Risk – Simply a Box of Chocolates?
What is financial risk, and is it all down to chance?
Whether you are investing for your retirement or for more immediate financial needs, there are three factors that could keep you from achieving your goals: inflation, taxes, and risk. It is easy to plan for inflation and to reduce taxes, but risk is another matter as it is so unpredictable.
Types of financial risk to watch out for include:
Investment Specific Risk:
Risk that affects a very small number of assets.
Risk of one country’s foreign policy unduly influencing or upsetting domestic political and social stability in another country or region.
Risk that a borrower will default on any type of debt by failing to make required payments.
Interest Rate Risk:
Risk that arises for bond owners from fluctuating interest rates. How much interest rate risk a bond has depends on how sensitive its price is to interest rate changes in the market.
The possibility that the value of assets or income will decrease as inflation shrinks the purchasing power of a currency.
Risk that stems from the changes in the valuation of currency exchanges. Fluctuations result from unpredictable gains and losses incurred when profits from foreign investments are converted from foreign currencies.
Risk of a change of price of a portfolio as a result of changes in the volatility of a risk factor. Usually applies to portfolios of derivatives instruments, where volatility is a major influencer of prices.
Risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss (or make the required profit).
Allocation of proportional risk to all parties to a contract, usually through a risk premium.
The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment.
The risk to each party of a contract that the counterparty will not live up to its contractual obligations.
Overcoming Risk: Prudential & Smoothing
Prudential Multi-Asset funds work by spreading your money across a number of different types of assets. Funds are designed to deliver smoothed growth through a number of investment options, such as company shares, fixed interest bonds, cash and property, balancing the risk being taken. So if one asset is falling in value, another may be increasing.
Risk: Simply a Box of Chocolates?
Understanding the importance of risk is a central pillar of financial planning. Risk can be measured and assessed; it can be managed. Learning how to do this is an invaluable aspect of becoming a successful investor.
Risk may be uncertain but it’s no box of chocolates. If you prepare for the uncertainty – do your research and seek relevant and informed advice – you can be fairly confident of what you’re going to get. It’s not all down to chance.
Looking forward to 2015
The end of the year is always a good time for reflection and this year we have had much to think about for our clients. However, as well as managing current financial risks for our clients, we are also forward looking. So I thought it would be a good time to do a quick review of some of the things that are on the horizon for 2015.
The UK Pensions Reform is big and we now have a reasonable amount of certainty of the changes taking place in April and it is unlikely that there will be any more changes of substance between now and then. The reform brings more flexibility, which is good, but the reality is that for many, the taxation outcome will be a deterrent against fully cashing in pension pots. This is likely to be even more so in France, where it is not just the personal tax and possible social contributions that are an issue, but also whatever you have left of the pot will then be taken into account in valuing your assets for wealth tax, as well as being potentially liable for French inheritance taxes.
The EU Succession Rules will come into effect in August. While the EU thinking behind this is good, i.e. to come up with a common EU-wide system to deal with cross-border succession, the practical effects will still have issues. The biggest issue for French residents is, of course, French inheritance taxes. Therefore, it may not necessarily be the case that the already tried and tested French ways of protecting the survivor and keeping the potential inheritance taxes low for your beneficiaries should be given up in favour of selecting the inheritance rules of your country of nationality. More information on the ‘French way’ can be found in my article at www.spectrum-ifa.com/inheritance-planning-in-france/ and on the EU Succession Regulations at www.spectrum-ifa.com/eu-succession-regulations-the-perfect-solution/
There is the UK General Election in May and who knows whether or not that will actually be followed at some point by a referendum on the UK’s membership of the EU. Nor do we know what the outcome of such a referendum would be and so there is really no point in speculating, at this stage.
For UK non-residents, we are expecting the introduction of UK capital gains tax on gains arising from UK property sales from April, subject to there not being any changes in the next budget. We had also expected that non-residents would lose their UK personal allowance entitlement for income arising in the UK, but we now know that this will not happen next year. The Autumn Statement confirmed that it is a complicated issue and if there are to be any changes in the future, these will not take place before 2017. Of course, there could be a change in government and so it might be back on the agenda sooner!
We will also have the usual round of French tax changes, although this year the expected changes are much less extensive than in previous years. The French budget is still winding its way through the parliamentary process and I will provide an update on this next month.
Turning to investment markets, my personal opinion is that the main factor that will have an impact in 2015 is central bank monetary policy. Whether this results in tighter or looser policy from one country to another, remains to be seen. What is clear is that the prospect of deflation in the Eurozone remains a real threat and not only needs to be stopped, but also needs to be turned around with the aim of eventually reaching the target of being at or just below 2%. Other central banks around the world have a similar target and in areas where recovery is clearly underway, the rate of price inflation and wage inflation also needs to increase before we are likely to see the start or interest rate movements in the right direction.
Last but not least, with effect from 1st January 2015, under the terms of the EU Directive on administrative cooperation in the field of direct taxation, there will be automatic exchange of information between the tax authorities of Member States for five categories of income and capital. These include income from employment, director’s fees, life insurance products, pensions and ownership of and income from immoveable property. The Directive also provides for a possible extension of this list to dividends, capital gains and royalties.
The above outline is provided for information purposes only and does not constitute advice or a recommendation from The Spectrum IFA Group to take any particular action on the subject of investment of financial assets or on the mitigation of taxes.
If you are affected by any of the above and would like to have a confidential discussion about your situation or any other aspect of financial planning, please contact me using the details or form below.
With care YOU prosper
I’m getting an increasing number of calls from expats based here in France who are very worried and sometimes completely dismayed by the financial advice they have received elsewhere. Worried by the fact that their investments have decreased in value, and dismayed when they realise that they cannot even withdraw their money or cancel their polices, as parts of the investment are now in funds that have been suspended (that is no-one can either buy them or sell them).
Now I’m not looking to get into any legal wrangle with the company concerned, and it is only one company, but I think this is a suitable time to flag up what is happening in the hope that some of you will avoid falling into this situation in future. I will also add that I am prepared to ‘adopt’ clients in this situation, in order to ensure as fruitful an outcome for the client as possible.
What is happening is not illegal, but it could certainly be regarded as unethical. The clients concerned have either unwittingly or deliberately chosen to put their faith in an adviser who is not regulated in France. This is not illegal, because we are all part of the wonderful organisation that is Europe, and that frees Europeans to ply their trade in other countries within the Euro block. That freedom of trade is not, however, backed up by a freedom of regulation. If you live in France and have cause to complain about advice you have received, the French regulator will show no interest in your case if the adviser is not in his jurisdiction. You will be guided to seek help from the regulator in the country where the adviser is based, and hopefully regulated. Good luck.
There are two main problems that I am seeing at present. The first relates to the quality of funds in which the clients are invested. At The Spectrum IFA Group we have an investment team that spend many hours evaluating hundreds, if not thousands, of funds and produce a recommended list for clients to invest in. There are of course hundreds of thousands of funds available, and we can’t look at them all, so we do allow our clients to choose their own investments if they wish, thereby ignoring our recommendations. All we ask, in this instance, is that you sign a form to accept that the investment was your choice. There are many good funds out there, but there are also some bad ones. All of the (now) clients who have suffered in this way have been put into a single asset class which has had a disastrous time in the past eighteen months. Needless to say, none of the funds involved are on our recommended list.
The second issue centres on a specific type of investment called a structured note. These are often complex derivative products, and the type of note that I am now seeing regularly, certainly falls into that category. So much so, that the product notes that accompany the investment clearly state that this is only for seasoned professional investors, who are willing to accept the potential for serious loss of capital. None of the people I’m taking to fall into that category. The structured note is an interesting concept, and not all of them are overly complicated. You may have seen me write about such a note in the past, and you may have seen such a product at our seminars, offering an excellent 12 month fixed deposit rate alongside a five year deposit where the reward is linked to the performance of the stock exchange index. Not exactly ‘Janet and John’ stuff, but I like to think that I can explain it completely to my clients. And I don’t use it unless I’m completely sure that the client also understands it. I don’t understand the notes I’m seeing recently, and I’m sure the client doesn’t either.
So why sell them? Simply because the companies that make up these products factor in an element of commission to the brokerage that sells the note to the end user, the client. Now I don’t know how closely you look at small print when you read articles from me or Daphne, but if you look at the bottom of this article you will see reference to our client charter at www.spectrum-ifa.com/spectrum-ifa-client-charter
If you have read the charter, or are just about to do so, you will see or have seen this:
Some investment funds or products within an Insurance policy may generate an additional initial commission. If this is the case, we undertake to rebate this commission to you (in full) by way of increased allocation.
Strangely (not), none of the new clients I’m speaking to seem to have benefitted from this principle. It seems clear to me that funds are being pedalled for the advisers benefit, not the clients. This is a very dangerous practice.
I must stress that no laws have been broken here, and no fraud has taken place. I sell a simple structured note, but I pass on the commission. I even have clients who are invested in the struggling asset class that we have been talking about, but only by their own choice, and for many months now that has been contra to our advice.
Be safe – use locally produced goods, and that includes financial advice.
If you have any questions on this, or any other subject, please don’t hesitate to contact me.
Investments and investment risk
As I am writing this article, the hot topic of the moment is of course the Scottish Referendum on Independence. The polls are swinging from one direction to the other, but only by a small margin between the ‘yes’ and the ‘no’ camps. The final result will most likely be very close.
Even the Queen has uncharacteristically got a little involved in the politics, by expressing her hope to a well-wisher in Scotland that people will think very carefully about the future. Whatever the result of the referendum, it is clear that the United Kingdom will change.
What will happen to investment markets if Scotland votes yes? Well the wider world outside of Scotland seems to have woken up to what is actually happening in Scotland. Sterling has weakened amidst the uncertainty of the outcome, but beyond this, I am not bold enough to forecast any further effect on markets. Like any other investment risk, it needs to be managed.
On this subject, The Spectrum IFA Group has produced a Guide to Investment Risk. This has been written in plain, no nonsense, down-to-earth English and covers a range of assets classes and strategies. The individual articles included in the Guide can be found on our website at: www.spectrum-ifa.com/spectrums-guide-to-investment-risk/
Alternatively, if you would like to receive a full copy of this Guide, please contact me.
We are also taking bookings for our Autumn client seminar – “Le Tour de Finance – Bringing Experts to Expats”. Our industry experts will be presenting updates and outlooks on a broad range of subjects, including:
- Financial Markets
- Assurance Vie
- Structured Investments
- French Tax issues
- Currency Exchange
Places for our seminars are limited and must be reserved, in advance. So if you would like to attend the event, please contact me as soon as possible. The date for the local seminar is
Friday, 10th October 2014 at the Domaine Gayda, 11300 Brugairolles.
Alternatively, if you are reading this further afield, you may be interested in attending one of our other events:
- Wednesday, 8th October – St Endréol, 83920, La Motte, the Var.
- Thursday, 9th October – Chateau La Coste, 13610, Le Puy-Sainte-Réparade.
For full details of all venues can be found on our website at www.spectrum-ifa.com/seminars
If you cannot attend one of our seminars and you would anyway like to have a confidential discussion about any aspect of financial and/or inheritance planning, please contact me either by e-mail at email@example.com or by telephone on 04 68 20 30 17.
The above outline is provided for information purposes only and does not constitute advice or a recommendation from The Spectrum IFA Group to take any particular action on the subject of investment of financial assets or on the mitigation of taxes.
The Spectrum IFA Group advisers do not charge any fees directly to clients for their time or for advice given, as can be seen from our Client Charter at www.spectrum-ifa.com/spectrum-ifa-client-charter
Making a Will in Switzerland
Wills in Switzerland
As a general rule, the Estate of anyone residing in Switzerland is governed by Swiss material law, especially by the relevant provisions of the Swiss Civil Code, which definitely apply in the absence of a Will, notwithstanding the deceased’s citizenship, personal status or religion.
Swiss law, which was influenced by the Napoleonic Code, provides for various solutions, either mandatory or optional, and includes the so-called rules of “forced heirship” – according to which some heirs (the spouse, the children and, in some cases, the parents of the deceased) are in any event entitled to a minimum portion of the Estate (similar rules apply in most countries on the continent and in Scotland).
Choice of Law
According to the Swiss Federal Law on Private International Law, foreign residents in Switzerland may, by making a Will, direct that their Estate be governed by the law of their country of origin and, thus, avoid all or some of the rules set by Swiss law.
This choice of law (that is not permitted in the event of double citizenship including Swiss citizenship) does not affect the jurisdiction of the Swiss authorities and, depending on the deceased’s Canton of residence, inheritance tax must still be paid in Switzerland (taking into consideration the deceased’s Estate on a worldwide basis).
As regards American citizens, it may be wise to specify the law of the relevant US State (with which they have some connections, e.g. California), while Brits should refer to “English law” (or “Scottish law” for the Scots) rather than UK or British law since it does not exist as such.
Making a Will
If made in Switzerland, the Will must have the form prescribed by Swiss law. As a rule, it must either be entirely handwritten, dated and signed by the “Testator”, or made before a Swiss Notary Public (where the Will is actually drafted by the Notary and signed by the Testator in the presence of two witnesses who are often the Notary’s assistants).
Typed Wills or so-called “joint” Wills (one single Will made by two people) are prohibited and void.
Handwritten Wills may be drafted in any language, while Wills made before a Notary Public are usually in the local official language (i.e. in French in the French-speaking area of Switzerland, such as Geneva or Vaud).
Although it is not legally required in Switzerland, when a handwritten Will may predictably need, at some point, to be proven in the US, it is worth asking two witnesses to certify the Will at the time it is signed by the Testator, as this would be expected by a US probate Court.
Making a Will before a Notary Public is especially advisable when the mental capacity of the person making the Will could later be questioned (due to illness, age, potential influence of other people, etc.).
Usually, Wills made with the assistance of a Notary Public are kept by the latter who must send them to the competent local Court or authority upon the testators’ death. When Wills are made privately, it is wise to leave them in some place where they will be found easily, but they can be lost or destroyed. It goes without saying that any Will may, at the Testator’s discretion, be changed, amended, replaced or cancelled at any time by their authors and mere photocopies are not effective.
Appointment of an Executor
Under Swiss law, when there is no Will, the Estate is usually handled by the heirs (who must act jointly).
An Executor (or more than one) may however be appointed by Will and, upon the Testator’s death, will be required by the competent local Court (the Judge of the Peace in Geneva and Vaud) to accept this mission. The Will may include some specific instructions to the Executor who is generally entitled to deal with the Estate without any restriction.
The appointment of an Executor in a Will (and a possible Successor Executor – contingent in the event of the death or incapacity of the first one) is recommended when some assets are held abroad (especially in the US, in the UK or in other common law jurisdictions), when some of the heirs are under 18 years of age or when the situation may prove complex for some other reasons.
Where no Executor was appointed, the local Court may, under some circumstances, appoint an Administrator to take care of the Estate and to protect the heirs’ interests, especially if they are not all known.
Anyone finding a deceased’s Will in Switzerland must send it to the local authorities. Probate proceedings include the notification of a copy of the Will to all the heirs and beneficiaries and, depending on the circumstances, to any relatives possibly entitled to a portion of the Estate.
If the heirs suspect that the deceased was insolvent, they may reject the inheritance within 90 days. Alternatively, they may, within 30 days, apply with the local Court for a formal inventory to be drawn up (at their own expenses) and only accept the inheritance accordingly.
When the heirs accept (even tacitly) the inheritance, they immediately become the successors of the deceased for all the Estate assets and liabilities. They must act jointly and they are severally responsible for the deceased’s debts and obligations (including outstanding contributions or taxes owed in connection with undeclared assets).
Usually, when the deceased was a foreign national, Swiss Courts require that the heirs submit a formal statement to be issued by a Notary Public, in accordance with information that must be given by two witnesses who have no interest in the Estate and who must confirm the deceased’s family status, along with a list of all relatives who may be entitled to the Estate. In the event of any doubt or if no one is able to provide the requested information, the Court may order that a formal notice be published in the official gazette, allowing any potential heir to challenge the Will within 1 year.
In some cases, the heirs also have to submit a legal opinion confirming the solution resulting from the application of some foreign rules (if selected in the Will) that are sometimes regarded as rather “exotic”.
Once the situation is clarified (and, where applicable, after a fiscal inventory is filed and inheritance tax paid), the Court issues a Certificate of Inheritance naming the heirs and allowing them to fully access the Estate assets and arrange for these to be distributed amongst them.
- Non-Swiss can (should) ask for their Estate to be governed by the law of their home country and state the country (i.e. will therefore avoid Napoleonic Code).
- They must clearly state in the Will that this is what they want to do, g. “I direct that my Estate shall be governed by *** law”.
- If it is not made before a Notary Public, the Will must be handwritten and married couple must write a Will each (so-called “joint-wills” are invalid in Switzerland).
- A handwritten Will does not have to be witnessed and it should be kept in a safe place.
- The appointment of an Executor (or more than one) should be considered.
- It is helpful to attach a list of worldwide assets such as the name of the bank, branch and account number in which accounts are held, details of life policies or any other assets, as well as the contact details of people who could inform the heirs (such as Attorney, Financial Advisor or Accountant).
Creating or Updating your Will / Estate Planning – The Right Questions
If you died today, how would your Estate be handled?
- Is there a Will and where is it?
- Which debts should be eliminated?
- Which assets should be sold (such as business or real estate)…
- … and which ones should be kept (such as heirlooms)?
- Who is to receive which assets (financial and sentimental)?
- Are there any distribution clauses (e.g. to give your watch to your son/daughter when they reach age 18)?
- Who is to take legal responsibility for any children under age 18?
- Who is to assist the heirs and to ensure that your instructions will be implemented?
- Did you know that, if you are a US citizen, Swiss banks can be required to freeze your accounts until all US taxes are declared and paid, thus a joint account could be frozen?
- If a joint account holder passes away, the account can be frozen until Swiss taxes are cleared up, with the surviving spouse only able to present bills for living expenses to be paid.
- If a married couple has children and one of the parents dies without leaving a Will, the child/children are deemed to inherit 50% of the Estate and depending on the Canton, may have to pay Inheritance Tax. In the Canton of Vaud, children may however be “gifted” up to CHF 50’000 per year each – tax free.
Careful individual planning allows to identify and solve a number of issues like these.
We offer a free initial consultation should you wish to discuss these or other financial planning matters and should legal advice be required, we will work in conjunction with excellent English-speaking Attorneys and likewise have access to excellent English-speaking Accountants if pertinent.
This notice is for information purpose only and does not constitute legal or other professional advice. Any specific queries should be looked at individually with a professional advisor. This document may not be disseminated or published without written authority.
How to protect yourself in uncertain times
Wealthy individuals have a lot more in common than just their wealth. Ambition, skill, patience, consistency and a strategic game plan are all vital to ensure success. Keeping an eye on the end goal and never giving up have been key to reaching greater heights.
Only a minority of the population become extremely rich, as the likes of Warren Buffet, Richard Branson or Paul Getty, but this does not mean that we can’t enjoy a comfortable lifestyle with luxuries and freedom.
World stock market performances over the last 60 years reveal that the enduring trend is up and it is evident that any sharp downward movements often coincided with world calamities. Even with the peaks and valleys, stock market performance over time still yields inflation-beating returns for those who remain loyal.
Despite this, investors are concerned about the fluctuating Gold price and negative impact of the mining and metal strikes in South Africa and the developing Russian/Ukraine crisis which is already a cause for alarm – Russia is now talking of disallowing air travel over its skies to the East thus hampering tourism, the lifeblood for many of the Asian Tiger’s economies.
Hearing the words ‘hang in there’ is not enough reassurance for those trying to save for retirement or financial independence. This in turn affects investors who feel the pinch whether it be through investment of stocks directly through their own portfolio comprising retirement annuities, pension plans, QROPS, unit trusts or any other long term investment products which are exposed to the share market.
The critical questions is …
“How you manage your income and investments to shield against market volatility?”
Well, there are basically two main strategies that need to be developed in order to provide an effective buffer against economic turmoil.
The first is effective management of income and the second is a well-structured investment strategy.
Effective Money Management
It is little wonder that rising interest rates cause such widespread concern when so many people and businesses are exposed to excessive debt. If you take an average small- to medium-size business owner, they will probably have an overdraft, two car leases, a home mortgage and perhaps credit card debt. In anyone’s book, this results in a big chunk of money to repay before the school fees have been paid or the life policy has been covered.
The first step to minimising the effects in uncertain economic times is to reduce debt. If you don’t have excessive debt, the impact of rising interest rates on your pocket will be negligible and it’s worth bearing in mind that if you have cash reserves, the higher rate will benefit you greatly.
Well-structured investment strategy
The consensus amongst investment experts is to advise individuals to construct an investment portfolio in order to take advantage of long term trends. If the long term structure of an investment portfolio is healthy, short term storms can be weathered.
The first defence against any volatility in the markets is diversification. What this means, is that investors need to ensure that their investment portfolio is structured in such a way that they have investments in different asset classes such as cash, bonds, property and equities.
Uncertainty and volatility are intrinsic to investment markets. For this reason, investment should be viewed as simply a means to having enough money to live the lifestyle that you would like to live.
An investment portfolio should remain unchanged during times of volatility, unless the factors upon which the construction process was based have changed.
Investors should not change a long term game plan based on short term volatility. Attempting to time the market based on short term movements only increases portfolio risk.
The best way to protect yourself from market volatility is to first reduce your risk, which can be achieved by reducing debt. By doing this, you will have a lot less to worry about if inflation forces interest rates up.
The next step is to ensure that your investment strategy has a long term view and a financial planner will be your best resource when setting up a long term portfolio.
If you realise from the above the importance of seeking proper professional financial advice involving risk classification and correct diversification, why not give me a call in order to facilitate a meeting where we can do this.
Precious metals and gold
Which of these has more value? Is there something better?
When it comes to hedging (protecting) against dollar debasement, few things have performed as well as gold. Having gold or unit trust gold funds could be said to be “preparing for the worst.”
Following the fairly recent global financial crisis, governments have adopted expansionary monetary policies by cutting interest rates and increasing the amount of money in circulation to keep their banks and indebted borrowers afloat. Even though the historical case for gold is strong and the price goes up, the raw supply and demand case for platinum and palladium might be even stronger.
Russia and South Africa currently hold 80% of the world’s platinum and palladium reserves and both are struggling to maintain output. In fact, global supply is becoming increasingly less as production declines in these two politically volatile countries. Strikes in South Africa have resulted in the loss of 550,000 ounces (14,174,761 grams) worth of production in the first quarter of this year. And the tensions along the Ukraine border threaten to trigger huge disruption in markets in Russia.
This instability in South Africa and Russia all but ensures that the platinum and palladium markets will see yet another supply deficit in 2014.
Regardless, demand continues to increase and is unlikely to come down soon. Primarily, these metals are used in catalytic converters, the mechanism in your car’s engine that helps reduce noxious gas output and helps to keep the air cleaner. As more and more cars hit the roads – particularly in developing nations – the demand for cleaner air looks set only to rise.
Do you have gold shares in your investment portfolio? Or Uranium or Platinum? Now is the time to look at exactly what assets make up your portfolio. After all, I am sure you want to cover all bases.
“The best time to invest is when you have money.
This is because history suggests it is not timing which matters, but time”
Sir John Templeton
The REAL effect of inflation
On a day-to-day basis, inflation isn’t necessarily something you spend a lot of time thinking about. However, occasionally, you might find yourself asking – what exactly is inflation? And how does it affect me?.
Inflation is simply a sustained increase in the overall price for goods and services which is measured as an annual percentage increase.
As inflation rises, every pound or euro you own purchases a smaller percentage of these goods or services.
The real value of a pound or euro does not stay constant when there is inflation. When inflation goes up, there is a decline in the purchasing power of your money. For example, if the inflation rate is 2% annually, then theoretically a £100 item will cost £102 in a year’s time and £121.90 in 10 years time.
After inflation, your money can’t buy the same goods it could beforehand.
When inflation is at low levels it is easy to overlook the adverse effect it has on your capital and the income it produces. Regardless of how things look today, the likelihood is that the price of all the goods we buy and services we use will be higher in the future.
Inflation does not reduce the monetary value of your capital, a pound is still a pound and a euro is still a euro, but it reduces the “real” value. It erodes the spending power of your money, potentially affecting your standard of living.
The chart below details the effect of inflation over a 15 year period, 1998 to 2013. It is easy to see that leaving money exposed to inflation risk and not attempting to beat it and achieve higher growth is a no win situation.
Many clients will say that investing is a risk (see my alternative article to risk), and of course there is always an element of risk but leaving your money in a low rate bank account, open to inflation risk, is surely the riskiest option…….you can’t win !!!
If you had left your money open to the effects of inflation between 1998 and 2013 then it would have lost 35% of its purchasing power.
As statistics prove we are living longer now which means that we can look forward to a longer retirement period therefore the impact that inflation will have on your finances needs to become a prime consideration.
An Inflationary Tale
An Inflationary Tale
Inflation is a complicated concept. It’s not easy to understand but if ignored, your money will slowly and stealthily reduce. As a teenager growing up in the 70’s I would hear the newscasters talk about inflation and price controls yet could never tell if it was a good or bad thing. Interest rates were going up as were house prices and income. This had to be a good thing I thought but little did I know!. What I learned later in life as I studied inflation is that, like most things, inflation is a double-edged sword. There are winners and there are losers. It is good for some and bad for others. As you read this tale focus on the two main concepts about inflation. Learn what it is and what it means to an investment portfolio.
What Does The Word Inflation Actually Mean?
Type the word “inflation” into a search engine on your computer and you will probably get information informing you that inflation is “A rise in the general level of prices of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation reflects an erosion of the buying power of your money – a loss of real value. A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the Consumer Price Index) over time.” If you are like me and read the above definition you are thinking blah, blah, blah, blah, blah. So since the objective of this Newsletter is to keep things simple, let’s just translate this to what it means to you as an investor.
I like to think of inflation in terms of what $100 can buy in the future if I don’t invest it today. Let’s say, for example, if I make 0% rate of return on my $100 bill because I either put it under my mattress or buried it in the ground or kept it in a safety deposit box and then a few years later I want to know what it can buy. This is what inflation means to the investor or consumer. What that $100 can buy is called purchasing power and purchasing power is directly proportional to the rate of inflation. The following table shows what $100 un-invested can buy at different inflation rates over different time periods. I call it my “Mattress Investing table” because it teaches us that you can’t put money under your mattress unless you want to guarantee that you will slowly erode the value of your money.
(The Loss of Purchasing Power Associated with Not Investing $100.00)
|Inflation Rate||5 years||10 years||15 years||20 years||25 years||30 years|
How should an investor read this table?
Investors should understand that if they keep money in a mattress for 15 years and the inflation rate over 15 years is 5% per year their $100 can only buy $46.33 worth of “Stuff” 15 years later. If inflation were to average 7% for 30 years their $100 could only buy $11.34 worth of “Stuff.” I know it’s silly to think that anyone would keep their money in a mattress but the reason I use the table above is because it illustrates the important concept about inflation which is loss of purchasing power. Inflation in and of itself is meaningless. What matters to people is what inflation causes which is the loss of purchasing power. As an example, when I get in my car to drive I have a rudimentary notion of how the engine functions. People that know me know I’m not mechanically inclined. I do however know how the steering wheel works. To an investor, inflation is the engine while purchasing power is the steering wheel. You can be completely oblivious to how an engine works and still be an excellent driver. So, if you are so inclined you can spend a disproportionate amount of time studying how the engine works or the nuances of inflation or you can learn how to drive and invest your money to combat the loss of purchasing power. How to invest your money to combat inflation is discussed in A Preservation Tale. I’ll give you a little hint—I am not a Gold Bug but if you put a $100 gold coin under your mattress instead of a $100 bill you have a much better chance of preserving purchasing power during inflationary times.
So once again, how should an investor read the Mattress Investing table?
Let’s focus on the 3% inflation rate since that has been a good approximation for so many decades. What this table shows is that if the inflation rate is 3% and you keep your $100 under your mattress, in 5 years it will only buy $85.87 worth of “Stuff.” I like to use the technical term “Stuff” to describe purchasing power!. To investors, the intended use of a $100 bill is to be able to buy “Stuff.” In and of itself the $100 bill is worthless. Its only value is the amount of “Stuff” it can buy. In this case it can only buy $85.87 worth of “Stuff” so the Mattress Investor has lost $14.13 of “Stuff” by keeping it in his mattress or not investing it. When you hear the term Loss of Purchasing Power it means “Stuff” you can’t buy!.
This leads directly to what I consider the minimum objective for investors and one of my maxims.
The purpose of investing should be to at a minimum maintain your purchasing power. I believe you should invest so that you don’t lose your “Stuff.”
So what can we learn from this tale that puts money in our pocket? Who wins and who loses from inflation? By now it should be clear that at any inflation rate greater than 0% you must make more than 0% on your money in order to maintain purchasing power. Yet when guaranteed interest rates are not accommodative, like they are today and have often been in the past, the investor must invest in non-guaranteed investments to maintain purchasing power. For investors that have read tales such as this one this presents a quandary. They can intelligently ask themselves, if I want a guarantee and guaranteed rates are so low that I can’t preserve purchasing power then I must accept a loss of purchasing power. However, if I want an opportunity to maintain purchasing power I must assume risk. This is the never-ending portfolio management question that is forever on every investor’s mind and will be at every stage of their life. While most investors answer this question by forgoing guaranteed returns in order to not just maintain purchasing power but to potentially increase purchasing power, others do not. There are investors that choose to avoid risk at all cost and are knowingly watching their purchasing power slowly erode.
Unfortunately, the sad circumstance for most risk-averse investors is that they behave as they do out of ignorance or fear and not based on knowledge. Many are willing to invest their money in bank CDs, money market funds and government bonds at below required levels just to keep it guaranteed. The only guarantee they’re getting during most periods is the guarantee of a loss in purchasing power. When and if there is increased inflation these are the people that will also suffer the most.
Lastly, I have included a paragraph from a 1977 article written by Warren Buffett for Fortune Magazine on inflation. Inflation was a big deal back then though we tend to dismiss it today since it’s been so low for so long. But I thought the paragraph would be appropriate since it is easy-to-understand writing and he has a unique way of thinking about inflation as a tax. If you think of it the same way you will quickly understand that inflation is a consumer of your capital. We as a society take to the streets if there is so much as a hint of our elected officials raising our taxes. Yet we have no problem when we willingly or out of ignorance tax ourselves by investing in below inflation rate guaranteed investments. The following is taken straight from the article.
“What widows don’t notice”
By Warren Buffet
The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislatures. The inflation tax has a fantastic ability to simply consume capital. It makes no difference to a widow with her savings in a 5 percent passbook account whether she pays 100 percent income tax on her interest income during a period of zero inflation, or pays no income taxes during years of 5 percent inflation. Either way, she is “taxed” in a manner that leaves her no real income whatsoever. Any money she spends comes right out of capital. She would find outrageous a 120 percent income tax, but doesn’t seem to notice that 6 percent inflation is the economic equivalent.
If you are concerned that your money is not achieving returns equal to or higher than the inflation rate or wish to review your portfolio so as to make sure it is geared to do so, then please do not hesitate to give me a call.
How to Invest – Basic Investing Strategies
Have you applied these when making an investment?
Recently, while talking to an expat who has been living in Barga in Tuscany for many years, he confided in me that he thought he could invest without advice from other professional quarters. However, after seeing some of his investments post no real returns (ie the net return after inflation is factored in), he was in a quandary as he felt he would “lose face” by speaking to a qualified independent financial adviser. And he also added that he had friends living close by who had shared the same experience.
Learning how to invest your money is one of the most important lessons in life. You don’t need to be college educated to start investing. In fact, you don’t even need to be a high school graduate. You just need to have a basic understanding of business and have the confidence to make a plan — consider it a business plan for your life. You can do it.
Why investing can be scary
For many of us, money and investments weren’t discussed at home. These subjects may even be taboo within certain households — quite possibly, in households that don’t have much money or investments.
If your parents or loved-ones were not financially independent, they probably did not give you good financial advice (despite their best intentions). And even if your family is/was well-off, there’s no guarantee that their financial advice makes or made sense to you. Plenty of parents encouraged their kids to buy a house during the peak of the housing bubble, because in their lifetimes, housing prices only ever went up.
The goal of investing
Of course, everyone has different financial goals — and the more you learn, the more confident you’ll be in determining your own path. But here’s a basic financial goal to strive toward:
Over decades of hard work, most people who are about to retire or those who have already retired, would like to make more money than they spend and then invest the difference. By the time they retire, they would like their investments to throw off enough cash — through dividends or interest – so that they can live on this income without having to sell any investments.
Notice the first part of this goal is about hard work. If you’re hoping to take a little bit of money and gamble it into a fortune in the stock market, you can stop reading now, this article isn’t written for you. But if you have worked for a few decades, and want to make sure that you don’t have to work until life’s end, you’ll need to spend less than you make and invest the difference.
Also, you’ll notice that this goal doesn’t recommend selling your investments. Rich people don’t sell-off their assets for spending money — if they did they wouldn’t be rich for long. They stay rich because their assets provide enough cash flow to support their lifestyle. And these cash-producing assets, through careful estate planning, can be passed down from generation to generation.
Enjoying your twilight years by living off your investment income and having something left over for your loved ones or for a charitable organization is something that all investors should aspire to. It may not be possible for everyone, but it’s the right attitude.
What to invest in?
Before you even start to look at this area, it is absolutely imperative that a “proper” financial risk analysis of yourself is carried out. And this does not take the form of much-used generalised risk questionnaires (that would be like you or your wife doing a compatibility quiz in a woman’s magazine!!) No, the emphasis is on the words “proper risk analysis”
Once this has been done you move on to the most important factor in investment planning.
Diversification (or, Spreading the Risk)
Many, many investors are under the impression that if they have, say, a term deposit at bank/institution A, another at B, and a third at C, they are diversifying. They could not be more wrong.
When investing one looks at doing so across what is commonly referred to as Asset Classes. These comprise Cash (very Conservative Risk ie term deposit), Bonds (Moderate Risk), Equities (high risk) and Commercial Property (Moderately Aggressive Risk). Then, taking one’s appetite for risk (from the Risk Profiler), one invests across the Asset Classes accordingly.
The most common investments are mutual funds (unit trusts), insurance investments, bonds and the stock market. This article is not aimed at those with the time, experience, acumen and who can afford losses by direct share purchases.
Unit trusts/Mutual funds can own shares or bonds and with some commercial property exposure on your behalf.
Know the difference between saving and investing
Your investments and your savings are very different things. What if the stock market crashes? If you do not have a cash savings account to cover for emergencies (usually about six months’ income), you would probably have to sell your investments at the worst possible time. Don’t fall into this trap.
Being a successful investor requires money, patience and, just as importantly, confidence. Having confidence to make and stand-by your financial decisions requires education. Never stop learning.
When last did you do a “proper risk” analyser?
What applied five years ago is not going to necessarily be the same today. We are getting older and as the years go by, more often than not we tend to become more conservative. Hence the need to do a refresher where risk is concerned and then use this to analyse your investments in order to ensure the two correspond accordingly. If not, you actually run the danger of investing by default/error which could have a material impact on your life in the not-too-distant future.
If you realise from the above the importance of risk classification and correct diversification, just as you visit your doctor (or should) for an annual check-up, why not give me a call in order to facilitate a meeting where we can ascertain things. As the saying goes “you owe it to yourself!!
‘Risk’ (with an Italian flavour)
“If no one ever took risks, Michelangelo would have painted the Sistine floor”
Neil Simon, Playwright