Case of luck and good management

By MARY HOLM

Q. When my daughter was 17, on my instigation, she invested $5000 from an ACC settlement in the Foreign & Colonial Investment Trust.

Now, seven years later, it is valued at $16,500. All dividends are reinvested.

My advice to her has been to try and forget this money exists and leave it to grow, with the knowledge that she has been able to make an excellent start to her retirement saving.

I have also suggested she may at some stage consider using it as a deposit for a house, as part of her long-term strategy.

Meantime, she has been through university and has a student loan of about the same amount to pay off.

Now aged 24, she is paying this loan off at $500 a month while working in London.

Her talents do not lie in the field of finance, so she accepts she should always take advice.

I know in principle she should be paying off debt as fast as possible. But I feel in this case, to date anyway, she has benefited from keeping this investment.

My questions of you are:

* Do you agree with the above arrangement?

I have used the principle that this enforced saving [paying off debt] is more likely to occur than saving the equivalent amount in a retirement scheme?

* If perchance you do agree, would you advise that she diversifies?

Put another way, at what point should a young person in this situation consider splitting this investment?


A brilliant Mum should take a bow. Or should she?

Your daughter's investment has done particularly well so far - more than tripling in just seven years. That's an annual return of more than 18 per cent.

On the face of it, that would seem reason enough to say you've advised her well. But it's not a good enough reason for me.

She's been lucky. The F&C Trust invests in companies throughout the world. And world shares boomed through the 1990s.

They have dropped since. But anyone who got into the market seven years ago is still well ahead.

In different market conditions, though, your daughter's investment might have grown quite slowly. It is even possible that its value could have dropped over seven years.

Under that scenario, she might have felt quite sick watching her student loan grow, knowing that she could have cashed in her investment and kept that debt lower.

It is because of market uncertainty that experts generally recommend paying off debt before investing.

Investing while you are still in debt makes sense only if you can make a higher after-tax return than the interest you are paying on your loan.

And the only way to make a high enough return is by investing in shares or property - if you're lucky.

As we've said, so far your daughter has been lucky. But that could change. It's a risky game.

Despite all of this, though, I reckon you have given your daughter good advice. This is one of those situations in which psychological issues outweigh financial ones.

As you say, she's more likely to pay off her loan than save the equivalent amount.

And having a good start on a retirement fund might encourage her to build on it.

Even if she doesn't add to her savings for some years, she has the security of knowing she has got a good lump sum put away.

At 24, she may not retire for another 40 years or so.

Her average return will almost certainly fall. But at just 5 per cent, after fees and taxes, her $16,500 would grow to $116,000 by the time she is 64.

Alternatively, as you say, she might use the money for a house deposit. In the long run, that should also prove to be a sound financial move.

I wouldn't feel so happy if it looked likely that her debt would hang over her for many years to come.

But at her present repayment rate, she will be rid of the loan within the next three years. And that means she won't end up paying vast amounts of interest on it.

On your second question, I don't think there is any great rush for your daughter to put some of her money elsewhere.

Stockbroker ABN Amro Craigs describes the F&C Investment Trust as "a low-risk investment providing a well-diversified defensive exposure to global markets."

And your daughter has, indeed, got a great spread within the trust, which holds shares in many different industries and countries.

Also, UK-based Foreign & Colonial has been around since 1868, and has a solid reputation. So I don't think your daughter needs to diversify because of fund manager risk.

And the trust, which is listed on the UK and New Zealand stock exchanges, doesn't pay tax on capital gains, so it is tax-efficient.

One point to note is that the trust has a strong UK bias.

About 37 per cent of its holdings are UK shares, and 24 per cent are American.

If the holdings reflected the relative sizes of the sharemarkets, it would hold 10 per cent UK shares and 55 per cent US.

The bias is fine if the UK performs better than average, but will hurt returns when UK shares do badly.

Because of that, once your daughter's investment reaches, say, $50,000, she could move half her money into a world index fund, which won't have that bias.

In the meantime, though, I would keep things simple and stick with what's she's got. And, Mum, do take that bow.

Q. I read with interest your comments that markets don't seem to stay down for more than 10 years.

I attach a graph from Schiller's Irrational Exuberance showing real S&P prices, without dividends. (The S&P500 is an index of America's biggest 500 companies.) Prices have stayed down for two periods exceeding 25 years in the last 70!

We have to work in real (inflation-adjusted) terms as the only valid measure, due to the variable inflation component over such long time frames.

During these periods dividend yields were about 3 per cent, which helped increase the returns.

Today, with S&P dividend yields at about 1 per cent, there is little relief from this quarter.

In my humble opinion, people who believe that equity markets are forever on an upward trend simply ignore the hard facts of history, and forget that if their savings period coincides with one of the 25-year periods of no capital return, then their savings will be very seriously impacted.

The devil is in the detail. One has to understand what the upward trend looks like over time frames relevant to an individual investor.

A. I've got three points to make.

* I reckon your statement that share prices "have stayed down for two periods exceeding 25 years in the last 70!" makes things sound much worse than they really are.

The graph you sent me covers 1870 to 2000. There are two particularly high peaks in that period. One is just before the 1929 crash and the other is in the late 1960s.

If you were unlucky enough to invest at one of those peaks, the value of your investment would have dropped quickly. And the index doesn't regain the peak level for about 25 years.

But if you had invested some years later, in the trough that followed, you would have made a fantastic return fast.

In most of the 25-year spans covered by the graph, the investor would have done well, and sometimes extremely well. The trend is clearly upwards.

Given that people don't usually make a single big investment in shares, but make many purchases over the years, the typical long-term share investor would have been pretty happy.

And that's true even using your graph, which contains a serious flaw. Read on.

* Looking at share returns without dividends is like looking at rental property without the rent.

You say dividends in the periods in question were around 3 per cent.

That makes a huge difference. If a share price didn't change over 25 years, but it paid 3 per cent dividends and they were reinvested, the value of the investment would more than double.

These days, as you point out, US dividends have dropped to around 1 per cent.

You seem to assume that modern investors are, therefore, worse off. Not necessarily.

As I said in last week's column, when companies reduce dividends, they tend to retain more of their profits for growth. This makes it more likely their share prices will rise faster.

Investors might not get as much "relief", as you put it, from dividends. But they might not need it.

Still, even at 1 per cent, dividends should always be included in returns.

I've tried to get historical data on real US share returns including dividends. Unfortunately, I could go back only as far as 1965. (The numbers are for the Dow Jones Industrial Index, but its performance is similar to the S&P500.) Since 1965, there has been one 12-year period, from 1972 to 1984, when real returns declined. There were also two six-year periods of losses.

But there were also periods of huge gains.

You like 25-year spans, so how about this one. If you invested at the end of 1974 and reinvested dividends, by the end of 1999 your money would have grown more than 16-fold. And that's after adjusting for inflation.

* I don't have an argument with your using real figures.

How could I, when I've written a little book about how important it is to take inflation into account?

(It's called "The REAL Story - Saving and investing now that inflation is under control", and you can get it free from www.rbnz.govt.nz. Click on 'publications'.) It's important to note, though, that when people discuss investment returns, they don't usually adjust for inflation.

When they do, all returns look worse - particularly in the 1970s and 80s when inflation was really high.

In most of that period, for instance, New Zealand bank deposit interest rates were lower than inflation. That means real returns on bank deposits were negative for many years.

And real New Zealand house prices fell for much of the 70s and at times in the 80s and 90s.

Whether you use real or nominal (not inflation-adjusted) figures, shares have risen faster over the years than the alternatives.

Note, too, that research shows that real share returns tend to be higher when inflation is lower. With inflation largely under control in the developed world, this bodes well for the future.

For all that, I certainly don't think share markets "are forever on an upward trend".

As I've said over and over, they are quite likely to fall over short periods, and sometimes over longer periods.

But once you include dividends in the mix, the falls aren't as severe.

And if you invest regularly - as opposed to putting lots of money in at once - you'll capture some good periods and some bad ones. Your average return over the long term is almost certain to be good.

Let's hope inflation stays low. But whatever its level, I'll still put my long-term money in the investment most likely to beat inflation over the years.

And that's shares or share funds.

Q. I am a 67-year-old retiree with a varied portfolio of trusts and managed funds recommended to me by a financial adviser some time ago.

I would like to monitor the asset allocation myself, and wonder if you could advise the current thinking of how a portfolio should be balanced. eg overseas shares, New Zealand shares, property etc.

A. There is no single ideal asset allocation.

How much you invest in different types of assets depends mainly on how much risk you can cope with, and how soon you will need your money.

If you might panic if the value of your investment plunges, or you expect to use most of your money within the next ten years, you should lean more towards fixed interest and less towards shares and property than otherwise.

Time of life matters, too.

Some people say that, on retirement, you should put most or all of your money into fixed interest, as you will want to get regular income from it.

But I would suggest that only for the most risk-averse person. And that doesn't sound like you.

At 67, you might live another 30 years or more.

And over the long term, the average returns on shares and property are likely to be higher, perhaps a lot higher, than on fixed interest.

You can still take regular income from share investments, and some property investments.

If the dividend or other cash flows aren't enough, sell some shares.

Another consideration is whether you own your home. If so, you've already got enough in property.

Maybe you could put 10 per cent of your money into a non-residential property fund or company. But that would be plenty.

For your share investments, I suggest more international than New Zealand. That gives you broader diversification.

So where are we?

First, decide how much you want in fixed interest versus more volatile investments.

For you, it might be anywhere between 30 per cent and 70 per cent.

Most asset allocations also include cash. That depends on your needs for an emergency fund and general flexibility. It might be 5 per cent.

With what's left, some people would include forestry, hedge funds, olive trees, chestnuts, who knows?

But all that makes your portfolio harder to manage, and it is not clear that the fancier investments add value, on average.

How about simply putting a quarter into New Zealand shares, and three-quarters into international shares?

There have been several "ifs", "ands" and "buts" in this answer. That is because everyone's situation and attitudes are different.

It might be a good idea to hire a financial adviser to discuss this.

Tell them you don't want ongoing support, but would pay an hourly fee for a single meeting.

The good advisers should be willing to help you.

Thanks, readers, and see you next year

Dear readers: This is the last Money Matters column for this year, and I'd like to thank some people.

First, a few readers have sent me material - ranging from financial to medical advice - that they thought would help people whose letters were published in the column.

I've forwarded it, and I'm sure the recipients appreciate your thoughtfulness.

Then there's a man who sent me an interesting book he wrote. And another who went to the trouble of translating a useful brochure from Dutch to English and sent me both.

Thanks, too, to the many readers who sent letters that didn't make it into the column. I receive far more than I can use. And, because I can't answer you directly, you must feel unacknowledged.

But I do learn something from every letter - even if it's only that many people are having a certain type of problem, or are interested in a certain issue. I can then make sure that at least one letter on that topic makes it into the paper.

To improve your chances of getting into the column, you might want to note the following:

* Try to stick to the 200-word limit, or at least not go too far above it.

* Avoid sending me lots of background material, which I then have to try to summarise so other readers know what's going on.

* Don't ask me to recommend a financial adviser. Sorry, but I'm not in a position to do that.

* Read the column regularly, if you can. Then you won't ask about something we've covered recently.

* Don't ask about situations that are unlikely to apply to many other readers. Examples are letters about foreign tax, pensions or investments.

One more point: I've received some lovely, supportive letters at times, including one recently that said, "I can't believe the amount of negative comments you receive (and publish)."

Actually, I receive many more positive letters than negative ones.

But I try to publish most of the critical ones, and those that offer alternative views to mine, for several reasons:

* I like to face my critics.

* Many heads are better than one. Readers often make valid points I hadn't thought of.

* Conflict makes more interesting reading!

But that's not a very Christmassy note to end on. Let's forget the debates for a few weeks, and grab a bit of sunshine.

See you again on January 19.

* Mary Holm is a freelance journalist and author of Investing Made Simple. Send questions for her to Money Matters, Business Herald, PO Box 32, Auckland; or e-mail: maryh@pl.net. Letters should not exceed 200 words. We won't publish your name, but please provide it and a (preferably daytime) phone number. Sorry, but Mary cannot answer all questions, correspond directly with readers, or give financial advice outside the column.