for the calendar year so far. 
 
The MSCI World Index - ex Australia, a measure of the global market, has fallen 14.15% over the same period.  The index is down 44.53% from the same time last year and down 46.74% for the calendar year so far.
 
Emerging markets have also experienced negative movement with the MSCI Emerging Markets Index falling 12.55% since the 7th of November.  This index is down 51.99% from the same time last year and down 54.12% for the calendar year so far.
 
Listed property has continued to fall over the past fortnight.  Australian listed property trusts have fallen 6.39%.  The index is down 61.07% from the same time last year and down 57.07% for the calendar year so far.
 
The S&P/Citigroup Global REIT - Ex Australia Index has fallen over the fortnight by 27.25%.  This measure is down 38.11% from the same time last year and down 37.58% for the calendar year so far.
 
Exchange Rates

As of 4pm the 21st of November, the value of the Australian dollar was down 8.00% against the US Dollar at .6186.  It is now down 30.24% from the same time last year and down 29.83% for the calendar year so far.  Since November 7th the Aussie has fallen 5.79% against the Trade Weighted Index, with the index now at 52.1.  This puts it down by 24.32% since the same time last year and down 24.16% for the calendar year so far.  (The Trade Weighted Index measures The Australian dollar against a basket of foreign currencies.)

Where are we on the business cycle?
Scott's Financial Happenings Blog - Posted Tuesday 11 November
 

Any introductory economics course will have at its heart theories surrounding the business / economic cycle.  The basics of this theory is that economies go through cycles moving from periods of expansion into contraction and then back to expansion.  The basic point of economic policy is to try to smooth out these cycles so that we do not have too strong growth leading to high price increases (inflation) or strong contraction leading to high levels of unemployment.
 
A lot of the talk in the media is whether we are moving towards or are already in one of those contractionary periods.  The technical term is a recession and the technical definition of a recession is a continuous period of two quarters (6 months) of negative growth.
 
Unfortunately we can only be sure about whether we have had a recession after the fact.  But even if we knew where we were on the economic cycle how does this flow through to the investment world?
 
A small article in today's Australian newspaper discusses an investor's perspective of the recession debate - "Future strategy easy in retrospect".  The original article was written for the Wall Street Journal by David Gaffen.
 
In the article Gaffen points out that investors start discounting an economic recovery about halfway through a recession which prompts a rise in stocks that continues as the economy picks up steam.  However two pieces of the puzzle are missing:
 
1. When has the recession started?
2. When is it going to end?
 
He suggests that many believe that a recession began in the US somewhere around the first quarter of this year.  In the 16 periods of economic contraction in the US since 1919, the average length of the contraction has been 13 months.  And the conclusion he makes is that the US recession is at or even past the halfway point.  (To add some further perspective, the two worst recessions of recent times began in November 1973 and July 1981 and both ran for 16 months)
 
Based on this analysis , have markets already priced in the recession and shouldn't we be jumping in boots and all into equity markets?
 
Unfortunately, Gaffen goes on to point out that the recession this time might be worse than average and we may not make halfway for another few months yet.
 
Whichever way you lean on the recession, this discussion provides an interesting perspective and some hope that the worst of the declines at least might be behind us.  We will never know until years down the track.
 
Regards,

Scott Keefer


Other blogs over the past fortnight have included:

 
Case Studies
 

Since our last edition we have received a range of suggestions for future case studies around the topics of tax saving investments, redundancy payouts, investing outside of superannuation and saving for a child's education.  We hope to address these issues over coming editions.
 
To keep the ball rolling we have included a second fictional scenario taken from our most recent book - A Clear Direction - Being a Successful CEO of Your Life.
 
Let us consider investor 2, a 55 year old couple with a $1,000,000 investment portfolio.  They have recently retired and wish for the portfolio to fund their cost of living in retirement.
 
Decision 1 - Defensive vs Growth Asset Allocation
 
The investors want to immediately start drawing $50,000 a year from their investment portfolio.  This is a drawing rate of 5% a year, which should be sustainable in the long term.
 
Now that they are living off their investment portfolio the investor has said that they are not very comfortable with as much volatility in their portfolio.  They feel that they would be able to accept a 20% drop in the value of their portfolio if a 1987 style investment crash (or 2008 collapse) were to recur.
 
The portfolio will also have to act as a 'cash reserve', and the investor has indicated that they would like to have a further $30,000 invested in cash so that in the event of any unforeseen need this money would be available.
 
On the basis of this information it would appear that at least $280,000 of the $1,000,000 should be invested in defensive assets.  This would allow the payment of 5 years of income at $50,000, with an extra $30,000 available if required.  However the reluctance to accept downside beyond 20% of the value of the portfolio suggests that only about 60% of the portfolio should be invested in growth assets. 
 
Let's review this decision against the three key drivers of the decision as to how much of the portfolio to allocate to defensive assets and how much to growth assets.
 
1/         The timeframe of the portfolio.  The timeframe for the portfolio shows that it is starting to be used to fund the investor's living costs immediately.  This suggests that a higher portion of the portfolio should be retained in defensive assets.  Of course, while the investor is retiring at age 55 they may well still be relying on the portfolio in 35 years time, which will require some of the portfolio to be invested in growth assets.
 
2/         The liquidity requirements.  At least $280,000 should be invested in defensive assets to provide the cash needs for the next 5 years plus a cash reserve of $30,000 to cope with any unexpected financial problems.
 
3/         The risk tolerance and experience of the investor.  They have indicated that they are comfortable with their portfolio falling in value by 20% in the case of a 1987 style stock market crash.  This implies a maximum growth asset allocation of 60% of the portfolio.
 
All in all allocating 40% of the portfolio to defensive assets and the remaining 60% growth assets is a reasonable decision.
 
Decision 2 - Within the Defensive Asset Allocation
 
40% of the portfolio, or $400,000, is to be invested in defensive assets.
 
In this case the need for cash can be met by keeping 18 months of income requirements ($75,000) and the $30,000 cash reserve invested in cash. We can round this to $100,000, or 25% of the defensive asset allocation.  The remaining $300,000 can be invested in fixed interest securities that will provide a slightly higher expected return.  At a practical level we would use a combination of a good cash management trust with the Dimensional Five-Year Diversified Fixed Interest Trust to meet this need.
 
Decision 3 - Within the Growth Asset Allocation
 
The first decision that the investor has to make relates to the weighting of Australian shares, international shares and listed property investments within the growth section of their portfolio.  In this case the investor was comfortable with the rationale for investing the growth assets:
45% Australian Shares
30% International Shares
25% Listed Property
 
In this situation the investor has asked that they use a conservative allocation towards value and small companies.  After discussions there is agreement to increase the exposure to the index fund and decrease the exposure to small company and value funds.
 
Within the Australian share portion of their portfolio they have chosen to have 60% of their assets in the index fund, 25% in value companies and 15% in small companies. 
 
Let us again be very clear about 2 factors here - 1/ this asset allocation provides a lower expected return than the asset allocation for investor 1 who had more exposure to small and value companies and 2/ it also decreases the risk (volatility) of the portfolio: taking on less small company and value company exposure decreases both the expected return and expected risk of the portfolio.
 
Within the international shares portion of their portfolio the theme for less exposure to small companies, value companies and emerging markets results in an asset allocation as follows:

60% of the international share exposure invested in an international index fund
20% invested in international value companies
10% invested in international small companies
10% invested in international emerging markets

 
Within the listed property asset allocation the investor was comfortable having 67% exposure through an Australian listed property trust and 33% through international listed property trusts (hedged).
 
The following table sets up the exposure to each asset class and sub asset class.  To work out the exposure for each asset class we start by multiplying the weighting of defensive vs growth by the asset class weighting by the sub asset class weighting.  For example, Australian index fund exposure is in the 60% growth allocation multiplied by the 45% Australian share exposure multiplied by the 60% sub asset allocation to the Australian index fund:
87.5% x .45% x .4% = 16.2%. 

 

We round this up to 16% because we don't want the figures to suggest that they are more precise than they really are.

 
 
Overall % Exposure of Portfolio
 
Defensive Assets (40% of portfolio)
- Cash (25% of defensive allocation) = 10%
- Fixed Interest (75% of defensive allocation = 30%
 
Growth Assets (60% of portfolio)
Australian Shares (45% of growth assets)
- Australian Index Fund (60% of Aust share allocation) = 16%
- Australian Value Comp (25% of Aust share allocation) = 7%
- Australian Small Comp (15% of Aust share allocation) = 4%
 
International Shares (30% of growth assets)
- Int Index Fund (60% of Int share allocation) = 10%
- Int Value Comp (20% of Int share allocation) = 4%
- Int Small Comp (10% of Int share allocation) = 2%
- Emerging Markets (10% of Int share allocation) = 2%

Property (25% of growth assets)
- Aust Listed Prop Trusts (67% of prop allocation) = 15%
- Int Listed Prop Trusts (33% of prop allocation) = 10%
 
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What are these case studies all about?
Over the past few months a number of users of our website have requested for us to include a section on case studies.  We are keen to be able to provide this for users of our website and email newsletter.  To help develop this part of the website it would be great to receive subscriber requests as to particular questions they might have regarding their financial situation.  Our plan would be to include a sample in each future edition of the newsletter along with copies on our website.  All respondents would remain totally anonymous with the understanding that any responses provided being general financial advice only.
 
If you were interested in getting involved please send through an email outlining your scenario or question.

3 Factor Model in Action
Updated Dimensional Trust Performance Graphs
 
Since our last edition we have updated the Dimensional Fund Performance Graphs page on our website.  The graphs show the performance of the Dimensional trusts that we use to build investment portfolios for our clients.  They have been updated to contain data up until the end of October 2008.
 
Commentary:
Unsurprisingly, the graphs show strongly negative monthly returns over October for all sections of Australian and international markets. In particular, the Australian Small Company, Australian Value trust, Australian ASX200 index and the global Emerging Markets trusts have seen the strongest falls.
 
Over the long run, the graphs continue to clearly show the existence of the risk premiums (small, value and emerging markets) that the research tells us should exist:
 
Australian Share Trusts
7 Year Returns to October 2008 (Premium over ASX 200
Accumulation Index in brackets)
ASX 200 Accumulation Index 10.23%
Dimensional Australian Value Trust 13.55% (3.32%)
Dimensional Australian Small Company Trust 14.05% (3.82%)
 
International Share Trusts
7 Year returns to October 2008 (Premium over MSCI World (ex Australia) Index in brackets)
MSCI World (ex Australia) Index -0.64%
Dimensional Global Value Trust 2.27% (2.91%)
Dimensional Global Small Company Trust 3.70% (4.34%)
Dimensional Emerging Markets Trust 12.68% (13.32%)
 
NB - These premiums are higher than what we would expect going forward.

For anyone new to our website, it is important to point out that we build investment portfolios for clients based on the best available academic research.  Take a look at our Building Portfolios and Our Research Based Approach pages for more details.  In our view, this research compels us to use the three factor model developed by Fama and French.  In Australia, the most effective method of investing using this model is through trusts implemented by Dimensional Fund Advisors (www.dimensional.com.au).  We do not receive any form of commission or payment from Dimensional for using their trusts.  We use them because they provide the returns clients are entitled to from share markets.
 
However, academic theory is nothing if it can not be implemented and provide the returns that are promised by the research.  Therefore, we like to provide the historical returns of the funds that we use to build investment portfolios.

Please let us know if you have any feedback regarding these graphs by using the Request for More Information form to the right or via our User Voice feedback forum.

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We hope you have enjoyed reading the latest edition.  If you have any comments or suggestions for future topics please do not hesitate to get in contact.
 
Have a great fortnight!
 
Cheers,
The Two Scotts
 

The Financial Fortnight is a publication of A Clear Direction Financial Planning.  It contains general financial advice.  Readers should check this advice with a professional financial adviser before acting on any of the material contained in this email.

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