Listin to Investing Compass here. 

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: Okay so two things; Shani number one is upset at me, but I'll get to that in one second, but she also wants me to plug the conference.

Jayamanne: Please do.

LaMonica: Once again, she's very proud and she should be for the agenda she arranged. So it's two days, October 11th and 12th –11th is just a digital day, so you can watch that from the comfort of your own home. If you're not in NSW, you can also watch the 12th from the comfort of your own home. But also, you can join us in Sydney if you're here at the ICC and come see the great lineup that Shani put together, and you can ask her about why she's mad at me.

Jayamanne: Not sure why I'm mad at you – I'd like to hear this to be honest.

LaMonica: Shani wrote an article and she put a Harry Potter reference into it. She – and you kind of forced it in there to be completely fair – she talked about the cloak of invisibility.

Jayamanne: I did.

LaMonica: And it was describing a lack of corporate transparency from Japanese companies, and because nobody understood what the cloak of invisibility meant, right afterwards, she wrote that – a lack of transparency in Japanese company. So I edited it out, not even knowing it was from Harry Potter.

Jayamanne: That's a bit rude and well, yeah.

LaMonica: Then she got very upset. So, anyway.

Jayamanne: I also have access to the uploader where we upload articles, so I'm just going to add it back in. Mark's going to leave in a couple of days so look out for that.

LaMonica: Well there we go if that doesn't get the hype. If maybe the Harry Potter fans start reading your article, think about the number of hits you'll get.

Jayamanne: I know.

LaMonica: Okay. Today we're talk about something different than Harry. Potter, though

Jayamanne: Let's hear it.

LaMonica: We're going to talk about performance.

Jayamanne: And that's normally something that we steer clear of at Investing Compares.

LaMonica: Yeah, but we're trying something new today, but we are going to talk about performance in the context of expected returns. And I guess the expectations that investors have for returns. And we're going to compare that to what they actually receive.

Jayamanne: I think this is very much more in our wheelhouse.

LaMonica: Exactly. So the premise of this is that the headline return is never what investors get. We look at the components that make up a total return.

Jayamanne: And we both talk to a lot of investors. We consume a lot of investing commentary. And when investors and investing commentators talk about returns one number is more likely than not to pop out. It has long been conventional wisdom that equity markets will return 10% p.a. to investors over the long run.

LaMonica: So what we are going to do today is deconstruct a return. And deconstructing a return means that we need a base case to start off with. And we are going to pick a base case of a return of 10% as Shani mentioned. And to be clear we’ve picked that return not because we think that is going to be the return that is going to be earned going forward. It is as Shani mentioned just the return we hear all the time.

Jayamanne: So our base case is a $100,000 initial investment and $1,000 additional investments every month, in 20 years (with returns reinvested). I would have $1,391,009.

LaMonica: Of course, this scenario completely ignores all the realities of investing – the costs of investing and taxation for example. These factors need to be taken into account because what matters is how much money ends up in an investor’s account.

Jayamanne: Exactly right Mark. So we’re going to try to account for that today. Understanding the holistic return ensures that you have more chance of reaching your financial goals. It also makes it more likely that an investor will pay attention to minimising taxes and fees

LaMonica: So let’s go through all of the variables to consider. And we’ve focused on everyone’s favourite asset class – Australian equities.

Jayamanne: But of course, this exercise is applicable for any investments – and we encourage you to do it.

LaMonica: So the first consideration is brokerage. And of course brokerage is one of those costs that will completely depend on the provider that you use and sometimes the amount that you are trading. We’re going to go with the most popular broker in Australia, CommSec, as it is the one you’re most likely to be with. We’re making additional investments of $1,000 – and they charge $5 for investments up to $1,000 in Aussie listed assets.

Jayamanne: The impact over the lifetime of the investment is $3,592. This of course is the best case scenario. We know that investors trade a lot more, and it is likely that they will buy and sell in that twenty year period.

LaMonica: That’s right Shani. So that seems like a pretty negligible amount compared to your total – it’s $1,391,009 – as a reminder. So 3.5k is just a drop in the ocean. But the point is that it adds up. We’ve been quite vocal that the best way to be unsuccessful as an investor is to trade frequently. So more than anything we want to get the point across that for most investors the best way to improve your results is to look at how much you trade and trade less.

Jayamanne: We’re just getting started, Mark. We’re gonna go for management fees next. If you’re investing in direct equities, you can skip this part. If your exposure to Australian equities in your portfolio is through an ETF, management fees will detract from your total return.

LaMonica: Morningstar manager research analysts’ choice for Australian equity exposure is VanEck Australian Equal Weight ETF (ASX:MVW), awarded a silver medal. We’ve spoken about this ETF before in our ‘build a portfolio with three trades’ episode. This episode contains our analysts’ rationale for why this is their choice for Aussie equity exposure.

Jayamanne: But today we’re focusing in on how it will impact your return. So the investment management fee for ASX: MVW is 0.35%. Over twenty years, your total return takes a substantial hit. The effect of fees is $76,473, dropping the balance of your portfolio down to $1,310,945. And it should be noted that 0.35% is rather cheap for a managed product. You could be paying much higher fees.

LaMonica: While we’re on the topic of trading expenses, we’ve also got buy/sell spread coming in at $131.

Jayamanne: Really counting our pennies, Mark.

LaMonica: That’s how the rich stay rich, Shani.

Jayamanne: Then we’ve got the least favourite of the lot, tax.

LaMonica: I would say that that’s your favourite, Shani.

Jayamanne: I thought you were supposed to know me a little better than that Mark. This episode and the example that we’re running through is generalising the circumstances of an investment to demonstrate how the headline return is not what you’ll receive. Of course, your circumstances will be different to this example and will result in a different outcome. This is because investing is deeply personal and based on your circumstances, including tax.

LaMonica: In the 20 years that you have held this investment, it is likely that your tax bracket has changed. The situation would also be different if you had held this investment in a different tax environment, such as a trust.

Jayamanne: For this scenario, we are going to assume the tax rate on a median income (32.5% plus 2% Medicare levy) and an average dividend yield of 4.17% (average yield of the ASX according to S&P Dow Jones).

LaMonica: Income tax paid over the course of the investment would be $180,443. This of course is not paid from your investment, but it is paid separately when filing your tax. This is an issue that has caught many new investors off guard. This however, is a gross number – investors receive a little respite from franking credits. And we will get to capital gains tax in a bit. This is just one component of tax.

Jayamanne: That is a perfect introduction to our next section. We’ve talked a lot about costs but here’s where we get something back. Franking credits are tax rebates that are given to investors in Australian companies. The rebate is to remove the double taxation of dividends by providing a credit for tax already paid by the company. Franking credits prove to be a pretty big contributor to returns.

LaMonica: The ATO provides the monthly average franking rebate yield on the S&P Dow Jones All Ordinaries Index. Between 2018 and 2022 the monthly average is 1.25%. This will vary for specific investors depending upon the individual shares in a portfolio but is useful to look at the overall index. Over the course of 20 years this will boost returns by 1.25% a year or $149,352. Since this credit occurs outside of an investment account, we’re just going to assume that it is not reinvested and have simply added the benefit from each year over a 20-year period.

Jayamanne: Inflation is next – everyone’s favourite topic. Milton Friedman famously said that inflation is taxation without legislation. Inflation is the silent thief of returns. Inflation is a real cost to investors since the whole point of investing is to grow a portfolio to pay for things in the future. The impact over 20 years is almost halving your ‘growth’. A portfolio of $1,387,417 in 2043 will have the value of $768,179 in today’s dollars (assuming a 3% p.a. inflation rate).

LaMonica: That is $619,238 less than what you would have expected. And it is a reminder that what matters to investors is the real return or the return that is made in excess of inflation. Simply put a return a 10% in an environment with 5% inflation is not the same as a 10% return with 1% inflation.

Jayamanne: We’ve given you a little respite but we’re diving head first into tax again. This time, it’s capital gains tax. Capital gains tax occurs upon the sale of an asset that has appreciated in value. For direct assets, this will be when you decide to sell your asset. If you’re invested through funds, ETFs and other collective investment vehicles, CGT isn’t as clear.

LaMonica: For collective investment vehicles such as managed funds and ETFs there will be changes to the holdings over time.  For passive investments, this might be to ensure that the fund is still tracking the index and the same holdings. For example, if we’re looking at the ASX/200, and the 200th stock changes due to a change in market capitalisation. The fund must buy the new stock, and sell the share that is no longer in the index.  This would mean that the investors in the fund may have CGT distributed to them if the share that is sold has appreciated in value.  

Jayamanne: For active investments, it would be a similar process if the manager decides to make a change or if the assets have fallen out of the mandated ranges for the fund. For example, Australian equities may make up 50% of a fund. The Aussie market performs extremely well and now makes up 70% of the fund. The exposure must be reduced and the appreciated assets must be sold. This is the same with equal weighted funds like ASX:MVW that must rebalance to ensure that the assets are kept equal weighted.

LaMonica: If these were direct assets, the CGT obligation would be relatively straightforward. In the scenario in this article, I have contributed $100,000 and $1,000 of additional investments every month for 20 years. This means my capital base is $340,000. With my investment appreciating to $1,387,417, my capital gain would be $1,047,417.

Jayamanne: We’ve held the investment for more than 12 months, so we receive a 50% discount. Assuming the highest marginal tax rate, the tax obligation would be $246,142. This is just one benefit of long holding periods.

LaMonica: The most obvious way to mitigate the impact of CGT is to hold the assets in a more favourable tax environment – superannuation. Super has a CGT rate of 15% in accumulation phase. It is 0% in retirement.

Jayamanne: Okay – we’re onto the last main consideration. And this is one that we’ve spoken about quite a lot. This is behavioural.

LaMonica: And it’s often that we will skip this part because we just never think that it will apply to us.

Jayamanne: When I purchased my first car – I was on a very tight budget because I was a student. I had to make sure I could afford the running costs, the rego – all of those extra expenses. And my dad said – make sure that you include the costs of any traffic or speeding fines.

LaMonica: I can’t imagine you ever breaking the law Shani.

Jayamanne: Well, my thoughts exactly. Of course, within 3 months I had a red-light camera ticket which I was and am particularly embarrassed about but that of course blew my budget before I had really gotten up and running properly.

LaMonica: With that insight into Shani’s teenage years, we can see how it’s easy to think that we will never commit the acts that everyone else does, and we can forego all of those extra costs. You are more than likely to act irrationally over a 20-year period. There’s going to be multiple market cycles and a lot of volatility to grin and bear.

Jayamanne: and behavioural risks reflect our tendency as humans to act emotionally during volatility. We are driven by fear and greed, which is a formula for buying at the top of the market and selling at the bottom. Both individual and professional investors create elaborate models and theories designed to dictate when and why to buy or sell a security.

LaMonica: Despite these models there is still a high probability that you’ll panic when the market is going down and fear missing out on profits when it keeps climbing. These actions have been shown to be to the detriment of the returns an investor achieves. We’ve spoken a lot about the behaviour gap on Investing Compass before – it is the gap between an investment return and the return an investor gets in the same time period. Constantly switching between investments and assets due to emotional responses has been proven to reduce returns for the majority of investors.

Jayamanne: It is difficult to say when or if you would switch out of your investments. The study has shown that the average investors earned 1.7% less than the total returns that their fund investments generated over the same period.

LaMonica: This gap between the returns investors actually experience and reported total returns can be attributed to a few reasons – cash flow timing, costs and tax efficiency.

Jayamanne: For the average investor, this means that through an ETF or fund, investor behaviour reduces the balance by -$290,101. For direct equities, it is -$308,655. And remember this poor behaviour would result in higher transaction costs and more taxes.

LaMonica: and that higher amount for direct equities is due to a reduced balance from management fees for ETFs/Funds. And once gain more than anything else this is just a reminder that there are all sorts of reasons that cause poor investor behaviour but they all manifest in one action – trading. If you trade less you will have less of a behavioural impact on your returns. And this is complicated because nobody is deliberately trying to minimise their returns. Each individual trade seems like a good idea at the time. But the best way to combat this is to trade less. Do less with your portfolio.

Jayamanne: There are many variables here that can alter the outcomes that you receive.  The purpose of this exercise was to understand the different components of a total return.

LaMonica: We can clearly see that a 10% headline return is not the real return that investors will receive. This is particularly important to factor in when you are understanding how much you need to achieve your goals. Taking the headline rate of return required to achieve you goal could result in a shortfall.

Jayamanne: In this case the total nominal return of 10% which does not include the impact of inflation was reduced to 2.90% on a real or inflation adjusted basis. If we look at the dollar amount we see a reduction from a $1,391,009 portfolio to $819,426 which doesn’t include the reduction of purchasing power for the portfolio. And that is a dramatic difference.

LaMonica: The purpose of this exercise was to understand the different components of a total return. Specifically, the elements that detract from the returns we often read about and what shows up in our brokerage accounts.  We can clearly see that a 10% headline return is not the real return that investors will receive. This is particularly important to factor in when you are understanding how much you need to achieve your goals. Taking the headline rate of return required to achieve you goal could result in a shortfall.

Jayamanne: This should also be a wake-up call for investors. Minimising fees, taxes and transaction costs all make a difference. Limiting poor behaviour and resisting the urge to churn a portfolio by constantly chasing the latest fads will make a difference.  Headline returns are useful. The return that is actually achieved is what matters.

LaMonica: All right. So that is a story from Shani's teenage years and just so everyone's aware, Shani does not currently own a car so if you're out there on the roads.

Jayamanne: You don't have to worry about me.

LaMonica: You don't have to worry about somebody blowing through a red light, so that's good news. But you can come talk to her about her driving mishaps at our conference on October 12th, in Sydney at the ICC.

Jayamanne: Do you know what's actually funny, we had the same first car.

LaMonica: I mean that that is true.

Jayamanne: I think mine was actually older than yours, yeah.

LaMonica: Yeah, which is amazing since I had one of those Flintstone cars where you have to run on the ground to get the thing to go.

Jayamanne: But it was the same make and model.

LaMonica: I know crazy stuff. All right, thank you guys very much for listening.