Common Biases we tend to exhibit as Investors - Andrew Page

There is a long list of academic theories and models that attempt to explain and understand the economy and markets. While none are perfectly infallible, many nevertheless have their merits and provide important practical lessons.

One of the most exciting and fastest growing areas of research is in the field of Behavioural Finance, which seeks to understand how we approach investing by applying the lessons of psychology. While most other economic schools of thought assume that investors are rational, sensible and well informed, behavioural finance acknowledges that we are emotional beings who often exhibit impulsive, irrational and sometimes self destructive tendencies.

While a thorough and detailed review of the field is not possible in this forum, I would nonetheless like to outline some of the major findings from this area of research. Hopefully this will allow us to better understand our motivations and allow us to avoid making poor investment decisions. (For those who are interested in a more detailed review, I highly recommend the book "Behavioural Investing: A practitioners guide to behavioural finance" by James Montier).

Below are some of the more common biases we tend to exhibit as investors.

1. Short term focus

Humans are highly focused on the short term, and will most often choose immediate satisfaction over long term gratification, even if the latter is objectively a more rewarding proposition. This means that we often opt to lock in small profits today rather than allowing our investments time to grow into something more substantial. Furthermore, it means we are easily scared off by short term losses even if there has been no fundamental cause for alarm.

2. Herd mentality

We are all hard wired to go with the flow. None of us like to act in opposition to the general consensus, and find it much easier to behave in a way that is consistent with our peers. This means that we are easily carried away by irrational exuberance and overly sensitive to crippling pessimism. Although it has been repeatedly demonstrated that the best time to invest is during periods of great pessimism and the best time to sell is during periods of unbridled optimism, the vast majority of us do the exact opposite.

3. Over confidence

It is easy to demonstrate that most novice investors tend to fare very poorly, but this fact does little to discourage people from diving head first into the markets with little understanding or planning. We all tend to see ourselves as "above average" and assume that we will be smart enough to avoid the stupid mistakes made by others. Furthermore, when investments go our way we chalk that up to our amazing skill and insight. When the market moves against us, it is simply bad luck. This means we often fail to recognize mistakes as mistakes, and are doomed to repeat our past errors. The lesson here is to remain as realistic as possible, and don't fool yourself into thinking that you have special abilities above that of the ordinary person.

4. Heads in the sand

We all love to hear things that agree with our own opinions and reinforce our beliefs. More importantly we loathe anything that disagrees with our outlook and tend to dismiss it as unimportant, or often simply wrong. The truth is that we do ourselves a serious disservice by ignoring information purely on the basis that it disagrees with our own view. Investors who limit themselves in this way are destined to fail at evaluating events in an objective and considered fashion.

5. A focus on the irrelevant

Our brains have evolved to identify patterns, and indeed this has provided us with an important survival mechanism. Unfortunately though, we are often prone to see patterns where none exist and in contradiction to what a more thorough and balanced analysis would tell us. Many people base their investment decisions on price alone, while others look to the heavens and use astrology as the basis for their decisions. Because unrelated phenomenon will inevitably align from time to time, we will most often view this as validation, and in conjunction with the previous point, will fail to consider anything that questions the assertion. Investors would do well to ignore any investment style or technique that is not strongly supported by evidence.

6. I know best

Many experiments have shown that we tend to give more weight to our own experiences than we do to the experience of others, or even rigorous statistical evidence. The classic example is with someone who has smoked all their life and never gotten sick, or who has a parent who smoked 10 packets a day and lived to be 100. Despite the fact that the dangers of smoking are well established, they will disregard the facts because it doesn't match their own experience. Similarly, if someone has lost money in the market then they believe that share market investing is a dangerous and reckless exercise. On the other hand, those that have done well recently will mistakenly believe that it is easy and relatively straightforward to make good money trading shares. The truth of course lies somewhere in between these two extremes, but few people are accepting of evidence that does not agree with their own experience.

7. The endowment effect

It seems that ownership tends to drastically distort our perception of value. That is, we tend to attribute a greater than reasonable value to something purely on the basis that it is ours. This gets us into trouble when we own shares that are performing poorly. We tend to assume that the market has made a mistake, not us, and that the price will ultimately recover. Sometimes this will even cause us to buy more stock in the hope of "averaging down" our losses. Smart investors do not become emotionally attached to their shares.

We cannot change the fact that we are emotional beings, and nor would we want to. The point is that investment decisions should be driven primarily by reason and objectivity. That is, although it may be easier said than done, you should invest with your head, not your heart. The best way to do this is to establish a very clear strategy prior to entering the market. Map out in advance what it is you are looking to achieve and have a clear plan of action to respond to all likely scenarios. This way you will never be taken by surprise, and will be less likely to act irrationally and emotionally.

Outlook for the remainder of 2009 - Ian Murdoch

It is difficult to know where to begin

2009 is turning out to be a very difficult year for investors as they cope with the barrage of depressing and negative news with the odd glimmer of hope that we can see the end of this cycle and the sharemarket starting to rebound.

In the global context all major economies are in a severe synchronised downturn or at the beginning or in a recession. There is the threat of deflation looming in the short term and then potentially back to a cycle of inflation as the global economy is pump primed by central banks and governments to get through and limit the impacts of recessions.

Source AMP

The financial system continues to be the main concern as losses mount and the possibility that there is still a lot of undisclosed losses particularly in the European banking system.

The International Monetary Fund (IMF) is continuing to lower global growth outlook to virtually zero levels for 2009 and it is difficult to see any real upside until 2010. Australia appears to also be in a recession although technically not called yet. However, the massive fiscal packages coupled with ongoing reductions in interest rates should add significantly to household and business incomes and at both levels it will be spent. The current outlook is that interest rates will reach levels around 2.25% to 2.5% down from the current level of 3.25%.

What is worrying everyone is the loss of jobs with the unemployment rate projected to be around 7% (currently 5.2%). Let's hope it is all short lived and the global and domestic stimulus packages turn the economies around to a synchronised growth cycle sooner than later.

In the short term

Unfortunately there is still a lot of pessimism out there and there will be more bad economic news from time to time. It seems that our markets have already priced this all in, as evidenced when even a little bit of good news inspires a market rebound, as we have seen recently. This rebound has all the attributes of a bear market relief rally.

When will it all end?

There is one certainty in that it will end but the question is when and what sort of recovery will it be. Here is a table of what happened in past recessions.

It shows that on average Gross Domestic Product historically in a recession falls about 2% over about four quarters, coupled with major falls in inflation, higher unemployment and lowering of interest rates. We are starting to see all of this happen.

Putting it all in context there is a large overhang of investment projects still to be completed in Australia, and there are no major stockpiles of inventory that need to be soaked up.

Our banks seem to be in reasonable shape and the Reserve Bank appears ready to move aggressively to reduce interest rates; our dollar is boosting exports and the government has taken pre-emptive steps to stimulate the Australian economy. So it is not all that bad.

A little optimism

One statistic is interesting in that it has never taken more than six and a half years for markets to regain the same levels of the last peak. So based on where we are now, this could mean that sharemarkets will double over the period or about 11% annualised return.

In this tough economic climate what can you do to improve your tax position as we approach tax time? -  H&R BLOCK

There are a number of things taxpayers can consider to improve their tax position for their financial year.

Individual/Non Business Taxpayers

1. Defer Income where Possible

If you are due an end of year bonus, with the tax cuts due 1st July, it is certainly worthwhile deferring these bonuses, if possible, to the next financial year.

2. Review your records, do you have the necessary receipts and records to maximise the tax deductions you are entitled to.

1. Motor Vehicle expenses
   • If you travel more than 5000 kilometres in the tax year you need to keep a log book to maximise your claim. This needs to be kept for a minimum of 90 days.
   • If you travel less than 5000 kilometres you can use the cents per kilometre method of claim, you just need to ensure you have records to estimate the number of kilometres you have travelled.
2. Home Office Expenses
   • Ensure that you have the necessary records to enable claims for these expenses. Business/Private logs for Computers, Home Phone, Mobile Phone, time spent in the home office for work related activities.
3. Other Work Related Expenses
   • Make sure you have the receipts and invoices for any purchases you have made, details of professional association expenses and Union memberships. Tools and equipment purchases that you have used for work. Professional subscriptions are also deductible.
4. Medical Expenses
   • If you or your family members need to have some medical work or procedure done, it is worthwhile trying to bunch them into one financial year as you are entitled to a rebate of 20c in the dollar for every dollar spent over $1500.
5. Self Education Expenses
   • If you have undertaken any self education that helps you do your current job you are entitled to claim a tax deduction for those expenses. Fees (other than HECS-HELP), books stationary travel are all deductible, you just need to ensure you have the records to substantiate the claims.
6. Make a Voluntary Contribution to your HECS - HELP Debt.
   • If you make a voluntary repayment of $500 or more, you will receive a bonus of 10%. This means your account will be credited with an additional 10% of your payment. Make the payment before the indexation date 1st June and save HECS. You need to make the voluntary contribution before you lodge your Tax Return.

3. Superannuation

• Contributions on behalf of spouse
  • This is subject to income limit of $13,800 but a rebate of $540 is available to those that do qualify. A full rebate will apply if the taxable income of the spouse is below $10,801 and it is reduced and cuts out at a taxable income of $13,800.
• Co Contribution
  • If you have taxable income below $27,500 you can make a contribution up to $1500 a year and the Government will match that contribution, with a payment to your super fund. The amount of the Government contribution cuts out at $40,000.
• Consider Salary Sacrificing some of your salary into super
  • This is a very tax effective way of maximising your retirement income.

4. Other Steps you can take

1. Offset capital gains against capital losses.
   • If you have a capital gain in this financial year, look to your other investments to see if it is worthwhile to realise a Capital loss, to offset the Capital gain.
2. Make any Tax Deductible donations.
   • Prepayment rules do not apply to these deductions.
3. Salary packaging.
   • If your employer will allow, see if you can salary sacrifice some of your income, such as superannuation, Motor Car, particularly if you are earnings fall into the top tax rate.
4. Maximise medical expenses.
   • If you or your family members need to have some medical work or procedure done, it is worthwhile trying to bunch them into one financial year as you are entitled to a rebate of 20c in the dollar for every dollar spent over $1500.
5. Pay as you go instalment payers.
   • With the drop in investment returns, you should consider lodging your tax return early to receive your tax refund.

Small Business Owners

1. Defer Income

To utilise this strategy of delaying income, you need to check what income you are likely to receive in the last quarter, and if appropriate delay that income to the next financial year.

The tax cuts that commence the 1st July make this a more attractive option.

2. Accelerate deductions

• Carry out any repairs to equipment and premises prior to June 30th.
• Prepay expenses, where allowable.
• Write off bad debts.
• Manage your Trading Stock.
• Do an advanced purchase of business consumables.
• Make any Tax Deductible donations.
• Income Protection

3. Superannuation

• Superannuation deduction for self employed business people
• Contributions on behalf of spouse
• Co Contribution

4. Offset capital gains against capital losses

• If you have a capital gain in this financial year, look to your other investments to see if it is worthwhile to realise a Capital loss, to offset the gain against.

5. Review Asset register to scrap/dispose of unused assets

• Review your asset register for any assets that are obsolete and no longer used in the business and dispose of them or scrap them. This will give rise to a balancing adjustment and a depreciation claim.

6. Other matters to consider for the end of the financial year

• You must do a Stock take any trading stock you have as at the 30th June, these should be listed with a total value calculation.
• Prepare a Debtors list as at the 30th June for those business, who use the accruals accounting method.
• Prepare a Creditors Debtors list as at the 30th June for those businesses who use the accruals accounting method.
• Manage the shareholder loan account for Companies.
• Plan to prepare the Pay As You Go Annual Statements for your staff to be issued in early July.
• Ensure all your BAS's have been lodged for the financial year. Large penalties can apply for non lodgement of BAS's. They start from $110 for every 28 days, maximum of $550 in one year, for each BAS not lodged and can be as much as $550 per 28 days depending on the size of the business.

7. Pay as you go instalment payers

• With the drop in investment returns, you should consider lodging your tax return early to get back the extra tax paid, due to the extra tax paid as this year's instalment is based on last year's tax return, and sales are maybe down due to the economic downturn.

Should I invest now or pay off my home first? It's a perennial question for would-be investors. - Michel Carman

IS IT better to pay off your home loan first and then invest in property, or should you invest while paying off your home loan?

There are valid concerns either way.

Paying off your home loan first means you can use the full amount of equity in your place of residence, which will likely have appreciated and which is unencumbered by any mortgage. After the mortgage is paid off there's also greater cash flow that can be used to service the loans for investment properties.

On the other hand, waiting until the loan on your own home is paid off before you start investing means there's potentially a lot of lost time where investment properties could be appreciating in your portfolio but aren't. In other words, you only have one property - your principal place of residence - growing in value when you could potentially have several others also building wealth for you.

Needless to say there are many other considerations that play into this decision including:

• Your income level - and at what rate it grows - which impacts how quickly you could pay down the loan on your own home.
• How easily (or otherwise) you qualify for property loans, at what cost, and using what loan criteria.
• The rate at which property values grow.
• Rents and rental yields, and their rate of growth.

Because so many specific factors come into play it's risky to look at the issue too prescriptively or generally. Instead we'll look here at a case study and see what works out best with some specifics. The results may surprise you.

OUR CASE STUDY: JOHN

For our analysis we'll study the case of John, who's in his 30s and currently earns a salary of $100,000 per year.

Here are the other vital statistics for our made-up case study:

• John's salary grows at 3 per cent per year.
• His living expenses (excluding housing) are $25,000 per year and these also grow at 3 per cent per annum.
• His annual tax bill, including the Medicare levy, is $27,500 and we assume that this average tax rate (i.e. 27.5 per cent) holds every year.
• Interest rates remain constant at 8 per cent per annum.
• His principal place of residence is purchased for $300,000, with a 20 per cent ($60,000) deposit he has saved up.
• The loan for his own home is a principal-and-interest loan, while loans for investment properties are interest-only.

To make the situation more realistic, rather than assuming that property prices rise at a constant rate of, say 8 per cent per year, we've constructed a makeshift property cycle by which property prices in the case study appreciate.

Figure 1 shows the cycles and values used for both property prices and rents: the property cycle is an adaptation of the property cycle of the weighted average of Australian capital cities seen between 1986 and 2005.

These property and rental movements give rental yields at purchase of between 2.6 and 4 per cent.

Although his own home costs $300,000 now, the properties John eventually accumulates as investments are less expensive: worth $270,000 now. His principal place of residence (PPOR) and investment properties appreciate at the same rate, as shown in Figure 1.

To map how he accumulates properties we apply a loan-servicing rule that John's total loan repayments must be lower than the sum of 30 per cent of his gross salary and 80 per cent of his rental income after any acquisitions are made. This sets the limit on the rate at which he can accumulate investment properties.

Let's see how John fares over a 15-year period under two different scenarios: when he pays off his principal place of residence before investing versus investing while he is paying off his own home.

SCENARIO 1: PAYING OFF THE HOME LOAN FIRST

Under this scenario John's aim is to pay off his home loan and he does this aggressively by taking out a 25-year principal-and-interest loan. The annual repayments on this loan are around $22,300. After he pays his tax and living expenses he has cash left over (free cash) of roughly $25,000 in the first year (although this increases in successive years as his wages grow) and he applies this to his home loan. So John is paying more than twice as much as he is actually required to pay off his home loan.

Because the interest on the loan is calculated on the outstanding balance, applying extra cash to the loan consistently in this way whittles it away very quickly so it's paid out substantially ahead of time.

What's fascinating to note is how quickly John is able to pay off his home loan in this way: after seven years in fact! (See Figure 2).

The rapid pay-down of principal reduces the interest payable, in turn allowing more funds to be dedicated to the repayment of principal, in one of those virtuous circles of compounding that has great power for investors and wealth creators.

John doesn't acquire any investment properties until the loan on his PPOR is paid off. Figure 3 shows his asset position and his borrowings over the 15-year period.

As soon as his own home is paid off John buys his first investment property in the eighth year. Applying our (reasonably stringent) debt-servicing rule he acquires his next investment property in year 13: the jumps in the asset value and borrowing bars in Figure 3 show when John makes his acquisitions.

John's net worth climbs steadily throughout, reaching $1.3million in the 15th year. Not a bad effort from a diligent pay-down of home loan debt and a consistent investing program. In the same way as he used spare cash to pay down the loan on his PPOR John uses his spare cash to offset his investment property loans in a line of credit arrangement, although of course the cash loss from his investment properties reduces the amount of cash used in this way.

SCENARIO 2: INVESTING BEFORE THE HOME LOAN IS PAID OFF

Instead of taking out a 25-year home loan, in scenario 2 John takes out a 30-year home loan so that his yearly repayments are lower (because they're spread out over a longer period of time - an extra five years). Rather than paying $22,300 per year in home loan payments he now pays $21,130.

The big surprise is that there's hardly any difference between this scenario and the first one. This is because the impost of paying off the home loan on the PPOR acts as a brake on the borrowing capacity needed to enable investment properties to be acquired. Because John still has surplus cash available that's not going towards investments he uses it to pay down his home loan - after all, if he's keen to invest what else is he going to use it for?

Figure 4 shows the results. The number of investment properties acquired over the 15-year period is the same as in scenario 1 (i.e. two investment properties) and these are acquired in the same time frame. John's net worth is just under $1.3million - almost the same as when he aimed to pay off his home loan first.

Although his home loan repayments are lower in scenario 2, because John has extra cash available that's not used elsewhere and he puts these funds towards his home loan, the net effect is the same in terms of paying down the mortgage on the PPOR.

SUMMING UP

The major lesson this potted example provides is the way a home loan impacts on an investor's borrowing capacity. Your capacity to raise funds for investing and to service the debt is a critical factor determining the rate at which you can accumulate properties and build wealth. In our case study John has a sizeable amount of spare cash after housing costs and living expenses - more than $25,000 per year - but even that kind of cash isn't enough to support both a home mortgage and an investment, using the lending criteria we applied here. Of course, some lenders are more lenient than others and have less stringent lending criteria, and that will have a major impact too, as will the point in the property cycle at which you are ready to buy: if prices are only growing slowly they'll be more affordable and you'll be able to accumulate earlier.

Another thing to bear in mind is there are other possibilities that parlay into the decision. You could, for example, live in rented accommodation while investing, then use the equity from your investments as security for the purchase of your own home.

What is clear though, whichever strategy you choose, is that you understand your borrowing capacity and use it to accumulate property equity, whether you buy your home first or invest first.

© Australian Property Investor magazine - www.apimagazine.com.au. Reproduced with permission.

This information is of a general nature only and does not constitute professional advice. You must seek professional advice in relation to your particular circumstances before acting. Please read our warning and disclaimer.

Are your SMSF strategic planning settings correct? - Laura Menschik

Recently there have been some changes that effect self managed super fund members, which should be addressed and applied to their strategic planning for contributions and pensions.

1) Reduction in minimum payments for account-based pensions

Regulations to temporarily halve the minimum payment amounts for account-based pensions for the 2008-09 financial year have been released.

The regulations reduce the minimum payment amounts for account-based, allocated and market-linked (term allocated) pensions by 50%. For example, a self-funded retiree who is 60 years of age is currently required to draw a minimum annual pension payment of 4% of their account balance as at 1 July of that year (or the account balance as at the commencement date of the pension, if it commenced during that year). Under the amended regulations, this percentage would be reduced to 2%.

This temporary relief addresses concerns that the minimum drawdown requirement for this financial year was based on account balances at 1 July 2008, when equity values were higher. It also responds to concerns that meeting the minimum drawdown amount in 2008-09 will mean having to sell investment assets and realise losses in a depressed market.

For those people who have already taken half of the current minimum payment for 2008-09, the annual nature of the minimum payment rules means that no further payments will need to be made until the end of the 2009-10 year.

The minimum annual payment rule, which varies depending on age, is designed so retirees draw down on their superannuation capital over their retirement. This rule recognises that superannuation is designed as a retirement savings vehicle with substantial tax concessions.

For those who have as yet not taken the full (previously advised) minimum, they should consider whether or not to reduce the amount they will take before 30th June 2009. Those on monthly or quarterly pensions can stop their payments over the next few months, or last quarter, and those taking an annual pension in May or June can now reduce these accordingly.

2) Low rate cap amount

The application of the low rate threshold for superannuation lump sum payments is capped. The low rate cap amount is reduced by any amount previously applied to the low rate threshold.

Note: In accordance with section 960-285 of the ITAA 1997, the low rate cap amount is indexed in line with AWOTE, in increments of $5,000 (rounded down). These lump sums are non taxable.

For members who had previously withdrawn up to former cap levels, they are now able to withdraw an amount that is up to the new level, less the amount previously drawn, without any tax consequence.

3) Contribution caps

• Concessional contributions include employer contributions (including contributions made under a salary sacrifice arrangement) and personal contributions claimed as a tax deduction by a self-employed person.
  
• Non-concessional contributions include personal contributions for which you do not claim an income tax deduction.

Note: In accordance with section 960-285 of the Income Tax Assessment Act 1997 (ITAA 1997), the caps are indexed in line with AWOTE, in increments of $5,000 (rounded down).

Note: In accordance with subsection 292-85(2) of the ITAA 1997, the non-concessional cap for an income year is 3 times the concessional contributions cap.

The above increases should be reviewed in line with the 'bring-forward' option available meaning that people under 65 years of age can make non-concessional contributions of up to $495,000, from 1st July 2009, over a three-year period. People who are able to make contributions may look to make a non-concessional contribution of up to $150,000 before June 30th 2009 PLUS, making a three-year contribution of $495,000 after July.

ALERT >>>>> An item for SMSF Trustees to investigate is their Annual return approved auditor details. Check with your accountant, as the ATO is concerned that a number of tax agents are placing their own names at the auditor details question (Q6) of the SMSF annual return, either without having first conducted an audit or without being legally qualified to conduct these audits.

All SMSFs need to be audited by an approved auditor before the lodgement of the annual return.

Approved auditors are those who meet the membership requirements of one of the professional accounting associations listed in super laws, or are registered company auditors.

As with all aspects of responsibly running a SMSF, if you are unsure about any issues applicable to your fund and its members, seek appropriate professional advice.

Laura Menschik
Director and Authorised Representative
WLM Financial Services Pty Ltd.
CERTIFIED FINANCIAL PLANNER TM - SMSF SPECIALIST ADVISER TM
WLM provides wealth and lifestyle management services in a professional and personalised manner, by qualified advisers, on a fee-for-service basis. WLM is independently owned by its Directors. Visit WLM Financial Services online wlm.com.au

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