The art of investment with any superannuation fund is primarily about risk management. In the past some investors have been too aggressive in their investment selection and have consequently seen their retirement nest-egg drop by over 30%. This is why we’ve put together some superannuation investment tips to help you maximise your superannuation funds.
Superannuation Investment Tip 1: Diversify your risk
All superannuation funds carry some degree of risk but the secret is to diversify risk by investing in different asset classes. The level of risk varies depending on the type of investment and the character of the investment.
One of the approaches available to an investor is to spread investments over a wide range. There is an obvious risk in investing all your assets into one venture.
A safer approach is to spread your investments across a number of different areas. The old adage of never putting all your eggs in one basket is important. By concentrating all the superannuation monies in one specific area such as property, shares, or fixed interest, investors are exposed to greater risks.
Investors should aim to reduce the amount of risk to an acceptable level so to avoid a permanent capital loss. This can be done by diversifying your superannuation monies between different sectors of the market.
Superannuation Investment Tip 2: Understand cyclical patterns
The different sectors of the investment markets traditionally follow a cyclical pattern of ups and downs. Property, Shares and fixed interest sectors are usually at different stages of the cycle at any one time.
So by diversifying between different classes your superannuation fund will have assets that are performing well, whilst other assets maybe giving a poorer return.
Superannuation Investment Tip 3: Know your investment market sectors
There are four major sectors of the investment market which most superannuation funds are invested, they are:
Cash, Fixed Interest, Property and Shares all of which can be invested domestically or internationally. One of the 4 major investment classes, cash, is deemed to be the safest investment; there is practically a nil chance of producing a negative return.
Since cash in the long term is not expected to compensate for inflation and the effect of taxation, achieving investment objectives generally involves investing in risky assets such as fixed interest, property and shares.
No one asset class consistently out performs inflation every year; therefore individuals should look at a diversified portfolio of different assets. If an investor has a time horizon in excess of 5 years then they can look at having a higher exposure to shares and property.
Many investors can remember the 1987 crash and are now living through the current stock market crisis which was triggered by the sub-prime defaults in the US.
Market crashes are awesome and daunting for many investors, however, over time the impact of market falls usually diminishes as a poorly performing sector then becomes fashionable as the investment cycle moves on.
Superannuation Investment Tip 4: Learn about Fixed Interest Securities
The third asset class a super fund may invest in is a defensive asset class – fixed interest securities. Fixed interest securities include Government Bonds, Company Debentures, Mortgages and Unsecured Notes.
Investors in fixed interest securities in effect are investing in debt. A standard fixed interest security is an agreement for the borrower to pay regular amounts of interest and a return of capital to the lender.
Fixed interest securities have generally been regarded as a lower volatility, safer class of investment. Fixed interest securities have historically provided consistent returns, underpinning portfolio performance via steady income streams and some capital gains.
When an investor purchases a bond or a fixed interest security they become entitled to a known amount of income over a set time period. When the bond matures (ranging from a few days to 10 years) the original capital is repaid.
Interest rates and capital value of bonds
It is important to understand the relationship between interest rates and the capital value of a bond. As interest rates increase, the value of the bond decreases. At first this concept seems contrary to common logic.
However this is the most important facet of bond pricing to understand. This relationship explains why we had a crash in the fixed interest markets earlier this year; expected interest rates rose swiftly, so the value of the bond portfolios dropped dramatically.
The actual value of the bond also depends on the time remaining until it matures. The greater the term of the bond to maturity, the greater the drop or rise in the bond price for a given rise or drop in interest rates.
A bonds maturity measures how long bond holders have to wait on average to get their money back. It takes into account the timing and amounts of both principle and interest payments.
Superannuation Investment Tip 5: Learn about shares
Shares are called growth assets and for a typical balanced superannuation fund they may commit up to 30% in Australian shares.
So, what are shares and why are they so important for my super fund? Ordinary shares are offered by companies to the public and provide an investor with the chance to ‘own’ part of the company.
This is significantly different to a creditor of a company which is the status of a debenture or note holder. As part owner of the company you share equally with all other owners or shareholders in the success or failure of the company.
Ordinary shares in public companies are listed on the Stock Exchange and are traded daily. The price of the share is determined by the market based on the ‘market’s’ perception of the future prospects of the company and the security of the company offering the shares.
Aspects of shares
There are two aspects of an ordinary share to value; the dividend each year and the likely capital growth.
Basically dividend income that has already been taxed by the company is effectively tax free in the hands of the shareholder where their income is below $80,000 (ignoring Medicare). The dividend carries a credit for the tax the company paid and can be offset against other income.
Tax paid dividends (franked dividends) are tax free for those in a tax bracket of 30% or less. Dividends that have not paid company tax (unfranked) are fully assessable with no tax credits. It is possible that some shares (particularly) speculative mining shares) may offer a low yield as well as little security.
The attraction of shares such as these is the potential for high growth. As the company is establishing the mine all available money is reinvested and little or no dividend would be paid.
However once the mine is operational good profits may become available, dividends would be higher and the value of the share would have escalated offering a large capital gain to those original investors.
Market price of a share
The market price of a share represents what a large number of investors feel is the value of the company, industry, and the expected earning potential of future dividends. Shares are one of the more volatile asset classes.
However, historically the more volatile investments such as shares and property have usually provided superior performance over the longer term.
If you invested $10,000 in each market sector over a 20 year period ending 30 June 2007 your share portfolio would have grown to an incredible $169,453 with an annual compound investment return of 15.2%.
The second best performing investment sector (property) is more than $20,000 behind during the same period. (This assumes that all income is reinvested).
Superannuation Investment Tip 6: Learn about property
The second growth asset a super fund may invest in is property. Many property funds differ from shares in that they generally tend to concentrate on income and tend to have a lower rate of capital growth.
Some see this as a sense of security since income is more reliable than capital growth. Property fund managers break property up into 4 main sectors; residential, commercial(office buildings), industrial and retail (shopping centres).
Rental income on property plays a major part in determining the capital value of a property. The property is generally determined on an appraisal basis.
That is, qualified values look at the likely rental income of the property, examine lease details to determine how secure the rental income will be and examine the location, quality and age of the property to determine how easy it would be to get new tenants if the existing ones move out. The ultimate valuation placed on a property is based on all these factors.
Income generated on property
The income generated from property will depend on the type of property, quality and position. The yields on prime offices in central Sydney are in the range of 6% – 12%.
One of the most popular reasons for investing in real estate is that people often feel secure with ‘bricks and mortar’. Investors often look at real estate as a buy and hold investment. In recent times property funds have been hit hard due to ‘stapling’, over- performance and the exposure to the US.
The recent trend over the past few years has seen property fund managers combining the management company rights with the more traditional property asset. The major disadvantage is that the true valuation may have been distorted. Another disadvantage with property is the large outlay required often in a limited market and the large costs of buying and selling.
Many of the worst crashes of companies and property trusts in recent years arose because of the insufficient security, as well as difficulty in converting security (ie a building) into liquid funds with a reasonable short time frame.
Superannuation Investment Tip 7: Understand cash in superannuation terms
The final major asset class is cash. Cash, by definition, is available at call, or, in the case of cash-based unit trusts, in a matter of hours. People who held account with the Pyramid Building Society in Victoria will understand better than many that cash is not entirely risk-free.
These investors were chasing higher interest rates, and higher returns resulting in higher risk. Cash is safe, depending on where you have it invested. On the investment risk spectrum, it’s as close as you can get to risk free.
Because of its low risk profile, cash also historically provides the lowest return. The late 1980s, when interest rates hit 17 per cent, were the exception. The low return on cash investments is a trade-off for the security offered by most deposit-taking institutions, such as bank, building societies and credit unions and the ease of accessibility.
Superannuation Investment Tip 8: Don’t chase past performance
Many superannuation investors in Australia chase the top performing investment class, hoping to achieve good short term gains. Unfortunately many investors base their decision solely on past performance which is spurred on by the media high-lighting the top performing Australian investment classes (at a point in time).
This strategy is fraught with peril. Past returns are no guarantee of future returns and this has led investors into rash short term decisions.
For example, up until June 2007 the Australian Share Market had been the top performer with returns in excess of 25% over the previous 3 years. However since last year the market has lost over 30%. The lesson here is that an asset class that has been the top performer for 4 years in a row has occurred only once in the past 50 years.
Performance in the past
Since the early 1980’s Australia has seen an incredible explosion in superannuation balances. This has been due to the compulsory 9% superannuation guarantee contributions by employers.
Superannuation funds now account for over $1 trillion dollars and this figure is continuing to grow at a roller coaster pace. Most superannuation investments work where there is pooling of money into common funds by a large number of smaller investors.
The funds are managed by full time professional managers who use their expertise to make investments decisions. The funds are continually reviewed to take advantage of changing market conditions, without exposing the funds to too much risk.
However all of the finds are invested in one of the four major asset classes which we will now discuss.
Superannuation Investment Tip 9: Fluctuations in the long term are normal
The maximum for any superannuation investor is the ‘higher the risk’ the ‘higher the return’. Over the past 20 years we have seen booms and busts in all of the four major asset classes.
Since the financial markets were deregulated in 1983 our economy has become more affected by global events. As a result of this volatility we have seen inflation fall from well into double digits to less than 2 per cent and we have also witnessed great booms in share prices (2003-2007) and property (1986-1988).
The share and property booms were followed by a significant downturn; shares tumbled 41% on 19 October 1987 and, at the top of the Sydney commercial market, prices have fallen by more than 50%.
Yet over the medium to long term, shares offer the best return. They may fluctuate in value significantly, but over the medium term they go up significantly more than they go down. And by diversification in your superannuation portfolio, you will achieve added growth without significantly increasing the level of risk.
Superannuation Investment Tip 10: Have exposure to all the investment sectors
As shown above, shares and property securities do not normally move together. Due to diversification, superannuation investors should be able to obtain the upside from investment in growth assets while limiting the downside.
It is vitally important that you have an appropriate exposure to all the investment sectors to manage risk and protect your capital against the effect of taxation and inflation.