Unconventional wisdom: Building wealth after the CGT changes
Higher CGT makes building wealth harder but financial independence is still achievable for thoughtful investors.
Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.
Unconventional wisdom: Building wealth after the CGT changes
Bitterness is like cancer. It eats upon the host. But anger is like fire. It burns it all clean.
- Maya Angelou
It is challenging to make rational decisions when emotions are at play. And the changes to how capital gains taxes (“CGT”) are applied have heightened emotions.
The passage of time has a calming effect. That doesn’t mean you can’t be concerned or hopeful about what the changes mean for Australia. And the political debate will - and should - continue.
If you are angry – then be angry in a productive way. Use that anger to overcome another obstacle in your pathway to financial independence.
Now is the time to get on with it.
Our mission at Morningstar remains consistent – we want to help you build financial security and independence. I want the same things in my own life and that is why I invest. We are on this journey together.
How to respond to the new tax changes
As a new investor I thought analytical skills were the secret to success. I believed the pathway to financial independence was developing a high level of skill at analysing information about investment opportunities so I could pick the best ones.
Long ago I concluded that while analytical skills are beneficial, of far greater importance is how you behave.
Success takes persistence and patience. Results are often more dependent on deciding not to act than choosing between two options.
Focusing on what you can control is more beneficial than responding emotionally to things you can’t.
In that spirit my focus in this column is to help you refine the framework that guides your decision making - your goals and investment strategy.
While taxes on capital gains will increase under most scenarios, the ultimate impact is difficult to estimate because it will depend on holding periods and inflation. That doesn’t mean you can’t give yourself a higher probability of success.
Revisiting your goals
It is difficult to achieve anything if you don’t have a definition of success. Setting a goal serves several purposes. It illustrates if your goal is feasible, it helps you create a plan, and it encourages you to keep going.
If you are trying to build wealth a goal connects where you are today to where you want to be in the future. Achieving the goal requires saving money and earning returns that outpace inflation.
Higher taxes result in lower after-tax returns. There are four ways to respond to higher taxes – you can invest more aggressively and hope to earn a higher pre-tax return, you can extend the timeline to achieve a goal, you can set a more modest goal, or you can save more money.
Investing more aggressively involves more risk and most people don’t want to compromise on their goals. For many investors saving more money is the most practical choice.
Investment strategy
Once you have a goal you need a plan to achieve it. That’s your investment strategy. A good investment strategy has several elements:
- Your asset allocation
- What structures you will use (super, etc.)
- What type of investment vehicles you will hold (ETFs, funds, individual shares)
- The criteria you will use to select investments
- The process for making changes to your portfolio
Asset allocation
The mix of growth and defensive assets in your portfolio is based on the return you need to achieve your goal.
The return that matters is what is left over after-taxes and after-inflation. Given higher tax rates it makes little sense to lower future expected returns by investing in more defensive assets.
For some investors it might be feasible and advisable to add more growth assets. But the best option might be to do nothing. Investors that already have high allocations to growth assets and / or are at a stage of life where volatility is a risk have little wiggle room.
Be wary of making meaningful changes to your asset allocation and remember there are other adjustments that can be made to your goal.
Investment structures
On a relative basis super and other lower tax structures are more attractive now.
For instance, investors with high marginal tax rates may want to consider structures like investment bonds which may offer lower levels of tax. Getting as much money into super as possible is a sensible move if it aligns with your goals.
One option is to be more thoughtful about what assets are held in what tax structures. Investments with a higher potential for capital gains should be in lower tax structures like super.
Investment vehicles
Given capital gains discounts are indexed to inflation and offsetting losses are not there has been a good deal of commentary about the advantages from a tax perspective of ETFs and funds compared to individual shares,
The basis of this commentary is the netting effect of gains and losses within a vehicle like an ETF or fund which isn’t available in a portfolio of individual shares.
However, there are other considerations like fee levels and distributed capital gains which make ETFs and funds less attractive.
This is an example where the relative merits of various investment vehicles likely matter far less than your behaviour. Your tax outcomes will be better if you trade less and have longer holding periods – that is something you can easily control and a more productive place to focus.
Investment selection criteria
Much of the budget commentary – including my own – focused on the tax advantages of generating returns from franked dividends instead of capital gains.
It is true that in most scenarios less tax is due on a franked dividend than capital gains. However, some context is required before making meaningful changes to your portfolio.
The new tax regime is not confiscatory. There is still an incentive to generate capital gains. Capital gains make up a large part of historic returns for growth assets like shares. Most investors need those capital gains to outpace inflation and earn the return needed to achieve their goals.
Remember that higher returns are still better than lower returns - even if taxes are higher.
Process for making changes to your portfolio
The previous steps of the investment strategy align your goals to the investments in your portfolio. That is a key foundational step for success. But where poor investor behaviour takes its toll is from constantly changing investments.
The new CGT rules further reward good behaviour and punish investors with short-term focus. The longer the holding period, the larger the capital gains discount. This is a straightforward concept to grasp.
Less obvious is how delaying taxes amplifies the impact of compounding. If an investor earns a 10% return annually for five years a $100 investment grows to $161.05. The after-tax outcome without applying a capital gains discount will vary depending on your marginal tax rate.
In the previous scenario capital gains taxes were delayed until the end of the period. An alternate scenario is selling every year, paying the tax and reinvesting the remainder at a 10% return.
By delaying the tax payment returns increase due to the impact of compounding. As the holding period gets longer the benefit increases.
The new approach to capital gains tax discounts amplifies the benefit of longer holding periods.
In this scenario the same 10% annual return is combined with 3% annual inflation which is used as the capital gains discount.
There is a greater benefit of holding shares for five years instead of annual sales when the capital gains discount is applied.
There has always been a tax benefit from taking a long-term approach. The new capital gains approach amplifies that benefit. Buy and hold investing may seem anachronistic but it is the most effective way to minimise the impact of taxes on a portfolio.
Final thoughts
Acting hastily is rarely productive when you are trying to build wealth. While the motivation of each investor is unclear, there are signs that many Australians are changing their investment approach.
ETF provider Global X reported that inflows into income-oriented equity ETFs set a record high in June at $309 million. Meanwhile BetaShares said that the cash flowing into cash and fixed interest ETFs doubled in June to $1 billion.
These changes may be strategic or they may be reactive. The challenge for all investors is having the patience to follow a deliberate strategy instead of emotionally responding to headlines, regulatory and tax changes or short-term market movements.
Slow down your decision making. Focus on what you are trying to accomplish and your unique circumstances.
For most investors tweaks are likely a better response than wholesale changes. Tread carefully until you understand the implications for your own financial situation.
Share your thoughts and email me at [email protected]
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What I’ve been eating
Mussels… the forgotten mollusk. Oysters get all the glory perched on their crushed ice like a haughty monarch on a throne. Pipis give off a laid-back vibe while turning your simple beachside pasta into a reminder of the bite of inflation.
I may not think about mussels much but I also rarely turn them down. Pictured are the mussels with saffron & roasted tomato broth from Bar Copains in Surry Hills. This great wine bar is dangerously close to my apartment. Amazing food and a unique wine list more than make up for the slightly annoying crowd of influencers.
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