The ownership of a company is divided into several portions. Each portion is called a share. Owning a share in a listed company entitles the owner to a proportional amount of any dividends paid from the ongoing profits of the company. A shareholder can also claim a proportional amount of any dividends paid on liquidation or other return of capital.
A shareholder does not own a portion of the underlying assets owned by the company. What the shareholder owns is a to dividends and any net capital if the company is wound up.
The value of a share is determined by expectations of future dividends, including any dividends paid on liquidation. The expectations belong to millions of potential investors around Australia and overseas, are inherently subjective and are influenced by an almost infinite number of variables. The market place co-ordinates these expectations into a market price that is quoted constantly on the world’s stock exchanges.
Why do people buy shares?
People buy shares to make more money. This money comes from two sources, being capital gains and dividends. Capital gains occur when the share increases in value, and dividends occur when the company pays out profits to shareholders
An unrealised capital gain occurs when the value of a share increases but the share holder does not sell the share.
Unrealised capital gains represent an increase in a person’s wealth and in this sense can be thought of as income. However, unrealised capital gains are not included in calculating income for tax purposes. This is a critical thought when investing in shares.
The benefit occurs when the share rises in value, not when it is sold. The act of selling the share just converts the rise in value to cash, and triggers a taxation computation (whether tax is ultimately paid depends on a number of other variables). But there is no tax charge just because a share goes up in value. If the share goes up in value the GP is better off, but does not face a tax bill at that time.
This is the key to investing for GPs: invest for tax-free capital gains.
A realised capital gain occurs when a share is sold at a price greater than the price it was bought for – it is sold for a profit. Usually, if a share has been held longer than 12 months only half of the capital gain is taxed. The other half is tax-free. If the share has been held for less than 12 months all the profit is taxed. So capital gains are taxed favourably under the Australian tax law.
This favourable capital gains tax profile is why GPs should invest in shares with the view to holding them for at least 12 months.
This was distorting the market and discouraging people from investing in Australian companies, which in turn restricted Australia’s economic development.
The Federal Government changed to a dividend imputation system based on the UK and the Canadian systems in 1987. Under the dividend imputation system the company is required to specify the extent to which the dividend is franked, ie, paid out of profits that have been taxed in the hands of the company.
The shareholder includes the franking credit in assessable income. Taxable income is computed, taking into account the shareholder’s other income and allowable deductions, and tax is computed. A credit is allowed equal to the value of the franking credit included in the shareholder’s income. Any excess credit is paid as a tax refund.
The amount of tax paid on the company’s profit depends on the shareholders’ tax profile. Assume a company makes a $1,000 profit, pays $300 tax and pays a $700 dividend.
|Description||20% taxpayer||45% taxpayer|
|Amount included in assessable income||$1,000||$1,000|
|Amount of tax paid||$200||$450|
|Less franking credit||$300||$300|
|Net tax paid (refunded)||($100)||$150|
The same profit will be taxed at either 20% if derived by the 20% taxpayer or 45% if derived by the 45% taxpayer. The tax paid by the company is imputed to the ultimate individual shareholder, thereby providing a lower net amount to pay or even a refund to a person who pays tax at a marginal tax rate less than 30%. The final tax paid to the government on a company’s profit depends on the tax profile (the marginal tax rates) of its shareholders.
How do you buy shares?
Shares in listed companies are traded on stock exchanges and in nearly all cases can only be bought and sold through recognized stockbrokers (or occasionally through a direct-share placement by the company itself, or, more unusually, in an off-market transfer).
For example, a GP buys a parcel of shares for $100,000, using $100,000 debt borrowed at 8% interest. At the end of the year the shares have increased in value to $130,000, but have only paid 3%, or $3,000, as an unfranked dividend. In this case, the whole of the $8,000 interest is deductible even though only $3,000 of the $33,000 total return (the dividend of $3,000 plus the unrealised capital gain of $30,000) is taxed. That is, the GP can claim a net tax loss of $5,000 ($8,000 less $3,000) and, assuming a tax rate of 47%, receive a tax refund of nearly $2,500, despite making $33,000 over the year.
If the share value does not increase as much or goes down in value then the addition in unrealized income will change accordingly.
This has the effect of dramatically lowering the average rate of tax paid on the GP’s income from the shares and on the GP’s total income. It is actually a form of negative gearing, which occurs whenever the holding costs of a geared asset exceed the taxable income (in this case dividends) derived by holding the asset.
In the long run most GPs who have borrowed to buy shares have done well. This is because the long-term average rate of return on shares is greater than the average long-term interest rate.
Nevertheless, care is needed and GPs contemplating gearing a share portfolio should consider:
- sticking with blue chip Australian shares that pay high and franked dividends;
- not gearing 100%, and perhaps not gearing more than 50%, of the portfolio; and
- taking a very long term view and realising that in the short term capital losses are possible and that gearing increases the amount of the GPs capital that is lost when capital losses occur.
Capital protected loans
Some financial planners will recommend “capital protected gearing plans” where the lender guarantees the investor’s capital will be protected at say the end of five years. Sounds good but there is a catch: the excessively high interest rate. The interest rates on these loans are often well above the long term average return from Australian shares of about 9.8% (Source ASX 2013 Investment Report), which makes it extremely unlikely that you will win this ‘bet.’
Diversification and risk reduction
Diversification, ie combining investments with a low positive or negative price correlation, reduces the overall risk in the portfolio. For example, if you hold shares in export companies and shares in import companies, the export companies will do better with a rising $A and the import companies will do better with a falling $A. Owning both export companies and import companies means you have diversified away (some of) the risk connected to exchange rate movements, and total risk is lower than otherwise.
(Of course, if you expect the $A to rise you might deliberately invest in export companies and deliberately not invest in import companies to create “up-side” risk. In this case you deliberately not diversify, to try to take advantage of the risk that the actual return is greater than the expected return.)
Studies show that holding as few as 15 shares effectively diversifies risk.
Taylor and Juchau in Financial Planning in Australia (LexisNexis 2013) provide a more technical explanation of how diversification reduces risk. They write:
The concepts of risk and return are fundamental concepts in finance. The return on the investment is the reward to the investor for taking on a certain level of risk. Risk is present if the investor is uncertain as to the outcome the investment will produce (ie the possibility of both positive and negative returns). Probability theory is a useful tool in determining the most likely return on an investment and the expected return.
The concept of diversification as we understand it today is based on modern portfolio theory which was developed by Harry Markowitz in the 1950s. Modern portfolio theory is based on mathematical-statistical model that looks at the risk return relationship that changes as additional assets are added to a portfolio. The theory revolves around expected returns, the risk associated with those returns (standard deviation), and the relationship that exists between returns (correlation) for both individual shares and portfolios.
Markowitz’s theory suggests that maximum risk reduction occurs when the assets in a portfolio are perfectly negatively correlated. That is, given certain environmental conditions (eg economic), the rate of return on assets will be in the opposite directions. This means the optimum correlation coefficient is -1. Hence the aim of the adviser in minimising risk would be to choose assets in the portfolio that are as close to perfectly negatively correlated as possible. Risk will be reduced to some extent if the correlation between the assets is less than +1 but the maximum reduction would occur when the correlation coefficient is -1. Hence we will seek to combine assets in a portfolio with negative correlations. Research indicates that combining up to 20 assets in a portfolio will maximise risk reduction. Each individual asset added after 20 has a minimal impact on the risk of the portfolio.
Diversification enables the investor to achieve higher expected returns simultaneously with lower risk.
This is, of course, why we recommend GPs invest in index funds. Index funds are highly diversified: they include literally hundreds of underlying shares, and therefore “enable the investor to achieve higher expected returns simultaneously with lower risk.”
The longer one’s time frame the less risky so called risky share investments and property investments seem to be. Looking back, one sees clear upward sloping trend-lines, even if they seemed rather random and chaotic month by month and even year by year. Time gives perspective and clarity, and allows real relationships to emerge and be recognised.
This is, of course why we further recommend that GPs hold index funds for decades, not years.
What are “derivatives”?
Share derivatives are, as their name suggests, a generic tag for any investment that derives value from a contractual relationship with another asset, usually a share.
What are the main types of derivatives?
Variations abound, but most derivatives fall into one of these three classifications:
- traditional options, being a right issued by a company on its own shares entitling the holder to acquire a number of shares at a fixed price on a given The options can be sold to other persons, but lose their value if they lapse, ie are not exercised. They will lose their value if the share price falls below the exercise price;
- exchange traded call and put options are similar to traditional options but are created by third parties not the underlying company. Call options entitle the owner to buy shares from the option writer. Put options entitle the owner to sell shares to the option writer. There is no obligation to sell or buy, so losses are limited to the cost of the option;
- warrants, which can be either:
- Trading warrants, being short term contracts based on a stock, currency or index; or
- Investment warrants, being long term contracts based on a stock, currency or index and which may include a loan, with the income from the stock applied to the interest and principal, ie instalment warrants;
- contracts for difference, ie a contract which allows the holder to speculate on changes in price of the underlying investment without owning the investment; and
- futures contracts are like exchange traded call and or put options but relate to commodity or financial instruments.
Over the years we have seen GPs become bankrupt playing the derivatives market. They may well have gone straight to the casino: it’s basically the same thing.
GPs should not invest in share derivatives. They are just too risky. Derivatives are “zero sum game” in that any gain made by one person is matched by an equal loss of another person so that overall there is no change in wealth. Poker and blackjack are zero sum games too. But share derivatives are even worse: they come with significant transaction costs so, on balance, eventually, the players always lose to the house. In this case the house is the financial institution that created the derivative, and the agency that sells it from one person to another, such as the ASX.
You gotta know when to fold them
We know of one GP who received $500,000 from a sale to a corporate medicine group and promptly lost it within 6 months. This was despite paying tens of thousands to an options trading ‘trainer’ who promised that he could not lose. When he did lose he was told to “put in another $500,000”, which is the same as the card dealer saying “double or nothing”. Thankfully he did not do this. He realised what he was really doing, ie gambling, stopped doing it, and returned to medicine.
Are there any exceptions to this advice? Yes. One. If you are a prize-winning maths PhD working full time in the finance industry with the best minds and the most powerful computers in the world on your team then you could give it a crack. But remember there is still a less than 50% chance that you will win. Are you feeling lucky?
This is standing instructions to all Australian financial planners. For example, the authors of Australian Financial Planning Handbook 2012-13 (Thomson Reuters) write:
The derivatives markets for options and futures evolved from the physical markets to enable the transference of risk from particular investors to speculators who were willing to take that risk. … Advisers will normally assist clients to invest savings and capital at the higher end of the security spectrum avoiding speculative asset acquisition.
In other words, they think derivatives are too risky too.
Without this sort of commitment it is really just gambling.
The question “property or shares?” is one that most intelligent investors ask. The answer depends on who you talk to. Those with vested interests in the share market tend to prefer shares. Those with vested interests in the property market tend to prefer property.
GPs should invest in both shares and property. Over time they tend to do as well as each other, often performing differently, perhaps even oppositely, at any point in time.
Broadly speaking, the property market tend to perform in shorter, larger, sporadic bursts while the share market accumulates more incrementally (and with smaller steps backwards and forwards in the process).
When you smooth out the cycles, between 1992 and 2012 the share market rose by about 9.8% a year and the residential property market did about the same. Both markets have merit and GPs should invest in both to maximise long-term investment performance.