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Eggs, baskets and diversified SMSF investment strategies

The ATO wants to ensure that, when an SMSF has a significant majority of its investments in a single asset class, the trustees have considered, as part of the investment strategy, the risks which could arise from that limited diversification.

       

 

Through the course of this article, we will consider the ATO requirements of SMSF trustees, and the auditor of the fund, regarding the issue of diversification of fund investments.

Is “having all of your SMSF eggs in the one basket” permitted?

The short answer is, yes. There is no legislative prohibition on the nature or proportion of the investments an SMSF may hold, although there are some additional requirements imposed if the SMSF holds certain assets, such as:

  • collectible and personal use assets,
  • units in a related unit trust, and
  • an investment made under a limited recourse borrowing arrangement.

While an SMSF trustee may hold virtually any investment available, there are legislative requirements concerning the formulation, and regular review, of the investment strategy of the SMSF, and this brings us back to the earlier reference to the ATO.

In August 2019, the ATO wrote to about 17,700 SMSF trustees (approx. 3 per cent of all SMSFs), as well as fund auditors, regarding what we have referred to earlier as “having all of your eggs in the one basket” — more formally referred to as the limited diversification of investments of those SMSFs.

Although the intent of the ATO correspondence was to remind trustees of the fact that the lack of diversification should be formally considered, an unfortunate component of the letter (at an early stage in the letter) was reference to penalties for non-compliance.

That overshadowed the intent behind the letters: to remind trustees and auditors of the requirements for the proper formulation of an investment strategy for their SMSF.

SMSF investment strategy requirements

The superannuation legislation requires that SMSF trustees [SIS Act s 52B(2)(f) and SIS Reg. 4.09(2)]:

  • “… formulate, review regularly and give effect to an investment strategy that has regard to the whole of the circumstances of the entity including…:

    (b) the composition of the entity’s investments as a whole, including the extent to which they are diverse or involve exposure of the entity to risks from inadequate diversification.”

So, while there is little stopping the SMSF trustee from lacking diversification in the investments of the SMSF, the trustee needs to have considered the various risks that may arise from that lack of diversification.

What circumstances may arise where it is likely there will be a lack of diversification?

A number of instances will occur in SMSFs which may result in the fund having significant exposure to one asset class, including:

  • the SMSF trustees know and trust investments in property, to the exclusion of other investment options;
  • the fund members invest in a variety of investments outside of the SMSF, and their aim for the SMSF is limited to holding a specific type of investment;
  • the fund members have most of their super in a public offer fund, but use the SMSF to hold an investment type, such as property, not available in the public offer fund;
  • for risk purposes, a decision may have been made to “quarantine” a real estate investment (such as a factory) in a second SMSF, so as not to risk the other SMSF in the event of a damages claim;
  • owners of a business establish an SMSF to hold the property from which their business operates, while each also has their own SMSF with their spouse; and
  • all available funds are applied to minimise the amount borrowed to acquire an asset under a limited recourse borrowing arrangement, with the eventual aim of broadening the investment range in the future.

Should trustees do anything to rectify the limited diversification?

Not necessarily. As mentioned, the lack of diversification is not the actual issue — the issue is whether the trustee of the SMSF has, as part of the creation or review of the investment strategy, provided adequate consideration to:

  • the extent to which the fund investments are diverse, and
  • the risks, including potential liquidity issues, from limited diversification.

Effectively, for trustees to be able to prove they have considered the potential risks of limited diversification, they will not only need to have a written investment strategy, but also written confirmation that the apparent lack of diversification, and resultant risks, have been considered.

Therefore, ensuring the investment strategy is up to date and that consideration has been given to the effects of any limited diversification is important.

Would planning for the future be beneficial?

Part of the risk from limited diversification is the forced action resulting from unexpected occurrences.

To plan for such eventualities is an important component of the role a prudent trustee would perform.

In the SMSF environment, that is generally referred to as an “exit strategy”.

Instances where an exit strategy would be of use include:

  • the situation of a two-member SMSF with a limited recourse borrowing arrangement, and planning for the occurrence of death, disability or divorce;
  • an agreement of business owners in the example covered earlier which could cater for the splitting of the business or the death or disability of a member, including a process to deal with the asset without causing an adverse impact.

Regardless of the ATO requirements, it is important for SMSF trustees to consider the risks which may arise from limited diversification, and the focus on those risks can be beneficial in formulating plans to mitigate any adverse impact.

How can trustees ensure they comply with the ATO requirements?

Step 1 in ensuring compliance is to confirm that the SMSF has a current investment strategy, as that is one of the covenants (the “non-negotiables”) under which SMSFs must operate.

Step 2 is to ensure that it is reviewed regularly — the ATO view is that regularly means at least annually.

Step 3 involves the specific considerations the trustee needs to cover in each review, including:

  • the investment risk and likely return;
  • the liquidity of the investments, having regard to cash flow requirements;
  • the ability to discharge current and future liabilities;
  • whether the trustee should hold insurance for the members; and
  • the composition of the “… investments as a whole, including the extent to which they are diverse or involve exposure… to risks from inadequate diversification”.

Formally undertaking a review of the investment strategy at least annually, such as when the SMSF financial statements have been prepared, with the review

  • ensuring the fund investments are within any parameters set out in the investment strategy, and
  • covering the matters detailed in Step 3 above, with particular attention to the diversification aspect, if applicable

will see the trustee effectively covering not only the ATO requirements but also meeting the specific covenant concerning SMSF investments.

More considerations

Mentioned earlier was the fact that some SMSF auditors had also received correspondence from the ATO. That occurred if they had audited an SMSF which has more than 90 per cent of its assets in a single asset class.

The correspondence effectively put auditors on notice to ensure trustees have given adequate consideration to the diversification issues we have covered in this article.

As a result, trustees can expect increased auditor scrutiny of their investment strategy documentation, including the diversification considerations.

Documentation

An anomaly with the investment strategy legislation is that, while the trustee of the SMSF must have an investment strategy, there is no stipulated requirement that it be in writing.

The same applies to the diversification considerations.

However, it would be a very brave trustee who did not support their decisions with proper documents as, without written proof, it is likely the auditor and the ATO will deem that no such investment strategy exists.

Topdocs recommends that an investment strategy be regularly reviewed and, if necessary, it be updated so as to ensure it remains reflective of the trustee’s intentions.

Additionally, if the investments are limited in their diversification, trustee resolutions confirming their deliberations of the risks involved must be prepared.

Conclusion

Having eggs in the one basket is permitted, but trustees need to have considered the risks and difficulties involved.

SMSF trustees have much to think about in the administration of their fund — the degree of diversification of investments is one consideration they should properly document.

 

 

Michael Harkin
27 November 2019
smsfadviser.com

 

Retirement planning in 15 minutes a day

There are few things in today's world as certain as this. Ask anyone how they are and the answer you're likely to get is “I'm good. Busy. How are you?”

           

 

The internet is filled with articles about '10 ways to feel less busy' or 'why you feel busy all the time'. This is not one of them.

This article is about how many of us, inundated by the challenges of everyday life, often push crucial tasks to the back of our minds, where they get lost forever. This risk rises with tasks that are urgent but have no clear deadline. For example, retirement planning.

When you are young, the idea of no longer working seems far off. The earlier you start planning, however, the more likely you will be able to generate sufficient income when you retire, thanks to the power of compound interest. Procrastinating on planning for the future could risk struggling financially late in life when you may not be able to earn your way out of the problem.

But retirement planning doesn't have to be complicated or time-consuming. You can plan your retirement in roughly 15 minutes (your time may vary a bit) a day over five or six days.

Here's how:

Day 1: Block out 15 mins a day for the next week. This sounds obvious, but blocking out time on your calendar commits you to getting a job done. At the very least, it will remind you to do the work. Try to pick a time of day when you tend to have more energy. If you have to reschedule, put the new time on your calendar right away.

Day 2: Set retirement objectives. Think about how you want to live in retirement. Do you plan to stay in your current home or downsize? Will you stop working completely or look for a part-time job? What are your current expenses? Are they likely to change in retirement? These are just a few of the questions to ask as you try to determine how much income you will need in retirement.

It's fine to just jot down a few ideas and save the nitty-gritty for later. Your goal is to get started. If a comprehensive retirement plan results, that's wonderful, but don't let a desire for perfection stop you from taking the first step.

This calculator from the Australian Securities & Investments Commission can help you estimate how much you are likely to receive in income from your super and the age pension.

Day 3: Review your super. We talk about super as if it's one account, but many Australians have multiple accounts because they switch jobs. To make sure you are tracking all your super accounts, log on to MyGov, where you can find a list of all your super accounts in the tax section.

Day 4: Consider consolidating your super. Now you know where your accounts are and how your investments need to be allocated. If you have more than one super account, it's time to consider consolidating, which can add thousands to your retirement balance.

Look for a super fund with low fees and the insurance cover you need. The fund you want may be one you already own, or you may choose a new one. You can compare funds here.

If you decide to switch, check whether doing so will affect your current employer's contributions.

Day 5: Complete consolidating. You may need to make a few phone calls and fill out some forms to consolidate.

Day 6: Align your portfolio with investment goals and risk tolerance. This is really the first step in retirement planning, so if you did it when you set up your super, congratulations, you just saved 15 minutes! If you didn't, or if market movements or other factors have pushed your portfolio out of alignment with your goals, retirement time frame and risk tolerance, you may need to reallocate shares, bonds and cash to get back on track.

And if you have recently consolidated some old super accounts, take the time to get a complete view of how your portfolio's asset allocation now looks – and make another diary note to review in 12 months time or perhaps on a significant day like a birthday.

Striking the right portfolio balance depends on your age, risk tolerance and other factors. Generally, you need enough shares to achieve returns required to generate sufficient income and keep up with inflation in retirement, and enough bonds and cash to cope with market volatility.

This guide can help you understand the basics of constructing a portfolio.

Day 7: Relax. You're done! It would be prudent to schedule some time in your calendar for six months or a year from now to review your plan and make sure your portfolio is still allocated according to your plan. You may need to rebalance if you are not in a fund that does that for you.

 

Steps one through six will take about two hours, possibly less. You complete them in bursts of 15 minutes, or all at once. Do whatever it takes to get started. Once you do, you may find it easy to keep going.

 

Written by Robin Bowerman
Head of Corporate Affairs at Vanguard.
19 November 2019
vanguardinvestments.com.au

 

Review queries retirement system understanding

The Retirement Income Review questioned if consumers understand the end purpose of the retirement system and if more needs to be done to make it clearer.

           

 

The Retirement Income Review (RIR) has questioned whether the purpose and objective of the retirement income system is well understood by the Australian populace and is seeking evidence as to the level of understanding across the wider community.

In doing so, the RIR had put forward the purpose of retirement income system is to generate funds for consumption in retirement, stating in a consultation paper released last week, the system “aims to allow older Australians to achieve adequate income in retirement, in a way that is sustainable for current and future generations”.

“Although individuals often focus on accumulating assets for a retirement ‘nest egg’, generating income to support consumption in retirement is the primary purpose of the system.”

The RIR paper also added the retirement income system was not designed for the creation of lump sums for spending, or to generate wealth to transfer to younger generations of the same family.

“The retirement income system is not intended to boost private savings per se, nor is it intended to be a source of savings for the purchase of large assets during an individual’s life (such as housing), or to assist with wealth accumulation in order to provide for inheritances.”

To prevent these things occurring, the paper noted policy settings had been put in place, including restricted access to superannuation before preservation age, minimum drawdown rules for superannuation, and the means testing of the age pension but questioned whether the overall objective was well understood.

As part of the consultation questions included in the paper, the RIR asked “Is the objective of the Australian retirement income system well understood within the community?” and also sought evidence to support any responses to the question.

In addition the paper encouraged input on what areas of the retirement income system would benefits from an improved understanding of its operation.

In releasing the paper, the RIR reiterated its exploratory nature stating decisions around retirement income involved ‘trade-offs’ and “it is ultimately up to the Australian community to make judgements about the merits of the various trade-offs.”

“The contribution this Review seeks to make is to identify relevant issues, provide a better understanding of the nature and consequences of trade‑offs, and develop a fact base to help the community make any decisions.”

As part of that work the RIR would also make use of existing research papers and reports, including identifying the basis for the different conclusions made by those publications and will also examine the Productivity Commission report on superannuation released in January 2019.

Jason Spits
November 25, 2019
smsmagazine.com.au

The economic and investment outlook for 2020

The 2019 year has been unpredictable for investors, with weaker economic growth and ongoing geopolitical tensions leading to heightened volatility on investment markets.

           

 

As we head towards 2020, expect a continuation, if not a deterioration, in the prevailing investment conditions as trade tensions and broader uncertainty erode economic growth and further destabilise markets.

Our just-released Vanguard economic and market outlook for 2020 points to a new age of uncertainty in the context of a continued slowdown in global economic growth, driven to a large extent by the unresolved trade tensions between the U.S. and China.

This, combined with unpredictable policymaking, is likely to weigh negatively on demand in 2020, and on supply in the long run as businesses defer new investments.

The global economy: Broader uncertainty

The global growth outlook is decidedly cloudy. Growth will remain subdued for much of the next year and, although we see U.S. growth decelerating below trend to around 1%, our expectation is that the world's largest economy will avoid a technical recession.

Meanwhile, we expect growth in China to drop below its 6% target rate to 5.8% and, in the euro area, growth will likely stay weak at around 1%.

For Australia, we expect a below-trend growth rate of 2.1%, with the domestic economy being cushioned to some degree by recent monetary and fiscal policy actions. “The pain of trade wars and other global uncertainty has been to some degree, alleviated by monetary and fiscal policy actions.

However, it is becoming increasingly clear in Australia that there are diminishing returns to further rate cuts and the overriding priority to achieve a budget surplus will likely limit the role fiscal policy plays at boosting activity in 2020,” says Vanguard economist Beatrice Yeo.

“Doubts of a meaningful near-term resolution of the trade war between the US and China, coupled with continued geopolitical uncertainty and deterioriating industrial growth have resulted in a slowdown in growth in the world's two largest economies.”

Inflation in Australia, alongside the euro area and Japan, is expected to undershoot the Reserve Bank's targets.

“In the absence of a strong solution to boost inflation and stimulate wage growth, we see a possibility for the deployment of QE-lite by the RBA or unconventional monetary policy of some form, once the cash rate hits 0.5 or even lower at 0.25 per cent,” says Yeo.

Investment markets: Subdued returns here to stay

Investors should be mindful that as global growth slows there will be periodic bouts of volatility in the financial markets, given heightened policy uncertainties, late-cycle risks and stretched valuations.

“Our near-term outlook for global equity markets remains guarded, and the chance of a large drawdown for equities and other high-beta assets remains elevated and significantly higher than it would be in a normal market environment,” says the global head of Vanguard's Investment Strategy Group, Dr Joseph Davis.

“High-quality fixed income assets, whose expected returns are positive only in nominal terms, remain a key diversifier in a portfolio.

“Returns over the next decade are anticipated to be modest at best. The fixed income return outlook has fallen further because of declining policy rates, lower yields across maturities, and compressed corporate spreads.”

The outlook for equities has improved slightly from our forecast last year, thanks to mildly more favourable valuations, as earnings growth has outpaced market price returns since early 2018.

Annualised returns for Australian fixed income are likely to be between 0.5% – 1.5% over the next decade, compared with a forecast of 2% – 4% last year. The outlook for global ex-Australia fixed income returns is slightly higher in the range of 1.0% – 2.0%, annualised.

For the Australian equity market, the annualised return over the next 10 years is in the 4.0% – 6.0% range, while returns in global ex-Australian equity markets are likely to be about 4.5% – 6.5% for Australian investors, because of slightly more reasonable valuations elsewhere.

Over the medium term, we expect that central banks will eventually resume the normalisation of monetary policy, thereby lifting risk-free rates from the depressed levels seen today.

So, broadly speaking, given our outlook for lower global economic growth and subdued inflation expectations, risk-free rates and asset returns are likely to remain lower for longer compared with historical levels.

 

 

Tony Kaye
Personal Finance Writer Vanguard Australia
25 November 2019
vanguardinvestments.com.au

 

 

 

Our Advent calendar for 2019

On behalf of all our staff we wish our clients a Merry Christmas, Happy New Year and a great holiday period.

Come back each day for an inspirational quote or poem about Christmas, summer and life in general from some of the great writers and poets.

(Please click on the image to open the Advent Calendar and then click on a date)

         

 

 

 

 

 

 

 

 

 

 

 

GDP by country since 1800

This animated chart is simply amazing.  It's fascinating to see how the world has changed and is changing.  Food for thought!!

         

 

Simply click on the image and see how things have changed but also how, in many ways, they've stayed the same.

 

 

 

 

 

 

 

 

 

 

 

 

 

Traversing a synchronised economic slowdown

The International Monetary Fund (IMF) grabbed headlines this month on releasing its latest World Economic Outlook report, downgrading its global growth forecasts to the lowest levels since the 2008-09 financial crisis.

         

 

Pointing to heightened economic and political uncertainty, particularly in China and the United States, the IMF cut its 2019 global growth forecast by 0.3 per cent to 3 per cent, and its 2020 estimate by 0.2 per cent to 3.4 per cent.

Vanguard also expects global growth to continue to soften over the next 12 months, and sees the likelihood of a shallow recession occurring in the US in 2020 as being above 50 per cent, with the risk of a more severe recession a 10 per cent probability.

The IMF's forecast also came with a stark warning: that the world is in a “synchronised economic slowdown”, with financial markets expecting interest rates to stay lower for longer than had been anticipated earlier in 2019.

Indeed, more cuts to official interest rates in the US, Australia and other countries are highly likely as central banks attempt to use monetary policy as a lever to kick start growth.

“Financial conditions have eased even more, helping contain downside risks and support the global economy in the near term,” said a joint commentary by the IMF's director of monetary and capital markets, Tobias Adrian, and deputy director Fabio Natalucci.

“But loose financial conditions come at a cost: they encourage investors to take more chances in a quest for higher returns, so risks to financial stability and growth remain high in the medium term.”

Risk and fixed income inflows
Macro-economic and policy events have been among the key drivers of markets instability for some time, although risk assets such as equities are continuing to trade at high valuation levels.

“These periods of time do come about and they tend to be a more difficult time to invest, because you need to stay engaged in the market to earn respectable returns,” says Christopher Alwine, principal, head of credit, of Vanguard's global Fixed Income Group.

“But, in staying engaged in the market, it's also important to make sure the risk levels that you're positioning your portfolios in are consistent with the risks of an economic downturn, because those risks are elevated.

“To a retail investor, that really comes down to how much you have in stocks versus fixed income and cash.”

Ongoing large inflows into listed and unlisted bonds funds, where investment returns over the past year have been very strong, are a strong indicator of the de-risking phenomenon that's been occurring, and continues to occur, globally.

In a weak macro-economic environment, pointing to low inflation, higher unemployment and lower growth, broad fixed income strategies should perform relatively well as a risk diversifier to more volatile equities.

Most importantly, when you have your worst periods of equity performance, you want to see fixed income perform well. Yet, that's not always the case.

Understanding interest rate risk
Investors do need to be aware that the fixed income asset class is not homogenous. Indeed, depending on the investment strategy being used, investors in fixed income can be exposed to market risks they may not have appreciated at the time of making their investment.

For example, interest rate risk or sensitivity (duration) can enhance returns when share markets perform poorly.

But a fixed income fund may not necessarily perform this way if a fund manager has structured a portfolio in a way where the fixed income investments made materially change the underlying nature of the fund.

“One of the biggest decisions that you can make in a fixed income portfolio is to make significant duration bets,” says Vanguard senior manager, investment product management, Scott Cornfoot. “They are single decisions that can be quite volatile and surprise investors.

“What you don't want is to invest in a fixed income portfolio and, when equities go badly or markets get jittery … to find that your manager has taken a big duration position (that is, has effectively gone underweight fixed interest) and your portfolio doesn't perform as you would expect.”

This is why low-cost actively managed global credit funds that invest in high-quality investment grade bonds, and which have very tight duration constraints, are attracting investor demand.

In addition to the risk-free component generated from government bonds, these credit funds seek to generate additional performance by investing across investment grade bond markets and by seeking out opportunities to add value through specific security selection.

So, in a synchronised economic slowdown climate, if you're moving to de-risk your portfolio by shifting capital into fixed income, it's important to understand the nuances within the asset class and how they may impact returns.

This is where a licensed financial adviser should be able to provide guidance.

 

Tony Kaye
Personal Finance Writer,Vanguard Australia
29 October 2019
Vanguardinvestments.com.au

 

Four key principles that help achieve portfolio success

Buy low and sell high is the mantra of many a seasoned investor regardless of the asset class. Just stick to this investment strategy and you will never go wrong – right?

             

 

If only investing were that simple.

Short of the ability to look into the future and timing the market, how do you determine what is low and what is classified as high?

Although keeping abreast of market commentary is always useful, particularly in helping to develop your investment acumen, it is unlikely to deliver guaranteed investment success.

So, what can you do to give yourself the best chance for investment success?

Start with the basics

Vanguard believes there are four simple principles that will help improve the chances of a successful investment portfolio – goals, balance, cost and discipline.

  1. Setting goals is possibly the most important aspect of any investment strategy. Having clearly defined goals that are attainable will help establish the strategy to achieve your goals at each life stage. Having specific goals in mind will also help you stay the course and reduce your vulnerability to investment noise during periods of market volatility.
     
  2. The concept of a balanced portfolio is about building an asset allocation strategy that aligns to your investment goals, based on realistic return assumptions. The strategy is balanced between potential returns and risk, and your portfolio holdings as a result should be broadly diversified.
     
  3. Although investment costs may seem small, they can take a significant toll on your portfolio, particularly when compounded over many years. Costs are an inevitable part of any investment portfolio but are certainly the one thing you can control. Ultimately the less you pay in fees, the more of what you earn stays in your pocket, where it belongs.
     
  4. Maintaining long-term perspective and a disciplined approach to your investment strategy will help to avoid making decisions that are rooted in impulsiveness or are in response to events with a short-term effect. Making regular contributions to a portfolio and increasing them over time can have a surprisingly powerful effect on long-term results.

De-risking as you age

Where possible, always make investment decisions and portfolio allocations based on your personal circumstances and goals. Accordingly, asset allocations in a portfolio should not only be guided by your risk tolerance and its ability to guard against market volatility, but also by the stage of life you are at.

An investment portfolio that has regular contributions (as a result of regular income) has more money working in compound than an investment portfolio that has regular withdrawals (typical of a portfolio of a retiree funding their retirement).

Thus, the asset allocation in an investment portfolio of a younger investor (typically upto 40 years old) should look markedly different to that of an investor in the early stages of retirement.

An investment approach that is quite entrenched in the US and gaining traction in Australia is the target-date fund model, which could perhaps provide some lessons in asset allocation to meet goals for each life stage. These allow investors to nominate their target date for retirement and the fund will gradually shift the asset allocation as they approach and then begin their retirement.

Vanguard's US target-date fund glide path takes place over four stages and constructs a portfolio based on balancing market, inflation and longevity risks in an efficient and transparent manner over an investor's life cycle along our basic investment principles. It generally segments investors into four phases, starting with investors aged 40 and below, then moving into the mid-to-late career.

Phase one starts with an allocation of around 90 per cent to equities and then begins de-risking during the mid-to-late career phase. Phase three encompasses the transition to retirement phase, where the portfolio de-risks further before reaching a landing point in the final retirement phase.

Too often a sound concept can be undone by sub-par implementation. This arose as a theme in the Productivity Commission's final report, highlighting the impact to outcomes that can arise from a target-date fund that is:

  • Too conservative in the early years when members have the greatest capacity to take on investment risk.
     
  • De-risks too early, or lands too low.
     
  • Is constructed to retirement, rather than considering the needs of investors through retirement.

Vanguard endorses the Productivity Commission's view. The objective of Vanguard's asset allocation model is to avoid being too conservative or too aggressive and to adequately diversify where possible.

Achieving your investment goals

Vanguard's research, time and again, continues to show that disciplined, diversified and patient investors who adopt a holistic view and focus on factors within their control are likely to be rewarded over the long term.

Following the four simple principles – goals, balance, cost and discipline – and focusing on the things you can control will help you become a better investor and ultimately deliver you the best chance for investment success.

* This article originally appeared in the ASX Newsletter on 8 October 2019

 

Balaji Gopal
Head of Product Strategy
09 October 2019
vanguardinvestments.com.au

 

Does your mind help or hinder your investment success?

Of all the decisions we make, investments ought to be the most rational. We should be able to whip off our rose-coloured glasses, replace them with green eyeshades and choose the lowest-cost investments with the highest-expected returns to create a diversified portfolio.

         

 

However, as with so many things in life, our emotions often get in the way of this rational approach. We buy shares in a company solely because a friend recommended it. Or, we innately believe the higher-priced product is always better, even though we have no evidence to back this gut feeling.

Those are just two examples of how our brains may mislead us when we ponder money. We're supposed to be rational, but more often than not, we are often irrational.

Understanding the general tenets of behavioural finance can help investors counter irrationality and improve investment decisions. It studies the psychology of financial decision-making and is based on a sub-field of behavioural economics. This field of research began when economists noticed that a pillar of economic thought known as the efficient market hypothesis often wobbled in the real world.

Its hypothesis posits that in a market with enough buyers and sellers, and where all investors have the same information, it's impossible to beat the market. But some investors do beat the market, often by capitalising on the irrationality of others. This caused economists to try to discover why.

And here's five key concepts from their findings:

Anchoring: This refers to the tendency to depend on, or get anchored in, limited information – some of it irrelevant to the matter at hand – to make decisions. Investors sometimes get anchored in certain numbers, which may influence whether we perceive a share price or market index to be high or low. A company share make look like a bargain if it falls from, say, $100 to $80, but the drop in price may not be relevant. The relevant question should centre on the company's expected return over a time horizon. And that is not an easy or straightforward answer.

Herd bias: Every time parents ask their children whether they would jump off a cliff if their friends did, they are actually referring to the concept of herd bias, the tendency to hop on a trend because “everyone else is doing it”. The dot-com boom and bust is one of many examples of the dangers of herd bias.

Home bias: The preference for sticking to the familiar has often resulted in investors investing in the shares of the country where they live even though diversifying internationally can generate stronger returns and lessen volatility. Home bias is especially prevalent in Australia. Australia accounts for just 2% of world markets, but figures show that Australians put 61% of their share investments in local companies. More research found the same effect affecting property investors, prompting them to invest in their own neighborhood, or close by, which may concentrate risk.

Attention bias: Advertisers count on attention bias. People are more likely to buy something they have heard of. So are investors. Research suggests that people are more likely to invest in companies they have casually read about or heard about on the news, for example.

Endowment bias: People tend to hold on to investments they already own, perhaps because they suffer from loss aversion. This bias has sometimes resulted in investors holding on to money-losing investments simply because it's painful to own up to a mistake.
Awareness of how our brains sometimes cause us to make poor choices can be the first step to making better ones.

Fortunately, there are shortcuts that can help you break these behaviors.

One simple solution is to adhere to four simple principles that will help improve the chances of a successful investment portfolio – goals, balance, cost and discipline. Set your goals, choose a number of well-diversified managed or exchange-traded funds with strong long-term track records. Keep your investment costs low. And finally, maintain long-term perspective and a disciplined approach to your investment strategy.

At the very least, you'll be less vulnerable to buying that share you just heard about on television.

 

Written by Robin Bowerman
Head of Corporate Affairs at Vanguard
18 October 2019
vanguardinvestments.com.au

 

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