One of the best pieces of advice I ever received early in my career was that if I wanted to be wealthy, I needed to focus less on growing my income and more on accumulating assets. In most OECD countries, this is true from both a finance and a tax perspective.
Assets grow faster than income
If you’ve picked up a copy of the Australian Financial Review at any point during the past 5 years, you no doubt would’ve come across an article about Australia’s weak wage growth figures. Wage growth is exactly what it sounds like – it’s a measure of the rate at which wages are growing. Since late 2013, wages in Australia have been growing at less than 3% per year. Once you adjust for inflation (i.e. reduce this figure by a measure of the general increase in prices of goods and services – see Economics 101), this figure becomes shockingly low, often hovering around 1%. This means that on average, any increase in your wages in recent history would’ve been almost negligible. Wages are growing faster in other OECD countries, but the proposition still stands that wages generally do not grow at an attractive rate.
An asset can be anything. Usually when we talk about assets in an investing context, we’re referring to assets which appreciate (rise) in value. These are assets such as shares, bonds, real property etc rather than consumer discretionary goods such as cars, laptops, unfashionable sandals and urban cowboy boots (although many of my colleagues, some of the most brilliant junior lawyers in the country, insist that a pair of R.M. Williams boots should be deemed an ‘investment’).
When you buy a share in a company, you are buying a fraction of that company. You become the owner of that fraction and you obtain certain rights. One of the most important rights is the right to receive a dividend. A dividend is a share of the company’s profits. In Australia, a company is not required to issue a dividend but if it does, you are entitled to receive a certain amount of money for every share you hold (depending on the class of shares you buy and your specific rights as a shareholder). How do people make money from holding shares? Let’s do the maths.
The two most common methods of making money from holding shares are through receiving dividends from being a loyal shareholder and/or by purchasing your shares low and selling those shares, well, less-low. Let’s say Connor buys 100 shares in XYZ Ltd at $50 per share. The directors of XYZ Ltd take a look at the company’s books and decide they’ve sold many more not-so-fashionable sandals (think birkenstocks) than they anticipated and so they declare a dividend of $2 per share. Connor is due to receive $200 ($2 for each of the 100 shares he holds in XYZ Ltd) in dividends. Assuming this is the only dividend the directors of XYZ Ltd declare for the year, Connor has made a return of 4% through his dividends ($2/$50). We call this the ‘dividend yield’ – the ratio of the company’s annual dividend over its share price. In Australia, the government incentivises investment in high dividend yield companies by giving investors a tax credit known as a ‘franking credit’ – more on this in a later article.
Let’s say investors of XYZ Ltd are delighted by the news that all their sandals are exiting the company’s warehouses and they start partying like it’s 1999. The company’s share price rises to $55. Connor decides he wants to sell his stake in the company (probably because it’s 1999). Connor has made a capital gain of 10% or $500 ([$55-$50]/$50). As we see further below, Connor is heavily incentivised to hold his shares for at least 12 months. Connor has done well for himself. He’s made a return of $700 (dividends + capital gain) on his $5,000 investment and he can boast to his like-minded R.M. Williams-sporting friends that he returned 14% on his investment ($700/$5,000). We call this the ‘return on investment’ or ‘ROI’.
According to the ASX/Russell Investments 2018 Long-term Investing Report (Russell Report), Australian shares yielded an average 4.0% per year in the 10 years to December 2017. Keep in mind that this figure is abnormally low for equities (shares) but that the time period assessed in the Russell Report includes the Global Financial Crisis. Also note that this is what the market returned as a whole. Some investors may opt to ‘stock pick’ (invest in specific companies listed on a securities exchange). The top 5 performing stocks on the ASX in the 2018/2019 financial year each returned over 100% during that year.
When you buy a bond (commonly, and probably incorrectly, also referred to as a fixed income security), you’re basically lending money to the person (usually a company or the government) who issues the bond. The most basic type of bond is called a plain vanilla bond. Let’s work through an example.
The buyer or bondholder ‘purchases’ a bond from the issuer for $1,000. The bondholder is effectively lending this $1,000 to the issuer of the bond. We call this $1,000 the ‘principal’ or the ‘face value’ of the bond and it’s due to be paid at ‘maturity’ which for us will be 5 years. The issuer pays the bondholder regular payments at a coupon rate (fancy way of saying the issuer pays interest). The coupon rate is 5% per year (5% x $1,000 = $50) and under the terms of the bond, the bondholder is due to receive these coupon payments once per year until maturity (5 years). At maturity, the bondholder receives his/her last coupon payment plus the principal amount ($1,000) the bondholder first paid for the bond.
How do people make money from holding bonds? We’ve already seen that a bondholder receives coupon payments as compensation for agreeing to buy and hold the bond. In the example above, the bondholder receives $250 ($50 per year, for 5 years) in coupon payments. However, the example I gave you above is a highly simplified one. In the real world, bonds have all sorts of terms and conditions and most importantly, they tend to fluctuate in value. A clever investor might be interested in buying a bond because he/she believes it’s trading at a discount (cheaper than it should be) and might hold the bond with the hope that market conditions pave the way for a surge in price.
According to the Russell Report, Australian bonds yielded an average 6.2% per year in the 10 years to December 2017.
Purchasing a property is likely the most significant investment you will ever make. Property is an example of an ‘illiquid asset’ – something not easily convertible to cash (unlike most shares and bonds).
An investor can typically expect to make money through rent, capital gains or both. Let’s say Nicky wants to buy an apartment. Nicky lives in Sydney which means she likes coastal walks, goes to bed at 10pm on Friday and Saturday nights, and has learned to live with sky-high property prices. She purchases a run-down shack of a prison-cell sized studio for a cool $1 million. She rents the apartment out for $500 per week (or $26,000 per year). Nicky’s rental yield is 2.6%. A property’s rental yield is the ratio of its annual rental income over its valuation (in this case $26,000/$1,000,000). 2.6% is not a very attractive return on investment, especially because Nicky is servicing a mortgage on the property for 90% of its value at a rate of 4%. She is therefore earning $26,000 per year but paying $36,000 ($900,000 x 4%) in interest alone.
Nicky expects the property’s value to grow at an average rate of 8% per year forever (because she lives in Sydney and literally everyone has FOMO). Nicky’s ROI is therefore 10.6% per year (rental yield plus capital growth). Her real return however is only 7% (ROI less interest on loan – $36,000/$1,000,000).
According to the Russell Report, Australian residential investment property yielded an average 8.0% return per year in the 10 years to December 2017.
When someone says they’ve invested their money in cash, they’re essentially saying they’ve left it in a bank account barely earning more than inflation (and that’s before taxes – there’s a whole separate discussion which needs to be had around wealth inequality and tax policy). Cash is one of the most defensive assets (low risk investments) you can hold. Many fund managers allocate a portion of their portfolios to cash during times of economic uncertainty to minimise risk. Obviously, making the decision to hold cash has to do with your level of risk aversion (a concept to be discussed in a later article). Many people hold cash if they’re saving up for something significant in the short-term and they can’t risk losing their capital (e.g. an expensive holiday or a housing deposit).
According to the Russell Report, Australian cash accounts yielded an average 3.6% return per year in the 10 years to December 2017.
Exchange-traded funds (ETF)
In a later article, we will discuss how you can get easy access to the assets we mention above without having to make any direct investments, and (in the case of real property) without having to wait until you have sufficient capital (i.e. a deposit) to buy-in.
Enter the tax man (or woman)
The Australian tax code incentivises investment in assets. On the other hand, our progressive tax system disincentivises any efforts you make to increase your salary. These regimes are similar to those in many developed countries but for the purposes of our discussion we’re only focusing on Australia. The most obvious example of this is our tax code’s treatment of capital gains. In very simple terms, you make a capital gain when you sell an asset for an amount greater than the amount you paid for it. Once you’ve calculated your capital gain, this figure is added onto your taxable income (income you pay tax on, duh) and you pay tax at whatever your marginal tax rate is (the highest tax bracket you fall into, less duh).
However, we said earlier that the Australian tax code incentivises investment in assets. For most assets, the Australian Taxation Office will allow you to reduce your capital gain by a whopping 50% so long as you hold the asset for at least 12 months. There is no equivalent scheme in place for any direct income boost (i.e. a raise). Let’s work through the following simplified example. Let’s say Mitch worked really hard last financial year and impressed his employer so much, she decided to increase his salary from $90,000 to $100,000. Let’s say Anna also earns $90,000 and did not get a raise in the same financial year. Anna invested some money in an ETF and sold her stake for a $10,000 profit, but she had held her stake for more than 12 months. Anna can reduce her capital gain by $5,000, meaning she’s only liable to pay tax on the remaining $5,000. The table below is a highly simplified example which assumes both Mitch and Anna have health insurance and aren’t liable for the medicare levy surcharge.
|Marginal tax rate||37%||37%|
|Net raise/capital gain||$6,100||$8,050|
Mitch and Anna both realise the same pre-tax monetary benefit ($10,000) but Mitch pays the tax man (or woman) an additional $1950 in taxes. This is the government’s attempt to try to incentivise ordinary people to invest in assets to stimulate growth. Most people would agree that it’s a very effective policy and if they were armed with the requisite knowledge and the financial capacity to take advantage of such tax incentives, they would do so.
We’ve demonstrated above that accumulating assets is arguably more important than trying to grow your income. It’s important to understand that the two are not mutually exclusive. By accumulating assets, you will likely also grow your taxable income. We saw how investing in shares may offer an attractive dividend, how investing in bonds may yield coupon payments, and how investing in real property may offer rental return. These are all examples of income. Assets can deliver both income and capital growth. Income is something which is relevant in the short to medium term. Investors often take a longer term view for capital growth. It’s up to you to assess which is more important to your livelihood and your portfolio.