Future Focus: The best place to put your next dollar
When it comes down to it, there’s a limited number of decisions. Here’s a framework to get you going in the right direction.
Mark and I have recently present to various chapters of the Australian Shareholder’s Association. We’ve included an audience activity and asked attendees to pick the best approach to achieve a specific goal given three different financial situations.
This exercise causes a flurry of conversation about the right approach to achieving a specific goal. However, realistically there are only a few levers to pull to get our hypothetical investor to the life they want.
Becoming the CEO of your own life
Capital allocation is the focus of William Thorndike’s book Outsiders. Thorndike looks at a group of eight successful CEOs. Success is defined as the degree the companies exceeded the return of the S&P 500 during the CEO’s tenure.
As a point of comparison Thorndike uses Jack Welch, the CEO of GE who achieved a phenomenal 20% return p.a. over the 20 years he was at the helm of the company. The S&P 500 averaged 14% in the same period. When we look at these eight CEOs, the proof is in the pudding. They averaged 30%.
Thorndike explains in this book that CEOs need to do two things well. The first is run their operations efficiently. The second is to deploy the cash generated effectively. CEOs have five choices for deploying capital:
1. Investing in existing operations
2. Acquiring other companies
3. Issuing dividends
4. Paying down debt and
5. Repurchasing stock.
We can categorise these choices in further: Investing in the business through internal or external activities, strengthening the balance sheet, or returning capital to shareholders.A CEO has three ways of raising capital:
1. Tapping internal cash flow
2. Issuing debt and
3. Raising equity
When you break it down into those points, it makes their job seem simple.
The overriding point of Thorndike’s book is that allocating capital effectively is the most important part of a CEO’s job. A good CEO makes a capital allocation decisions guided by the best utilisation of the capital to create value for shareholders – the owners of the company. This is not a static decision, and will vary based on the company, the industry and market conditions.
For individual investors who are their own CEOs, there are also a limited amount of places to allocate capital.
- Paying down consumer debt
- Contributing to cash/savings/emergency fund.
- If they have a mortgage, allocating it to the redraw or offset to pay down the loan faster.
- Investing inside of super.
- Investing outside of super.
We can also categorise these choices even further – paying down debt, saving and investing.
The main considerations for capital allocation is effective return, tax, time horizon and flexibility.
Effective return: Hurdle rate
Return is the most intuitive concept, it represents what you earn on your capital. The issue that investors confront is that future returns are unknown. That is where the concept of a hurdle rate comes in. When comparing the known benefits of paying down a mortgage or other forms of debt a hurdle rate is the amount an investment must achieve to surpass the benefit from an alternate use of the money.
For debt, the ‘return’ is the effective interest rate that you avoid paying. Consumer debt tends to have very high rates of effective interest, with many credit cards charging 20%+ p.a. This is a ‘guaranteed’ return that very few investments can match.
I’ve previously addressed the hurdle rate for mortgages and offset accounts in detail. This is a risk-free return. Any investment return that you are comparing to your interest rate must also account for tax and transaction costs.
For this reason, superannuation is usually a much lower hurdle rate than an investment outside of superannuation that must account for higher marginal tax rates.
Generally, this is why consumer debt should be the priority, with the hurdle rate required where the next dollar is most effectively placed. There are other variables and considerations for this – read on.
Flexibility
Flexibility refers to your need and ability to access funds when needed or adjust plans if circumstances change. For cash and savings, liquidity is high. You can access funds at any time to deal with emergencies or opportunities. Similarly, paying down high interest debt increases financial flexibility by freeing up future cash flow.
Superannuation is not as flexible. Although it offers strong tax efficiency, your funds are locked away until preservation age. There are also contribution caps and restrictions on the types of contributions you make that make this vehicle more restrictive.
Part of flexibility is ensuring that you have an adequately funded emergency fund. It opens up the flexibility to invest confidently, without having to dip into your investments if there is an emergency. An emergency fund should be your second priority after consumer debt.
Time horizon
The time horizon until you need your money matters when you are choosing where to put your next dollar.
Short horizon (<3 years)
Cash or fixed income is usually preferable due to the sequencing risk. Super is off the table if you might need the money soon and you’re not close to retirement. If you have an offset account attached to your mortgage, this is tax free guaranteed returns. I use my offset account in this way.
- Emergency fund: 3-6 months of expenses for salaried individuals, 1 year for self-employed.
This amount covers job loss, medical emergencies or unexpected repairs.
- Upcoming short-term goals (next 12-24 months)
This could be an overseas holiday, maternity leave or a renovation. Investments in equity markets that typically offer higher returns may be too volatile for this short time period. Putting it in the offset will reduce your interest expenses in that period while maintaining liquidity.
- Every day cash flow cushion
I use my offset account for lumpy costs that I know are incurred annually or every few years. This includes home insurance, council rates, land tax and health insurance. It can reduce interest while providing a place to save for these lumpy costs.
Medium horizon (3-10 years)
Investments outside of super may be reasonable for this bucket for non-retirement goals, giving you the best balance between growth, access and liquidity. This must be considered based on your hurdle rate if you own a mortgage. Understand whether your effective guaranteed return in your offset account is higher than expected returns from your equity investments.
Long horizon (10+ years)
For non-retirement goals, the hurdle rate is important again but expected returns for equities over a long time period with returns reinvested make investing an attractive proposition. For retirement goals, combining the long-term return potential of growth assets with the tax advantages of super are difficult to beat.
Individual circumstances may vary but a simple hierarchy can help with decision making.
- Eliminate high interest debt first – credit cards, personal loans and high interest products are generally the worst ‘investments’ you can make. Paying these down is equivalent to earning a risk-free high return.
- Build an emergency fund – 3-6 months of living expenses in accessible cash provides flexibility and peace of mind, allowing you to take investment risks elsewhere without jeopardising your financial security.
- Pay down your mortgage (optional) – if you have a mortgage, offset or redraw contributions can reduce interest costs and provide a guaranteed return with flexibility to access the cash for emergencies or opportunities. This is an especially attractive proposition if interest rates are high. If you don’t need the funds in the medium to long-term, consider whether superannuation or investing outside of super has a better return and diversification benefits.
- Invest in super – maximise concessional contributions if it aligns with your retirement goals and time horizon. The combination of compounding and tax efficiency can be powerful over decades which is hard to beat outside of super.
- Invest outside of super – if you have medium term non-retirement goals, investing in a portfolio aligned to your financial goals provides flexibility, growth potential and access to funds before retirement.
An example of capital allocation
To understand next steps, there are a few questions you need to ask:
- Clarify your financial goals and constraints
What are you trying to achieve and by when?
- Assess your existing financial position
Take stock of your debt levels, cash buffers, superannuation balance, mortgage structure and investments.
- Calculate your personal hurdle rates
What return must each option exceed to be worthwhile?
Tom, age 34 earns $120,000. His assets and liabilities:
- Consumer debt: $4,000 outstanding on a credit card at 20% p.a. interest rate
- Mortgage: $650,000 loan at 5.8% variable, with an offset account
- Super balance: $95,000
- Cash savings: $8,500
- Investments outside of super: $12,000
Tom’s goals are to build a bigger emergency fund, make some needed repairs on the home in the next 18 months of $5,500, and retire comfortably at 65.
He has an extra $1,000 a month.
Hurdle rates
Consumer debt hurdle rate = 20% p.a. guaranteed return
Paying down the credit card gives Tom a risk-free return of 20% p.a. which is almost impossible to beat elsewhere. Even if he invested in shares and earned a long-term ASX average of around 9%, the after-tax return (after 39% marginal rate including Medicare), the effective rate of return is closer to 5.55%.
The available surplus needs to clear the consumer debt.
Mortgage vs investing hurdle rate
Mortgage interest is 5.8% guaranteed, tax free. This means that any investment outside of super must earn a net return of more than 9.5% (5.8%/(1-0.39)) given his marginal tax rate. That’s a high bar to exceed consistently. Investing inside of super means a more easily exceeded return at 6.8% (5.8%/(1-0.15)). However, superannuation is illiquid until retirement, and Tom wants to renovate in 18 months. Liquidity is important.
Apply the framework
This is not a one-time decision
It’s important to recognise that just like for CEOs capital allocation is not a one-time decision. Life events, market conditions and changes in goals may require adjustments. For example, a pay rise that increases super contributions and your disposable income could mean a different approach. If interest rates go up that could shift the priority towards mortgage payments.
Just as the CEOs in the Outsiders adjusted their capital allocation based on circumstances, investors should treat allocation as a dynamic process, revisiting it periodically and adjusting for maximum effectiveness.
The lesson individual investors can take from their own approach is that success is about making deliberate choices, in the right order, consistently over time. There’s only a limited amount of decisions that an investor has to make when allocating capital. Finding the right levers to pull at the right time is one of the most powerful tools you have to shape your financial success.
Invest Your Way
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