Investors hate paying tax. But could that dislike be leading them to make worse investment decisions?

In the latest episode of Investing Compass, Mark and Shani look at how investors appear to be responding to Australia’s new capital gains tax rules, with a particular focus on the surge in money flowing into ETFs.

A record $6.8 billion flowed into ETFs in July, with around a quarter of that money going into fixed-income and income-focused ETFs. The pair explore what might be behind the shift and whether investors are allowing the ‘tax tail to wag the investment dog’.

Other insights on tax:

Future Focus: The new capital gains tax trap for your portfolio

How much managing your portfolio is going to cost you with the new tax changes.

The investment that sidesteps the new tax traps

A rundown on insurance bonds.

Should you pay off your mortgage or invest after the latest tax changes?

The equation has shifted. Find out what your best option could be in the latest Investing Compass episode.

You can find the transcript below:

Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances, or needs.

Mark LaMonica: We’re going to do an episode to commemorate, celebrate whatever, the one-year anniversary of our book release. We want to answer reader questions. So if you have a question, send it to my email address. It’s in the show notes, and we’ll answer the question on that podcast. But today’s episode, we’re going to talk about your favorite subject, Shani.

Jayamanne: I didn’t realize you wrote a whole episode on Priscilla.

LaMonica: Well, that would actually, Priscilla is Shani’s dog. For people who have not been longtime listeners, that would be appropriate because Priscilla’s birthday was this week.

Jayamanne: It was. I got him a roast chalk. It’s his favorite food, and I put candles in it.

LaMonica: Like the what’s it called?

Jayamanne: The bachelor’s handbag.

LaMonica: Okay, I got him a present as well.

Jayamanne: You did.

LaMonica: I got him lamb rosemary dog treats.

Jayamanne: He did like those.

LaMonica: But I guess I should have gotten him like a lamb roast.

Jayamanne: But I’m guessing this episode isn’t about Priscilla.

LaMonica: No, no. It’s about your other favorite topic, one that Shani does talk about a lot, and that is taxes. And we think that this will be a popular episode because as people probably know, there have been recent changes to capital gains taxes. So we did a previous episode that discussed the implications, what we thought investors should do, but today we want to take a different approach.

Jayamanne: And we’ve been seeing a lot of data around ETF flows, and that may indicate how investors are reacting to the changes. We don’t know the exact motivations of each investor, but there are some profound changes to what types of ETFs people are buying since the new tax changes were announced.

LaMonica: And the headline numbers ETFs continue to be incredibly popular with investors. 6.8 billion, which was a record, flowed into ETFs in July, and that is 900 million more than the previous record, so a big difference. A quarter of all that money went to fixed interest and income ETFs. And fixed interest has been a particular favorite of investors. That was the biggest month ever of inflow into fixed interest in July.

Jayamanne: And the dividend ETFs do make sense, as we’ve discussed on the podcast before. The new CGT rules result in high taxes under most scenarios. That makes franked dividends more attractive on a relative basis. Fixed interest is a little bit more of a mystery.

LaMonica: Yeah, and I think one reason why it’s a mystery is this is a really challenging environment and has been for a while for bonds. So yields have been increasing, interest rates have been going up overall, which means bond prices are going down. So over the past five years, most of the major bond indexes are down, meaning you have lost money. So on the surface, this is a little bit strange because investors, even though we warn you against this, investors do tend to chase performance. But two of us talked about this, Shani, and you have a theory.

Jayamanne: Yeah, conspiracy theory.

LaMonica: Yeah, not like your theory on whatever true crime you’ve been listening to recently.

Jayamanne: Yeah, and obviously this is just a theory, and as Mark mentioned earlier, we can’t know why investors are doing certain things and motivations do vary. I think given the negativity around the CGT changes, this might just be investors letting the tax tail wag the investment dog and putting a large emphasis on investment products and assets that have been heavily discussed as more efficient.

LaMonica: Okay, so let’s break down Shani’s theory. So there could be two different components to this, right? It could be confusion or frustration. So let’s start with confusion. Confusion might stem from all of the discussion in the media, and we’ve discussed it as well, about the relative attractiveness of income versus capital gains in this new tax environment. And Shani, based on this commentary, is it a good approach to invest in fixed interest?

Jayamanne: Yeah, it’s hard to say it is. Fixed income earns income and capital gains. Those capital gains taxes will be higher under the new tax rules, and the income will be treated exactly the same. There are no franking credits from Bond ETFs, which is where the relative advantage we’ve discussed comes from.

LaMonica: Yeah, that’s right, Shani. And for an equity investor, the new tax rules make it better to receive, as you mentioned, better to receive franked dividends instead of capital gains under most realistic scenarios.

Jayamanne: We also spend a lot of time talking about the importance of asset allocation in this podcast. Your asset allocation should be aligned with the return you need to achieve your goal. And over the long term, growth assets like shares have higher expected returns than defensive assets like fixed interest. So if taxes go up, it makes a little sense to respond by getting more conservative with your asset allocation.

LaMonica: Yeah, exactly. And it actually makes more sense to do the exact opposite, right? If you need a higher pre-tax return to make up for higher taxes, you should potentially be getting more aggressive. But this gets to another potential reason for this large inflow in the fixed interest ETFs. People just hate paying taxes. And I will say this is probably another counterproductive reaction to the higher taxes.

Jayamanne: And we thought, given everything going on, we’d go back to a bit of the foundations because I think that’s important in times like this.

LaMonica: Okay. So let’s start with the purpose of investing. Saving and investing money is often portrayed as a sacrifice. And we certainly get that portrayal, and in some ways it is. There are always different things that you want to spend money on. But savings and investing is really incrementally buying yourself financial freedom.

Jayamanne: And financial freedom is often portrayed as something that just happens all at once. Concepts like your fire number reinforces view. One day you aren’t financially free, and then just like magic, you are the next.

LaMonica: And in reality, financial freedom is gained step by step. So you establish an emergency fund and you gain freedom from worrying about unexpected bills. You build enough wealth to support yourself over the short term, and you have the freedom to quit a job you hate or leave a relationship, or I guess on a more positive note, to take advantage of an opportunity that’s out there or try something new professionally.

Jayamanne: And saving is half the battle, but earning a return that is higher than inflation is also critical. And to demonstrate that, we’re going to use a rule of 72 to demonstrate why growth assets are needed.

LaMonica: Okay, so the rule of 72 is just a shorthand way of figuring out how long it takes to double an investment. If you earn a 1% return, it’ll take you 72 years to double your investment. If you’re in a 10% return, it’s 7.2 years.

Jayamanne: So in our book, we use the rule of 72 to demonstrate why growth assets are important. We use some assumptions, but given the years of employment for the average Australian, which is 45 and a 12% annual savings rate, you need to double your portfolio 5.2 times during your working life.

LaMonica: Do you do you think knowing that the average Australian works for 45 years, like that seems like a good incentive to save money and invest?

Jayamanne: Yeah, it does.

LaMonica: Shani was hoping to win the lottery the other day.

Jayamanne: Every week, really.

LaMonica: Yeah, but you said that the lottery amount was not enough for you to quit your job.

Jayamanne: No, unfortunately not.

LaMonica: But it probably would have helped.

Jayamanne: It would have, yes.

LaMonica: Okay. So we understand how long it’s going to take to how many doubles you need to actually retire, so 5.2 doubles. Now we can turn to Vanguard’s 30-year asset class performance chart to see how many times you can double your investment based on different asset classes over a work life. And so this also includes historic levels of inflation. So all the returns we’re talking about and all these doubles, those are real or inflation adjusted returns.

Jayamanne: So for cash, it takes you 48 years to double your money, so that’s not going to work. Aussie bonds take 24.82 years, that is less than two doubles in a lifetime. Defensive assets will not get you to financial freedom. They can, of course, play a role in your portfolio, but for long-term investors, it should not play the primary role.

LaMonica: And then meanwhile, based on those historic numbers, Australian shares allow you to double in 11.25 years. US shares in 8.57 years. And Australian shares, those historic returns won’t quite get you to enough doubles, given our assumptions. US shares will get you there.

Jayamanne: So that’s the next lesson. For many people, you need to save more money than the compulsory super contribution rate to achieve your goals. Mark, you wrote an article about this. What number did you come up with?

LaMonica: Yeah, and I did use similar assumptions to that rule of 72 discussion we had. That’s really replacing around 70% of your salary. And the number that I came up with from a savings perspective is roughly 15% a year. So that’s obviously more, as we said, than that compulsory super amount of 12% a year.

Jayamanne: And there’s a lot of noise around the CGT changes. There is a lot of frustration and anger, and we imagine that some people have just decided is too hard and feel like giving up. But taxes are a way of life, and they do frequently change. If you are young, they will likely change multiple times in your lifetime. They might get lower and they might get higher. Nobody knows.

LaMonica: So we would encourage people, of course, not to give up. As we said, in most scenarios, taxes will be higher under the new CGT rules. And there are several steps that you can take, which we covered in that first episode where we talked about the changes. But ultimately it’s likely going to come down to a combination of things. Two of those are making sure your asset allocation is correct and aligned to your goals. And then of course it’s making sure you have enough money, you’re saving enough money to reach your goals as well.

Jayamanne: And we put so much emphasis on setting goals because if you do have that framework established, you have the foundations to course correct. You can run different scenarios by adjusting the returns needed or your savings levels.

LaMonica: And if you haven’t established your goals, now is always a great time. We’d encourage you to do that. It’s something we spend a lot of time in our book talking about, and we go through a step-by-step process, and we talk about a lot of the theory around goal setting as well. So just a little plug for the book at the end of the podcast, and another plug for the book episode. If you do have questions, send them in. We’ll answer them on that podcast. Thank you very much for listening and watching today.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)

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