Introduction to Financial and Investing Concepts

  • Basic financial concepts that are critical to understand in order to best utilise your money (spending/saving/investing/borrowing).

What is Finance/Investing? +/-

What is Finance?

Finance is an umbrella term that encapsulates the various methods of managing money. Broken down further, finance is how an individual or organisation acquires, invests and manages its financial assets.

Put simply, money is the tool that makes the world tick. Whether you are saving money at a bank or purchasing products at the shops you are always interacting with the world of money and finance. Understanding finance and financial concepts is a critical skill that can help maximise your wealth, and enhance your ability to achieve your real-life objectives.

There are two main sub-categories of finance that we will be exploring:

  1. Personal Finance - Understanding the value of optimising your spending and saving habits as well as how to budget for your goals and obligations.
  2. Corporate Finance - Specifically related to investing (shares, bonds, etc). As an individual, corporate finance provides you with a broad range of investment opportunities which can grow your money.

Investing (A Method of Managing Money)

One of the methods of managing money under the umbrella of finance is investing. By purchasing a portfolio of financial assets, investing can be a powerful tool to grow your money.

Compound Interest +/-

Compound interest is simply the extra interest earned on any money that was previously earned as interest. This extra interest is paid in addition to the interest earned on the principal (the original investment/deposit). In comparison with simple interest, compound interest has the power to increase the rate at which your money grows. The following chart compares the difference in performance of compound interest vs simple interest (repeatedly paid as a % of the initial principal).

What does this mean for you? Compound interest is a powerful tool that, when harnessed, can help grow your money and investments, especially as the time horizon increases. In the figure above the growth of compound interest is exponential and increases rapidly and significantly by the 20th year. Examples of compound interest in action include your savings at a bank. Similarly, compounding returns increase the overall performance of your investment into assets like shares by compounding returns on top of previous returns. [Video on compound interest]

Time Value Of Money +/-

The time value of money (TVM) is a concept which states that money held in the present is more valuable than an identical sum in the future. This is due to factors such as interest and inflation.

Money owned in the present can grow in the form of investments (e.g. earning interest) over time, whereas that same sum in the future loses that ability. This earning power is inherently valuable as shown below:

Depositing $100 at a bank which pays 5% interest per annum today would provide the lender with $105 in one year's time. Naturally, owning and depositing $100 now to receive $105 one year later is more valuable than receiving $100 (same sum as the original deposit) in the future.

Interest Rates, Inflation and CPI +/-

What are Interest Rates?

Interest rates are the costs paid by borrowers to lenders in exchange for borrowing money. They vary for the type of borrowing agreement. Some examples of these include personal loans & mortgages, business loans and savings accounts. It is important to understand the types of interest rates that can be charged by lenders:

  1. Fixed Interest Rate - A fixed interest rate is one where the rate remains constant throughout the duration of an investment or loan. Examples of products with fixed interest rates include bonds, term deposits and certain durations of mortgages (often first 3-5 years).
  1. Variable Interest Rate - Variable interest rates are interest rates that fluctuate. They are normally linked to benchmark rates called reference rates for various types of financial transactions. For interest at your bank, the quoted interest rates follow the Reserve Bank of Australia's cash rate (Current Rate). This is the 1-day (overnight), interest charged on loans between banks. Examples of products with variable interest rates include bank deposits, credit cards and mortgages.

Inflation and CPI

Inflation is the phenomenon that leads to increases in the cost of goods and services over time. Inflation is widely seen as a critical component for economic growth (which will be discussed below) but for now, the reason one unit of currency held now can purchase less in the future, or has reduced purchasing power, is inflation. (This is demonstrated in the video at the end of this section). Inflation is usually measured by increases/decreases (deflation) in the cost of living, or the cost of maintaining a certain standard of living.

CPI

The cost of living is measured by the Consumer Price Index (CPI), which illustrates the average price of a standardised group of goods and services (food, transport, medical care). Changes in CPI are used to measure and track changes in these prices. It provides a strong indicator of the level of inflation (a 5% yearly increase in CPI ~equals 5% yearly inflation).

CPI is a measurement expressed in relation to a base level of 100. A CPI of 105 means the same basket of goods measured when CPI was 100 has increased 5% in price.

Causes of Inflation

There are 2 key and closely related causes of inflation:

  1. Cost-Push Inflation & Price/Wage Loop - Decreases in the supply of goods/services or raw materials used in production inflate the prices of goods/services. Additionally, employees attempt to keep their wage above inflation and companies pass on extra costs to consumers (higher prices/inflation). This leads to a feedback loop where employees attempt to increase their wages, which then results in higher prices of goods and services (inflation), which employees attempt to increase their wages in excess of and so on.
  1. Demand-Pull inflation - Favourable spending conditions (such as with low interest rates) encourage spending and increase levels of demand, resulting in upward pressure on the price of goods and services. (Think supply and demand, high demand/low or relatively lower supply = increased price). Additionally, higher wages (as discussed above) result in more money being available to spend increasing demand so this inflationary pressure is intensified.

Two critical components that impact a nation's monetary policy are inflation and interest rates (which serve as a tool to control inflation).

Positive levels of inflation are linked to economic growth. Inflation encourages spending money now, in the present, as its value will be eroded over time as the price of goods and services increase. Interest rates dictate whether it is more economically effective to save money or spend money. High interest rates make it attractive to deposit money at a bank and save money. This slows economic growth by reducing demand (more saving/less spending) subesequently lowering inflation.

Low interest rates encourage spending as savings at a bank earn minimal interest. Additionally, borrowing money is easier and has low interest repayments (useful for purchasing houses, cars etc.) This increases economic growth by increasing demand which increases inflation.

As mentioned above, greater levels of saving than spending slows down economic growth and inflation, and ultimately the speed at which goods and services price increases. It is the relationship between inflation and its control (in the form of interest rates) that serve as the basis for monetary policy. There is a consensus between economists that a moderate amount of inflation (2-3%) is good for the economy as it encourages consistent growth.

For example, the overnight cash rate of 0.1% in 2021 was set to encourage increased spending, growing the Australian economy and ultimately increasing inflation.

  • Taking control of your own financial destiny by learning about budgeting and the importance of saving money, setting financial and life goals, understanding what you owe and what you own, as well as protecting your wealth now and in the future.

Personal Goals and Financial Objectives +/-

Personal Goals

It is important to have short- and long-term goals that are separate from any financial metrics or aspirations. Personal goals should be goals that are important to you and your wellbeing.

Some examples of short-term personal goals:

  • Lose 5kg in the next month
  • Complete an online education course

Some examples of long-term goals

  • Obtain your dream job
  • Own a home
  • Have a child

Whilst personal goals as a concept are simple, the importance of setting goals cannot be understated. They motivate you to achieve the things you want to achieve in life for yourself, family, career, etc. Additionally, it is important to set goals that are realistic and bound by a timeframe to ensure that you achieve what you can achieve.

You only have one lifetime so make sure you formulate the goals you want and work towards the achievements you want to complete.

Financial Objectives

Financial objectives are monetary targets that you desire to achieve over time and by set dates. Financial objectives can be a variety of categories including: earning aspirations, savings targets, a target amount of money invested and certain performance levels by your investments.

Through the combination of earning, saving and investing listed below are some potential examples of financial goals that you may wish to achieve:

  • Save money for retirement
  • Have enough money to afford your dream home/car
  • Have enough money to start a family

Aligning Personal and Financial Goals

Financial goals should be seen as targets that enable the achievement of your various personal goals. You could have a target of saving $20 million, however if your dream home/lifestyle costs $3 million, there may not be much point setting an arbitrary target especially if it doesn't align with the life you desire or can reasonably attain. An example of this alignment would be the personal goal of having a child. You will notice the financial goal 'have enough money to start a family' is in service of the personal goal.

It is important to set both personal and financial goals for yourself, and utilise the power of money to achieve the goals you want in life.

Budgeting +/-

Budgeting, Buckets and the Rainy Day Fund

A crucial component of achieving the financial goals we just discussed is budgeting and saving.

The quote "A dollar saved is a dollar earned" highlights the importance of strong saving habits. It means that every dollar you save by not spending is a dollar you don't have to earn again in the future.

But what is budgeting and how do I implement it? The following videos provides a good overview of what budgeting is and how we can create a budget and then track our progress against it.

Creating and Following A Budget

As the video discussed, an important part of budgeting is buckets. It is important to allocate money to the various parts of your life, such as travel or entertainment. Buckets allow you to set goals and track your expenditure in each category.

Rainy Day Fund

An important sub-category of budgeting that wasn't touched upon is the idea of a 'rainy day fund'. This is an essential amount of savings that ensure you can maintain your standard of living in the case of emergency or a large and sudden liability (renovation of a broken roof/repairing a broken down car). It is important to implement a rainy day fund before allocating money to investing. Whilst many emergencies can be insured against such as a personal injury and being unable to work (income protection insurance), it is important to have a safety net for uninsurable events (exclusions). We will discuss types of insurance in a later.

Budget Template

Attached is a budget template we've constructed for your usage. Feel free to make a copy.

An excel tracker like this provides a historical log of your expenses and income. It shows where your money actually goes. The entries don't have to be exact to the dollar (up to you if you would like to), they should be just enough that you can roughly gauge how much you make or lose monthly.

[Link to Template]

Assets and Liabilities +/-

What are Assets/Liabilties

Put simply, assets are what you own and liabilities are what you owe. Knowing how much you have of each is important to understanding your financial position.

Some very simple examples of assets and liabilities include:

Assets

  • Cars
  • Houses
  • Shares and Managed Funds
  • Savings at the bank

Liabilities

  • Home and investment loans
  • HELP Debt
  • Credit Card Debt

Financial Net Worth

Subtracting your total liabilities from your total assets gives you your financial net worth.

Knowing your financial net worth paints a picture of your financial position and serves as the starting point for progressing towards your financial goals. If your financial net worth is low or negative, it may mean you need to start repaying debts, saving more and/or spending less. If your net worth is positive, you may have sustainable spending and saving habits, but you should still gauge your progress towards meeting your financial goals. In combination with other tools such as budgeting, your financial net worth provides a rich overview of your finances including what form your wealth is in, what you owe, and your overall financial health.

Common Liabilities

Detailed below are a number common liabilities you may have or eventually have.

Mortgages

Mortgages are loans used to purchase property, where the property is used as security by the lender such as a banks, until the date at which the loan is completely repaid and the mortgage is discharged. The property serves as 'collateral' to reduce the lender's (generally banks) risk of loaning a significant amount of money, as they can take ownership of and resell the property if the loan isn't repaid.

Certain criteria must be met in order to be eligible for a mortgage, including proof that you have sufficient surplus income over expenses (so that you can pay monthly repayments), a down payment (an upfront deposit of normally 5%-20%), minimum credit score (a score assigned that evaluates the past repayment history and current levels of debt amongst other factors, to indicate a likeliness to repay loans). With these criteria met you will be able to attain a mortgage for the outstanding principal (amount owed) after subtracting the down payment from the purchase price.

As discussed in previously, the interest rates charged on mortgages can vary, especially as reference rates for the various types of lending (mortgages, bank deposits, etc.) fluctuate. If the overnight bank loan rate was to rise, a knock on effect would be expected for mortgage interest rates.

Some banks offer fixed interest mortgages, where the interest rate is locked for the duration of the loan, however it is more common for there to be a fixed period (3-5 years) and any subsequent years are charged at a variable interest rate. Variable interest rates for a mortgage are based on and impacted by the overnight bank rate discussed earlier, where a margin is applied on top. Various different combinations of variable and fixed interest rate mortgages are offered.

Interest-Only Mortgages/Loans

Another type of mortgage is an interest-only loan. As the name suggests repayments only pay off the interest component of the loan. The benefit to interest-only loans is that they have lower monthly payments than traditional loans; at least at the commencement of the loan. At the end of the interest-only period, these loans are either renegotiated, repaid in full or converted to a traditional interest and principal repayment loan.

Refinancing

The renegotiation seen at the end of an interest-only loan is a type of refinancing. Refinancing replaces an old loan agreement with a new loan, with new terms, most commonly including the repayment period (loan duration) or interest rate (% charged and type of rate (fixed/variable)).

HECS-HELP Loan

When undertaking tertiary (university-level) study you can request financial assist to cover tuition fees in the form of a HECS-HELP loan. This is an interest-free loan that you begin repaying when you earn in excess of the repayment threshold (Current Repayment Thresholds). The only "interest" applied is an indexation added yearly to adjust the loan to inflation and cost of living increases. Often called the set-and-forget loan, HECS enables individuals to gain access to higher education, and repay the loan incrementally in small repayments over their career, almost imperceptibly.

Go to: www.studyassist.gov.au for more information on eligibility and rules for study assist loans.

Credit Cards/Buy Now Pay Later Services

Credit cards provide users with access to a credit facility (pre-approved loans), where they can borrow money to make purchases, often when they do not currently have either the money, or the liquidity (money that can freely be converted into cash) to make said purchases. The caveat is that credit cards charge high interest rates (10%+) for the access to this money (especially in comparison to other loans).

Credit Limit

A credit limit is a pre-set and agreed upon limit on the amount of money (credit) you can borrow at any one time. The term credit means the lender is providing you with money or adding (crediting) money to your account. Debit and debit cards perform the opposite by removing money from your account as you pay for goods and services.

Similar to credit cards, Buy Now Pay Later (BNPL) services like AfterPay and ZipPay provide users with access to credit. Where they differ is in how they implement their payback methods.

Credit cards charge interest on any balance that remains, normally at the end of the month. BNPL services instead operate a fixed repayment instalments model where interest and fees are charged if scheduled payments are not made on time. An example would be failing to pay a fortnightly repayment and being charged fees.

It is important to be prudent when using these services as well as credit cards, as high interest rates can be very costly in the event of failing to repay your debts. As stated above, credit cards are best for when an individuals liquidity circumstances require access to money now (wage paid in a few days/money tied up in investments), and less good when people don't have the money they are spending. Remember that applying for a mortgage takes into account your credit score (repayment history). Having a poor score may hinder the terms of your mortgage or even the ability to get a mortgage.

For many people purchasing products now and paying later is a risky practice, and goes against many of the established budgeting principles as they encourage people to spend above their means and deal with financial consequences later.

Personal Insurance +/-

Insurance Basics

Whilst the focus of this section is on personal insurance like life insurance and income protection, the following video introduces some general terms applicable to many different types of insurance policies.

Types of Insurance

Death/Life Insurance

Death or life insurance provides a lump sum cash payment to the designated beneficiary upon the death of the insured person. Life insurance is especially important when you have a spouse and/or children as it provides a significant amount of capital to cover debt costs and living expenses, dampening the financial effects of losing the insured persons income.

In order to have a life insurance policy, regular payments (premiums) must be paid. Life insurance can also be paid from your superfund, which generally has taxation benefits.

There are two main types of life insurance durations including:

  1. Fixed Term - The policy lasts a set number of years (e.g. 10, 20, 30 years) and then lapses and must be renegotiated. It charges cheaper premiums than permanent policies.

  2. Permanent - The policy lasts until the insured person dies or stops paying premiums.

There is a balancing act between affordability and cover, especially as subsequent fixed terms become more expensive as the insured person ages.

Trauma Insurance

Similar to life insurance, trauma insurance provides a lump sum payout in the event of a serious illness or injury. These include illnesses like cancer, heart attacks and strokes. The lump sum can then be used to pay medical expenses and any costs related to rehabilitation and recovery. Trauma insurance policies can be packaged with life insurance policies to reduce premiums. As with life insurance, premiums depend on the amount of cover ($ value of the lump sum) required, the insured persons age, job, family history amongst other factors. Trauma insurance protects against the “medical lottery” of unforeseen and serious illnesses.

Trauma insurance charges the highest premiums because trauma policies are most likely to be claimed, however payouts are normally smaller amounts in comparison to other types of insurance payouts.

Premiums can be charged in two ways:

  1. Stepped Premiums - Premiums start off low and increase with age and policy renewals.

  2. Level Premiums - A higher initial cost but the premiums stay fixed over the life of the policy, besides the adjustment for inflation (indexation).

Income Protection Insurance

Income protection insurance protects your income when you are unable to work due to sickness or injury. You can protect 75% of your income stream (based on your annual earnings from the previous 12 months) up to the age of 65 for up to 5 years.

Human capital is your most important asset in earning an income and is crucial for you to earn your income, so protecting this asset is important. As with some other personal insurance types the premiums are tax deductible.

Income protection policies have a waiting period which is a specified length of time that must elapse from when you are injured to the date before you receive your first payment (anywhere from 14 days to 2 years). The longer this period is the cheaper the premiums are.

There are two types of income protection: fully disabled (unable to work) and partially disabled (working in a limited capacity e.g. 2 days a week). Partially disabled income protection covers the loss in capacity.

An important consideration to have when choosing an income protection policy is the amount of sick leave you have saved up, as this can be used in the waiting period and also to subsidise your income for a certain time as well.

Total & Permanent Disability

Pays a lump sum in the event of permanent disability or a permanent inability to work. The payment is designed to pay debts and expenses such as rehabilitation and recovery costs, home renovations as well as providing some income for the future. The same criteria discussed above like the amount of cover required, and your age, impact on the premiums. There are some variations on what qualifies as a permanent inability to work, including an inability to work in any occupation (an occupation you could reasonably perform) or an inability to work in your own occupation. However, they both function in the same way in terms of payouts, etc.

  • Learn about the various ways to grow what you own now into the funds that enable you to live the lifestyle you desire in the future as well as important investment considerations.

Investment Types

Equities (Shares) +/-

What Are Shares?

Shares are individual units of equity (ownership) in a company and are classified under the asset class of equities.

Firstly, we will discuss what shares are and clarify some terms related to owning equity.

Shares represent fractional ownership or equity in a corporation and can be bought and sold on public markets (stock exchanges). The ownership of a company (holding stock in a company) is divided into individual units called shares. Therefore, shares represent the smallest unit of stock that can be held in an individual company.

The following diagram highlights the slight differences between stocks and shares.

Think of it as: what stock (company) do I own and how many shares (amount of ownership) do I possess.

Benefits of Share Ownership (Ordinary Shares)

Benefits of share ownership include:

  • Potential for capital gains (increase in share price results in growth of investment)
  • Historically, average market returns have outpaced inflation
  • Income from dividends (semi-regular payments out of company profits)
  • Large variety of companies/funds to invest in
  • Highly liquid (ability to sell for cash easily)
  • Avenue for investment into sustainable and ethically conscious companies
  • Easily accessible type of investing (apps, integrated into bank websites)

Ordinary Shares

In this section we will be focusing on ordinary shares, rather than preference shares which are outside of the scope of these materials. They are also referred to as common stock as they are the most commonly bought type of shares. Each individual share represents the same amount of ownership in a company.

Ordinary shares entitle the owner to various benefits including:

  • Participation and voting in annual meetings (voting on important decisions, ability to influence how the company is run and select the company's board personnel)
  • Dividends and dividend reinvestment plans (dividends are not compulsory/companies may offer to reinvest dividends for you to buy more shares)
  • Limited Liability (in the event of debt or legal damages the holder can only lose the value they invested)

Risks of Share Ownership (Ordinary Shares)

  • Volatility and price depreciation (losses when share price goes down)
  • Income isn't fixed (dividends are optional or may fluctuate depending upon the company's profits, cashflow needs and economic factors)
  • Capital gains are only actualised when shares are sold
  • Lowest priority for payment (behind debt) when companies stop operating
  • Difficulty to consistently pick winners. (Over a 100 years only 4% of stocks account for the entire net gain of US stock market)

Remember – for every seller there MUST be a buyer.

Returns - Capital Gains and Dividends

Returns can be divided up into two categories we have already discussed; Capital Gains and Dividends.

  • Capital Gains - Capital gains are the increases to the value of a held asset (shares/house). They only become realised as income (actually earned) when the asset is sold.

  • Dividends - A voluntary payout of profits by the company to its shareholders in accordance to the amount of shares they own (mandatory for preference shares). This can be used to calculate the dividend yield (decided by the company), which expresses the value of the dividend per share as a percentage of the share price (stock price = $100/dividend = $1/dividend yield = 1%).

Returns are how much money you have made/lost on your investment.

Stock Exchanges and Brokers

Stock Exchanges are the marketplaces that facilitate the buying and selling of financial securities (tradable financial products e.g. shares and bonds). Different stock exchanges primarily serve investors and companies based in their geographic location (Australian Stock Exchange, New York Stock Exchange). Companies list themselves on either their geographically relevant stock exchange or by the size of the stock exchange depending on various factors including cost and visibility. Apple elected to list themselves on the Nasdaq stock exchange even though the NYSE is larger due to costs and the visibility of the Nasdaq-100 index which we will discuss in a few paragraphs. Stock Exchanges connect buyers and sellers, or house stockbrokers, who are agents that trade on the behalf of their clients. With the advent of new technology, stockbrokers have now largely transitioned into digital apps and platforms that facilitate trading anytime and anywhere, for a fraction of the costs (sometimes even commission-free in the case of Robinhood and Stake (investment apps)).

ETFs/Market Indexes/Managed Funds

Market indexes measure either an entire market or a certain subset of securities from an overall market. They are hypothetical "portfolios" of companies selected in accordance with specified criteria. For example, the S&P ASX 300 contains the top 300 companies by market capitalisation (share price x number of shares) and the Nasdaq-100 includes the top 100 largest non-financial companies in the US.

Exchange Traded Funds (ETFs) are managed funds traded on stock exchanges. They can be purchased like regular stocks; however, each unit of an ETF is comprised of a portfolio of various financial assets. The most common type is index ETF's which seek to track their related market index (e.g. Nasdaq-100) by containing the same companies in the same weighting as the market indexes. They turn the hypothetical portfolios (market indexes) into a singular purchasable security that mirror the performance of their respective indexes.

ETF's have grown in popularity due to their low-costs (often sub 1% annual fees), easy access to diversification (many securities in one product) and because they are highly liquid (easy to buy/sell).

There are two types of managed funds; Passive and Active Management.

Active management refers to the frequent buying and selling of holdings to deliver higher returns, often through stock picking and market timing, where managers believe they can pick winning stocks at the right time. However, it is important to note that only ~1 in 5 actively managed funds outperform their respective benchmark indices over long time periods (15 years). Actively managed funds normally have greater fees due to the ‘management’ of the fund (management fees) as well as fees charged on performance (performance fees).

Passive management subscribes to the idea that markets are the best reflection of current prices, and it is best to target market returns. These funds adopting a longer-term view of investing, incurring fewer transaction costs, due to buying and holding stocks rather than buying and selling,

The benefit of investing in actively managed funds is that they can outperform their index and deliver significant returns, whilst passive funds deliver market returns for low fees. Lorica Partners utilises funds that aim to embody both of these characteristics. These funds replicate market indexes but actively weight the portfolio towards stocks with characteristics that their respective providers have researched and subsequently found to be linked to returns in excess of the market. (Profitability, Size and Value).

Glossary of Share Terms (Useful for Personal Research)

Ask Price/Bid Price - The ask price is the selling price (how much is the seller asking for). The bid price is the offering price/purchase price (how much they are willing to pay for the asset).

Bearish/Bear Market - Expected decreases to a share's/market's value. A period where the share market (most shares) decline (20% decline over 2 months).

Bullish/Bull Market - Expected increases to a share's/share market's value. A period where there is continuous and sustained growth in share prices.

Capital Gains - Increases to the value of a held asset (shares/house). They only become realised (actually earned) when the asset is sold.

Correction - A 10% or more decline in the price of a stock or asset type/market e.g. Tesla (stock) or US shares (market/asset type).

Dividend - A voluntary payout of profits by the company to its shareholders in accordance with the number of shares they own. The terms cum-dividend (a stock about to pay a dividend) and ex-dividend (first day of trading after a dividend) describe stages of dividend payouts.

Dividend Yield - The company's dividend calculated as a percentage of the company's share price.

Dollar Cost Averaging - An investment strategy where the investor purchases assets at regular intervals regardless of whether the market is going up or down.

Earnings Per Share (EPS) - The amount of profit earned divided by the number of shares (used as valuation metric).

Economic Bubble - General sentiment where an investor(s) feels that an asset's price is overvalued or unjustified when applying valuation metrics that are correlated with asset prices like earnings per share.

ESG - Refers to environmental, social and corporate governance, which measures the sustainability and ethics of a company.

Liquidity - Ability to quickly convert assets to cash.

Market Capitalisation - The total value of a company's outstanding shares (total number of shares x share price)

Market Index - A hypothetical portfolio of investment holdings that represents a segment of the financial market. The calculation of the index value comes from the prices of the underlying holdings." (Investopedia)

Outstanding Shares - The number of existing shares of a company's stock. Similarly, the term float refers to shares available on the secondary market (public market that trades previously issued assets).

Retail and Institutional Investors - Retail are individuals that invest for the benefit of themselves, whilst institutional investors investor for the benefit of the clients.

Share - Shares are individual units of equity (ownership) in a company.

Share Buyback - A company repurchases it shares reducing supply (generally increases share price because of supply/demand impact).

Stock Split - When a company decides to divide its shares to increase the total amount of shares. Normally used when the price of a stock is historically high to make it look more accessible to investors without changing the actual price.

Volatility - Large fluctuations in the price of an asset or in regards to investment returns, large deviations from the expected/average return.

Bonds and Fixed Interest +/-

What are Bonds?

Vanguard defines bonds as "like an IOU, whereby you lend your money to the issuer for a set period of time, in return for interest paid over the term of your investment. In addition, your investment is also then paid back to you in full at the end of the investment term.

Bonds can provide stability in times of volatility. Where equities offer opportunities for growth and great profit, bonds provide safety to smooth out the turbulence of the market when share prices fluctuate. Bonds generally have longer maturities than cash investments most commonly ranging from 1 to 30 years.

Both companies and government issue bonds to raise capital for several reasons. Government issue bonds to finance daily operations and provide funding for infrastructure and projects. Similarly, companies issue bonds to fund projects, acquisitions and purchases (e.g. office real estate).

Important Fixed Interest Terms

Face Value - The face value or par value is the amount that is paid to the lender/investor at maturity (end of the investment term). A bond with a face value of $1000 can be bought and at maturity the investor receives $1000, plus interest payments. Purchasing the bond for the same amount as the face value is called buying a bond at par, however there are two other types of bonds related to their pricing.

Discount/Premium - Discount bonds are those traded below their face value (e.g. A bond with a face value of $1000 is bought for $950). On the other side there are premium bonds which trade above their face value (e.g. a bond with a face value of $1000 is bought for $1050). The reasons they trade above and below their face value is due to the difference between their coupon rate and the market rate for similar bonds as a point in time (discussed below).

Coupon Rate - The coupon rate is the annual interest rate paid to the owner of the bond by the borrower (government/corporation). If the coupon rate is 10%, on a bond with a face value of $1000 the investor receives $100. This interest payment is known as a coupon. They are often paid semi-annually, so the investor would receive two payments of $50 each six months for the length of the bond. There are also types of bonds called zero-coupon bonds which trade heavily below their face value so that the returns earned are the difference between purchase price and face value.

Market Rate - This is the coupon rate for similar bonds in the bond market. This fluctuates day on day which is why bonds trade at discount, par and premium value. When the coupon rate is in excess of the market rate, the investor receives greater interest (coupon payments) than similar bonds. As such the price of the bond goes up . The inverse holds true for discount bonds.

Maturity - A bond's maturity is the length of time before the face value of the bond is repaid. As mentioned above they normally mature anywhere from 1-10 years and as long as 30 years.

Excluded from this topic (but included if you wish to research yourself):

Bond Yield - Yield is similar to the coupon rate however it is the rate of return earned not the interest. It is rate of the return calculated by dividing the coupon by the actual price rather than face value. There is a relationship between bond yield and bond pricing that will be explored in the next level.

Yield Curve - The general curve of a timeline plotting the different interest rates of short and long-term bonds. Long-term bonds generally pay more interest as there is greater risk over long periods of time including increases to inflation and corporate default (bankruptcy) risks.

Types of Bonds

Government bonds - issued by a government (state or federal). As mentioned above, in Australia, the federal government issues bonds to pay for daily operations and to provide funding for infrastructure and projects.

Corporate bonds - issued by public companies to fund projects, acquisitions and purchases. Various companies are graded on their likeliness to repay bonds (better rating pays less interest as they are safer due to risk vs. return) but generally all corporate bonds are viewed as riskier than government bonds, so they generally offer higher coupon rates.

To counter this, some bonds are backed by collateral (collateral bonds), meaning the borrower (corporation) offers an asset that is transferred to the lender in the event that the corporation can't repay their debt.

Hybrid bonds - There is a type of corporate bond called a hybrid bond (debt and equity characteristics) or convertible bond, which pays the investor coupon payments, however at maturity or prior to maturity they can receive equity (shares) in the company, instead of receiving the face value of the bond. The conversion option can also either be forced by the company in some cases or redeemable anytime by the investor. The investor can still elect to receive the face value of the bond and waive the conversion right.

Risk and Return of Bonds

Bonds are low to medium risk investments (depending on whether it's a government or corporate bond) and are suited to investors investing one year or longer (up to 30 years per bond). Whilst they don't provide the high growth that equities can, they provide regular income through coupon payments, even during times of volatility. This income is an important characteristic for many investors (such as retirees), and we will discuss the difference between growth assets like shares and defensive assets like bonds. Bond returns can be obtained in the form of coupon payments or by selling the bond before maturity for gains (or losses) (remember the fluctuations in bond prices due to the relationship between coupon rates and market rates (which do change and effect bond prices)).

Some investors aim to profit from price fluctuations as yields change.

E.g. an investor purchases a bond at par value for $1000 with a coupon rate of 5% and a market rate of 5%, and then 6 months the market interest rate dropped below the coupon rate of the bond (4%), becoming a premium bond worth $1020. The investor can either hold the bond for its higher coupon payments or sell the bond for capital gains of $20. (pricing simplified for this example).

This graph below demonstrates that shares and bonds have historically performed differently and that bonds can act as a cushion or buffer, reducing the ups and downs and giving a smoother ride.

Where To Buy Bonds?

As mentioned above bonds can be sold before their maturity on the secondary market. The secondary market, in the case of bonds, is normally the same marketplace as the share market, in that bonds can be bought on the ASX (government and corporate bonds).

Property +/-

The Australian Dream

Investing in property is one of the most common investment strategies in Australia. Over 70% of households own their own home (one of highest proportions worldwide). Property is rooted in the 'Australian Dream', which says owning a home enables owners to 'live a better life'.

However, sharp increases to house prices in the last decade, with the median price in Sydney over $1.35 million (as of December 2021), makes affording a home more difficult for many people across all demographics. Due to this, property is no longer laser-focused on houses, with the rise in apartment numbers citywide representing a new market for potential buyers.

Various Terms Relating To Property

Stamp Duty - A state tax imposed by the relevant state government on transactions such as real estate and vehicle purchases.

Land Tax - An annual tax charged for owning the land on which your property is based. Your main residence is exempt from this.

Council Rates - Annual payment for local council services.

Strata Fees - A payment by the building tenant to ensure general upkeep of the building and the maintenance of shared areas on the property (courtyard/communal pool, etc.). It is charged on apartments and townhouses (connected with neighbouring houses). It is often about 1% of the buildings value annually.

Renting Vs. Buying Here are a couple of points that summarise some of the forces that may dictate the decision to buy or rent property for you.

  • Very hard to forecast what house prices will do in the future
  • Long run house price growth expectation is inflation = no real (actual) gains
  • Buying can be a forced savings plan for those who struggle to manage cashflow
  • Easier to budget for rent payments than repayments on a large loan

  • The decision to buy is typically an emotional one:

    Security for family + Security if income stream disappears in future due to redundancy or retirement

  • A primary residence (lived in) is currently one of the the only tax exempt assets you can own.
  • Rent payments are permanently lost whereas mortgage principal payments earn equity (ownership) in the property

Property Vs Shares From an Investment Perspective

Since 1970, the average annual return of Sydney houses has been approximately 7.5%. According to the Reserve Bank of Australia inflation calculator, inflation over this period averaged 5.2% pa, resulting in a real return of 2.3%.

But would you have been better off putting your money into the share market rather than Sydney houses, even though property returns have been so solid?

We have compared Sydney house prices over rolling 7 and 10 year periods to two global share portfolios:

Portfolio 1 – Mainly Australian shares

Portfolio 2 – Mainly International shares

The following comparison further elaborates on the differences between property and shares, irrespective of returns.

What does this mean? It means despite the favour for property in Australia, the varying characteristics (e.g. liquidity, entry/exit cost/return profile) dictate that property does not represent a replacement for shares and should be considered in addition to an equity portfolio.

Other Asset Classes +/-

Cash Investments

There are several types of cash investments including term deposits/certificates of deposit, treasury bills/notes, and saving accounts.

Treasury bills/notes (TB) work by locking away your deposit for a set period in exchange for earning interest. They are purchased below par (the amount you receive at the end) and the interest they earn is received in the form of the face value (the amount you receive upon maturity) and its difference from the purchase price. United States treasury bills are sometimes referred to as the risk free rate, or the rate at which there is no risk on your investment, as the US government would have to default for the interest and principal not to be repaid. They are normally issued with a maturity of less than a year (1-12 months). Because there is practically zero risk, the interest rates on treasury bills are currently anywhere from 0.15 to 2%+ depending on maturity.

Certificates of deposit (CD) or term deposits (TD) are similar, however instead of paying a price below the face value and receiving the face value at the end, where the interest earned is the difference in the price, certificates of deposit charge the face value and pay interest on top of the value of the deposit.

CD/TD = Initial investment of 1000$ at an interest rate of 1% p.a. for 1 year. Investor receives 1000$ (principal) + 10$ interest upon maturity.

TB = A treasury bill with a value of 1000$ and an interest of 1% would be purchased for $990.10, and upon maturity the 1000$ would be transferred to the investor who has earned 1% interest due to the difference between purchase price and the face value.

Savings Account

The most common form of investment is the interest earned at the bank. As everyone would know you earn interest on you deposits. A risk related to bank interest is that it does not keep up with inflation. The interest rate for major banks is currently 0.1%, whereas inflation was 3.5% for 2021, resulting in you losing 3.4% on the value (in terms of purchasing power) of your savings. Your money purchases 3.4% less than it could last year. To counter this some banks have set up youth saver accounts offering greater interest rates for young savers. Here at Lorica Partners, we pride ourselves on remaining independent, so if this interests you, you can search youth savers accounts and read up on your options.

Alternative Investments

Private equity (direct investment into companies not on public markets), commodities (gold/silver), derivatives (put/call options, futures/forward), cryptocurrency (Bitcoin, Ethereum), real assets/collectibles (e.g. wine/classic cars) are all out of the scope of these materials, however some examples have been provided if you are interested in researching further.

Investment Considerations

Investment Structures and Tax Considerations +/-

Investment Structures

You can invest your money and own assets (equities, properties and fixed interest) assets using all the four following investment structures. However, each of these investment structures has different characteristics that are important to understand.

These include:

  • Superannuation Funds
  • Individuals - Investing by yourself and withdrawing gains through your personal income
  • Trusts
  • Companies

Within these materials, we will be focusing on Superannuation, Individuals and Trusts.

Superannuation

What is Superannuation?

Superannuation is Australia's retirement pension scheme, where a mandatory percentage of your income must be paid by your employer into your super fund. The mandatory or superannuation guarantee percentage is currently 10% and rising incrementally to 12% in 2027. Superannuation is not to be confused with the age pension scheme (government paid support).

Super funds manage your money by investing it until you can access your super on or after a prescribed age or event. The age at which you can generally access your super is called your preservation age.

Fees

In exchange for this management, super funds charge a combination of flat management fees and percentage fees on your balance. It is important that you take time to understand super now as the fees of different superfunds vary drastically. Some funds charge up to 3% p.a.

To illustrate how Fees play a significant role in the growth of your money, the following calculations show the impact of just a percent change in return over 30 years.

Investing $1,000,000 in super for 30 years:

  • 6% Annual Return = $5,743,491.17

  • 7% Annual Return = $7,612,255.04

The 1% difference in return has a 32.5% difference ($1,868,763.87) on the final amount, highlighting the importance of shopping around with your super and making sure you have a superfund suited for your needs and financial situation. In the compound interest section, we talked about the exponential nature of growth as the compounding period (time) increased, so the earlier you do this the more time your money has to grow exponentially.

Types of Superannuation Investment Portfolios

It's worth noting that despite the average return of 7%, superfunds have various different portfolio types including aggressive/high growth, balanced, retirement (safe) and sustainability (socially conscious) portfolios which have different risk and return profiles.

Superannuation and Insurance

We previously mentioned that you can pay fees/premiums out of your super to obtain insurance, and that the payouts are often smaller. It is worth researching the level of cover you will have if you insure yourself through super versus directly purchasing an insurance policy from an insurer.

Low Income Co-Contribution

The ATO states that "super co-contributions help eligible people boost their retirement savings."

But what is a Co-Contribution?

If you are low or middle-income earner (under $37,000) and make a contribution (payment) to your super fund, the government will match your contribution (a co-contribution) up to a maximum amount of $500.

Like the co-contribution described above there are numerous incentives like tax reductions associated with voluntary contributions to superannuation but for these materials we have decided to focus on just this one.

Superannuation Taxation

The taxation characteristics of superannuation are drastically different to the other investment structures. When contributing to super you can elect to make contributions out of pre-tax income (salary sacrifice) by asking your employer to contribute a certain portion of your income into your super directly. These contributions are taxed at 15% as they are deposited in your super fund. For many people this would be significantly lower than their appropriate marginal tax rate and a tax efficient investment. Considering the impact of taxation when investing is important as lower taxation of your investments means that you require less returns, and you may even be able to reduce the risk profile of your portfolio due to this. The trade-off for lower taxation in the case of super is access to the money you deposited. Aside from the tax incentive of salary sacrificing, superannuation withdrawals (effectively income) by an individual over 60 are tax free.

Omitted Topics: Self Managed Super Fund (SMSF)

Additionally, we have excluded self-managed super funds from these materials, which are more advanced concepts unsuitable for introductory materials, however we have included it here in case you desire to research the topics yourself.

Individuals

We have already discussed how an individual can invest and what they can invest in. Next are the tax implications of investing as an individual.

The first investment structure is investing by yourself, and taking profits through your personal income. For the purpose of your knowledge as an individual investor the most important types of taxes are income taxes and capital gains taxes.

Income Taxes

Income taxes are charged on your personal income at a marginal rate (tax rate paid on each additional dollar of income).

For salary earners, your tax is collected over time through the Pay as You Go (PAYG) withholding, which automatically subtracts a certain amount (based on the table above) from your paychecks throughout the year. For others, there is a need to provision cash to pay the tax when due.

The formula for calculating how much tax you should pay in a given year includes:

Assessable income - (everything you earn + capital gains when assets are sold)

Allowable deductions - (work related expenses e.g. clothes, travel, vehicle expenses, work from home expenses (electricity). Additionally, some other deductions may be claimed:

  • Cost of managing tax affairs (accountant fees)
  • Gifts and donations
  • Fees incurred earning interest, dividends and for investments
  • Life insurance premiums

Assessable Income Less Allowable Deductions = Taxable income (on which the table above is applied to calculate the initial/basic tax payable)

Capital Gains Tax and Related Investment Taxes

Capital gains taxes are the taxes charged on the profits you have made from selling an asset. This amount is calculated by subtracting the purchase price and various fees paid during ownership from the selling price. In the case of shares, the price paid should include management fees which reduces the profit overall and therefore the taxable amount.

How Capital Gains Tax is charged?

The profit on a sold asset is added on to your personal income and then is taxed at the appropriate marginal rate.

Selling at a loss can be carried forward or calculated against any other capital gains you have. This will reduce overall profit from capital gains and therefore the amount of capital gains tax paid.

There are some exclusions and deductions in the case of capital gains taxes and taxes related to investments:

Any asset held for over 12 months in Australia is eligible for a 50% discount on capital gains where only half of any profit is assessed for taxation purposes. This does not apply to companies. Any capital gains on the sale of your main residence (primary living address) are not taxed. Dividend payments in Australia may be "fully-franked" which means the company paying the dividends has been taxed on their profits at 30% (corporate tax rate) so dividends are only taxed again when they are distributed to shareholders who have a marginal tax rate of over 30% and in this case still at a reduced amount.

Trusts

A trust is another investment structure, which allows you to hold investable assets. Firstly, it is important to understand how a trust fund operates.

A trust is a pool comprising of various asset holdings (stocks, property) set up by a trustee (sets-up the trust (they also contribute to it in the case of a family trust)) to provide income for its beneficiaries, who are decided by the trustee when they set up the trust fund. The purpose of a trust fund is to periodically provide income to these beneficiaries (normally family members) which is distributed to the beneficiary either periodically (every month/year) or when a certain event occurs (beneficiary turns 18). This income can arise from the sale of assets held by the trust, interest payments or dividend distributions.

When considering the tax implications, it is important to note that the income of a trust isn't always taxed directly. It may instead be distributed to the beneficiaries that are taxed at the relevant marginal tax rate for the individual (so the same table from the individual section would apply). If the beneficiary is under 18 this tax rate is as high as 66%.

Choosing the Appropriate Investment Structure

When deciding how you are going to invest it is important to consider the various characteristics of each investment structure especially the need for asset protection, taxation impacts and ability to access funds.

The decision between investing in super and as an individual is whether you are willing to trade access to your funds now for tax-efficient investment and withdrawals later in life. The lowest marginal tax rate for an individual is 19% (after $18,200 of annual income), however it much more likely you will earn in excess of this tax bracket and pay a higher rate than this. There is a significant difference between taxation on the income contributed to super (15%) to an individuals marginal rate whether through a trust fund or not. Trusts funds may also be more tax effective, especially when you are trying to distribute wealth to your family. An individual withdrawing $500,000 a year to spend on their family (of 4) from their trust fund would be taxed at the full marginal rate (45%), whereas if they were to distribute even proportions to each family member, the tax rate would be 37% (excluding income from working).

Being aware of the options you have and the trade-offs for each option is critical before investing. You should pick a vehicle that best aligns with your requirements.

Risk and Return, Portfolio Creation & The Emotions Of Investing +/-

Risk and Return

Now that we understand the categories of assets that we could potentially invest in, we can start to look at how to assemble a portfolio and the benefits of holding a diversified portfolio comprising of many assets across multiple asset classes.

Risk Profile

Aligning Financial Goals and Life Goals

When setting financial goals and investment goals you work within certain constraints you have including:

  • Your Time Horizon - How long are you looking to hold your investments for. Your investment time horizon impacts how risky your asset allocation is (longer periods can withstand more volatility).
  • Income Needs - An investor requiring regular income from their investments may have a different portfolio composition than someone looking to significantly grow their principal investment.
  • Risk Tolerance - How much risk are you willing to accept in order to 'sleep at night'. Understanding this will also help to avoid making emotional decisions in the event of volatility.
  • Risk Capacity - What is your ability to withstand a less than ideal outcome in the short term. We touch on this below when comparing the investment needs of a 90 year old and a 20 year old.
  • Risk Required - The rate of return is normally linked to the risk of an investment. Your portfolio should be built around the returns required to reach your goal, which in turn dictates the degree of risk in your portfolio. But remember high risk doesn't ensure high return.

Diversification and Asset Allocation

There are two categories of investment assets:

Growth Assets - Including shares and property. There are more risks associated with this type of investment due to price and income volatility, however they typically grow at much faster rates than defensive assets and have the potential to increase the value of investments significantly over the long term.

Protective Assets - Including bonds and cash investments (term deposits, high interest savings accounts). Protective assets are categorised by their ability to deliver stable and predominantly fixed returns in the form of interest, albeit lower than alternative investments.

Each of these categories have their strengths and help tailor an investment portfolio to the investor's risk profile.

A 90 year-old would not have the same investment horizon as someone that is 20. They may desire income to live off rather than long term growth. The increased volatility of growth assets aren't aligned with the consumption habits of someone looking for regular income from their investments and their portfolio may not be able to withstand the volatility (reduction in income generated due to portfolio value decreases) that a 20 year-old with a longer investment horizon could withstand. Due to this, varying proportions of growth and defensive assets can help tailor a portfolio to your unique situation.

The super investment options (different levels of risk/return characteristics e.g. balanced/high-growth/conservative) we discussed earlier follow these principals, selecting different proportions of growth assets and protective assets. The same can be applied regardless of the investment structure you choose.

For example:

  • High-growth portfolios would be 100% growth assets (e.g. equities/property) in order to maximise the rate of return of the investment portfolio.
  • Balanced portfolios generally have an allocation of anywhere between 60% growth assets/40% protective assets) and 80% growth assets/20% protective assets, balancing the risk/return of growth assets with the stable but lower returns of protective assets.
  • Conservative portfolios would increase the allocation weighting to defensive assets. A typical conservative portfolio would be a 40% growth/60% protective allocation, which prioritises the stability and fixed nature of the income of defensive assets.

Above we discussed the benefits of asset allocation, in tailoring a portfolio to the investors needs. Building on that it is important to understand the value of diversification.

First, it is important to understand the key risks that an investment may face (simplified to cover the most material risks)

  • Market Risk - This is the risk of pervasive events that impact the value of investment markets.

  • Credit Interest - For fixed interest, generally credit risk is the risk that the borrower will not be able to repay the lender what they borrowed.

  • Diversifiable Risk - Risks related to the unique characteristics of an individual security. This risk is confined entirely to a company, industry or asset class.

Whilst market risk (also known as systematic risk) is not diversifiable, credit risk and diversifiable risk can be mitigated against by constructing a diversified portfolio. The idea behind a diversified portfolio is to spread your exposure (risks you are vulnerable to) across multiple risk factors including asset classes, geographic markets and in the case of bonds and shares, various companies/institutions.

You never know which market or asset class will outperform from year-to-year. By holding a diversified portfolio, you can position yourself to capture returns wherever they are. Based upon historical data, the following figure shows just how much each asset class deviates from its "average return" and the frequency at which each asset class fluctuates across the spectrum of best-worst performing.

Diversification for equities is especially important due to increased risk (chance of a large share price decrease/company goes out of business) and volatility (fluctuation in returns). We discussed earlier how 4% of stocks on the US stock market accounted for the entire gain of the US stock market, whilst the remaining 96% only returned the same as a 1-month US treasury bill (risk free rate). Bear in mind the US stock market returned an average of ~9.6% year-on-year and yet only a small handful of stocks are responsible for this.

The above chart epitomises the importance of holding a basket of stocks rather than individual stocks. Selecting "winners" can greatly impact your return as you reduce your odds of actually holding the best performers. As we will stress in the following sections, picking individual stocks is akin to a guessing game. Diversification is a way to consistently perform using evidence of what works in investing, acting rationally and avoiding making mistakes and emotional decisions.

Finally, it is important to understand that a diversified portfolio will not protect you from market risk. Diversification's strengths lie in its ability to protect you from the volatility of owning individual stocks, which can fluctuate hugely day to day, ultimately helping to grow your investments more consistently and sustainably.

Investment Fees

As we touched on during the superannuation section, fees can drastically impact your investment returns. When investing, its important to take the time to understand all of the fees you may be charged including account fees, management fees and buying and selling fees. ETFs are a good example of a product charging fees you might not be aware of. The issuer of the ETF will periodically subtract fees from the actual share price of the ETF, which an average investor would likely miss.

Fees will also need to be justified, especially in the cases of managed funds, which may underperform relative to the market benchmark. Additionally, for years where returns may be negative, fees will intensify losses in that year.

However, investment fees can be deducted against tax, whether that is when you have capital gains or as part of your normal investment lodgement process.

The Emotional Side of Investing (Emotional Fallacies)

The most important thing we stress when investing is to focus on evidence rather than a gut-feeling on a stock or an emotional response to volatility. Emotional investing leads to the biggest and most costly mistakes for new investors both in terms of actual losses (sold at a loss) and future losses (lost growth opportunities). This section is all about trying to reassure you of the investment approach and some of the habits that lead to investment growth in the long term.

Power of Markets

Financial markets facilitate the buying and selling of financial securities (bonds/shares). In addition to the facilitation of buying and selling, financial markets are powerful information processing machines. Markets aggregate vast quantities of information worldwide and reflect this in the form of accurate security prices. Additionally, the market effectively enables competition (sets and influences buy/sell price) among many market participants who voluntarily agree to transact/trade.

Harnessing the market's power means accepting that market prices are the best reflection of all currently publicly known information rather than trying to outcompete with other traders because you believe you have knowledge the rest of the market doesn't.

  • With each trade, buyers and sellers bring new information to the market, which helps set prices
  • No one knows what the next bit of new information will be
  • The future is uncertain, but prices will adjust accordingly
  • This doesn’t mean that a price is always right—there’s no way to prove that
  • But investors can accept the market price as the best estimate of actual value
  • If you don’t believe that market prices are good estimates—if you believe that the market has it wrong—you are pitting your knowledge and hunches against the combined knowledge of all other market participants.
  • And remember, whenever someone thinks now is a good time to sell a security at a certain price, there must be someone who believes now is a GREAT time to buy that security for the same price.
  • So whenever you hear there was a ‘sell off’ in the market, it means other investors thought it was a great day to buy into the market.

Market-Timing & Stock Selection

Given the above, it is not possible to consistently pick the perfect time to invest as you have access to the same public knowledge as the rest of the market, and you will therefore not have any informational edge over other market participants. The same principle applies for picking the perfect stock. Accepting that market prices are the most accurate price we have based on information that currently exists means that you won't be able to attain extraordinary returns by consistently picking undervalued stocks.

An example of this in action is when the market’s pricing power works against managed fund managers and those who try to outperform through stock picking or market timing. As evidence, only 14% of US equity mutual funds and 13% of fixed interest funds have survived and outperformed their benchmarks over the past 15 years. If they can't consistently pick stocks as their profession it is unlikely you will be able to either.

Remember: Time in the market is more important than timing the market. The following figure shows that missing days with the highest return (and highest losses) can drastically impact the value of your portfolio.

Volatility

It can be considered normal for stock markets to experience short-term volatility. For example, in 2021 when the ASX 200 ended up 15%, at one point during the year, the index was down 10%. If you sold when it was down 10% you missed out on significant growth. The importance of remaining focused on the long-term view is epitomised by the chart below.

Declines in the market occur, but zooming out provides evidence that a smart investing approach works.

Why A Stock Peak is Not a Cliff

The Human Side of Investing

The human brain is not wired for disciplined investing. When people follow their natural instincts, they tend to apply faulty reasoning to investing. Avoid reactive investing. Many of the best days in the market follow large declines. Selling during declines means you would miss out on the recovery days. Trying to avoid the bad days or selling when your investments go down can harm your long term wealth, as indicated in the figure above showing the impact of missing the markets best days.

Key Takeaways Regarding Emotional Investing:

  • Losses are only realised when you sell (avoid reacting to volatility and focus on the evidence)
  • Zoom out and take a long term approach to investing
  • Price changes are due to unforeseen events, not existing knowledge
  • You can't pick the winners and you can't time the perfect date to invest (trying to pick these will only harm your returns)
  • You have to be in the market to benefit from it
  • A stock peak is not a cliff (it's by design that share prices increase. Companies must act in the best interest of their shareholders)

Summary of Investing

Remember that the reason we invest is to succeed in achieving our personal goals. Our financial objectives must be aligned with these goals to enable us to live the lifestyle we want. Investing helps to outpace inflation and grow our money in service of these objectives. The key considerations that you should have when investing are:

  • What are your goals and what are the finances required to achieve them? (Do I need income/capital growth)
  • What is my current financial situation looking like? (What is my financial literacy? How is my budgeting, existing savings, debt situation looking?)
  • What are my constraints and do I need to adjust my goals? (time horizon, risk profile)
  • How should I invest? (What investment structure should I use? Am I aware of the implications of taxes and fees?)
  • How should I act after investing? (sticking to the evidence-based principles - diversification, asset allocation, acting rationally during volatility) Following the principles and information you have learned should provide you with the best framework to succeed.

From all of the team at Lorica Partners,

Congratulations on finishing these materials.