On my previous post, Mr Kevin Pattison brought up some excellent points that brings me to this post about “What if’s”.
As Kevin pointed out, there are many other variables out there which can catch you with your pants down. I’ve often thought of three things that could hit at the same time which would deliver a crushing blow to my well laid plans:
- Markets crash – I am fully invested in multiple index funds now. My contingency against this situation is two fold, a) keep working, keep buying the laggards at bargain prices, or b) sell my bond-based ETF’s to purchase the laggard to turbo-charge the swing up again. (Once again, all about maintaining your target ratios).
- Interest rates shoot up on my home loan. Already as of this month they are coming up rapidly in Singapore. I’ve been enjoying 1.38% or something ridiculously low like that for the last year. If it really started to get out of hand, I may start diverting funds allocated for investment into the loan instead.
- Unemployment – if things really took a turn for the worse, this would really be a stinker – especially if the other two occurred at the same time. It’s really easy to expect your current salary for the rest of your life; today I was reading about a CFO in Singapore making good money for many years, lost his job, and could only manage to find after many months searching a job which pays him 50% of his previous salary.
Never say never, this would be a black swan event for all three to strike at once but it is possible and is very scary. I am quite well covered for hospitalisation, death, critical illness and other life insurance related situations. At least this part I don’t have to worry too much about although I still do need to get my Will sorted out.
Back to Kevin’s other points though:
“In your example above, don’t forget that if you don’t pay the extra $36K each year off your mortgage (i.e. you choose the option of paying your mortgage over the entire 25 years) you pay an extra $250K in Interest over that period, and remember, you have to pay your marginal tax rate on most of the investment earnings (which are positively geared) so your $2M extra is suddenly looking closer to $1M extra, and your calculation is based on your ability to earn 9% cumulative every year for 25 years – I haven’t seen that happen too often ! As a comparison, most major Australian Retail Super Funds have only averaged about 4.5% nett over the past 25 year period. (and that’s only because the last 3 years have been pretty solid)”
I will readily admit my simple spreadsheet comparison was exactly that – simple. Unfortunately for me, Kevin doesn’t know of my OCD tendencies – which means I’ve had to do it all over again – this time using historical data of bank interest rates and ASX/200 returns going back to 1989. The results of which are very interesting… (I probably should have used a 50K loan instead of a 500K loan – who was borrowing that much back in 1989?)
- ASX/200 returns are Total Returns meaning dividend reinvested returns
- Dividends are assumed to be 5% every year of the TR, of which tax is paid fully at the highest marginal rate.
- Franking credits are not taken into consideration. So this is possibly a worst-case scenario example from a taxation point of view.
You’ll probably need to click on the images above to see it clearly, but doing the same exercise as before, this time the advantage of investing early was ‘only’ about $200K. That’s 10x less than my very excited example last time! I can fully understand with interest rates as high as they were why people may wish to pay off their loan first – who knows what tomorrow will bring.
Why is the delta so low this time around? A few reasons – interest rates were ridiculously high in Australia in the late 80’s / early 90’s. But even throughout the rest of the 25 year period it averaged 8.67% – a lot higher than my conservative 5%.
Second, the 2008 financial crisis wiped 40% of the invested value in almost one fell swoop.
But still, this doesn’t really account for everything…. it’s TAX!! Wow, I had no idea how badly tax at the marginal rate of 45% kills you.
Check out the same example, but without taxing the dividends:
Now we’re talking! $4.376m (investing early), versus $3.582m (paying off the loan first, then investing).
Technically the amount of interest paid on the home loan is irrelevant. In both scenarios you own the home and the balance of your investments. Take the one with the larger investment pile even if in the process you helped make the bank richer.
This finding also mirrors the finds of the ASX Long Term Investing 2014 report:
As you can see, if you’re investing into Australian shares directly and you’re on the highest tax bracket, it will significantly bring down your long term average. This is why it’s a good idea to invest through your Superannuation fund if you’re sure you won’t be needing that money until retirement.
“The impact of tax had a cumulative and compounding effect” – That sends shivers down my spine. Ah, the joys of living in a country that doesn’t tax dividends or capital gains!
Back to Kevin:
“In my view, it all comes back to how long you want to invest for – this is a major determining factor in what type of investment you need to choose. Over a 25 year period, depending upon economic conditions (eg. interest rates and unemployment rates – in Australia and overseas) you need to remain flexible with your investments, to give you the best chance of achieving your goal. The trouble is – its always easy to know when to buy into something – the challenge is knowing when to get out – and none of us ever get that right.”
Couldn’t agree more – this whole blog is really about investing for retirement – definitely a long term view. Remaining flexible is paramount for me. I believe that a good mixture of ETF’s that provide wide diversity delivers exactly that. Very liquid if you need to change path due to any unforeseen circumstance.
In regards to getting out – this is another part of passive investing that is very interesting: There is no real getting out stage, and there is no timing involved. You build it up year over year, increase your home bias and bond allocations, and when it’s time to retire you start just selling lot by lot what you need to live. You keep the bulk though and hopefully it will outlast you. You’ll pay minimal capital gains tax as you won’t have any other income, plus you held for the long term so you’ll get a good CGT discount.
I’m sure Kevin knows people that were due for retirement soon after the GFC, but probably had to keep working a bit longer due to the massive impact that downfall had. I would say though that if that wiped them out so badly, they may have been invested too heavily in assets not suitable for that stage of their life.
“I agree with your comments re; paying off your loan – you should never do this if the differential between the mortgage rate and the investment rate is significant – providing your future income is somewhat secure.
I know lots of successful investors, and every single one of them have taken a ‘hit’ or two or three along the way. No one gets it right all of the time – Its all part of life’s great learning curve.
So be careful – simple spread sheet calculations can lead you astray if you’re not careful.”
I’m already feeling a ‘hit’ coming on. I feel like I’ve entered right at the top of the market, but in reality I’ve been investing a good amount each month right after the worst of the GFC happened. (This was the Zurich Vista product which it turns out is a very expensive product in terms of fees). Truth be told though, it still performed alright although it could have been a lot better though if I knew then what I know now. Because of the boost that fund gave me, I would not be in the position I am in today when I finally made the maximum partial withdrawal. Those are the funds plus some additional savings which I have now invested into low-fee index tracking ETF’s.
As for simple spreadsheets – as I’ve confirmed today they’re not too bad in Singapore where investing and taxation is very simple! As for Australia though, this really just double confirms my prior thought about getting my numbers double checked by an expert. It is complex and I am still only 50% confident that those above spreadsheets are accurate. There’s a good chance I’ve still missed something.
Anyway I am spent. Give me a few days breather Kevin if you need to comment further!