Now we have “GFC 2.0” which we are informed will lead to . . . you guessed it . . . another Great Depression! We won’t bring up inconvenient facts such as the global economy is actually growing (although not as fast as many people would like).

“GFC 2.0”? Who thinks up these names? It sounds like something that the marketing department of a news organisation would come up with to boost newspaper sales or Financial News TV subscriptions! But seriously, a sequel makes a lot of financial sense. You don’t need to waste money on journalists, just pull up last year’s script, cross out “Lehman Brothers” and “Sub-Prime Debt” and substitute “Greece” and “Sovereign Debt”.

A Banking crisis or a Sovereign Debt crisis have historically happened about five times per decade – about every couple of years – so there is nothing new here. The current problem is just a little more widespread and a bit closer to home. Banks in emerging economies have largely avoided these problems and most emerging economies do not have large government debts or unfunded pension liabilities.

So, is it safe to venture out onto world stockmarkets? Perhaps we should ask: Is it ever safe . . . ? There are two important answers to that question:

Firstly, if you have some money or can save some money – and you want to build your investment wealth – then you have no choice! You won’t get rich stuffing cash under your mattress or lending it at low interest rates – where its value will be eroded by income taxes and inflation. And are fixed interest investments with Finance Companies, Banks or Governments safe? If you want to build your wealth then you need to invest in shares. Shares are also the only real hedge against future economic uncertainty and technological or political change. Companies are best suited to adapt to the ever changing environment.

Of course, you need to avoid stupid mistakes: You need to diversify over many companies because some will fail along the way! That has always been the case . . . and always will be. You also need to avoid leverage or margin or using borrowed money which makes you vulnerable and can result in forced sales in a crisis when prices are at their lowest.

So you will need to work out a medium term strategy for saving and investing and making your first $100,000 – knowing that you may temporarily lose $30,000 of that in some future crisis (GFC 10.0?). Then turn that remaining $70,000 into your first $1,000,000 – and expect to lose perhaps $300,000 in another unexpected stockmarket crisis. Stick at this long enough and you might make $10 million – which means you will be wealthy enough to perhaps lose $3 million in some future crisis! Of course, you can avoid all of those losses by remaining poor . . . but you will be better off having a share portfolio large enough to fluctuate in value by millions of dollars!

Secondly, forecasting the future of share prices is particularly difficult. In fact, a major financial crisis, when everyone is pessimistic and the outlook is the darkest is usually the very best time to be buying shares!!! So if you buy shares in periods of economic prosperity and growth, and sell when there is talk of crisis and depression, then you will almost certainly be buying near the market high and selling near the market low! The media is the worst forecaster of the economy and stockmarket.

A little bit of common sense can help too! You are not buying an economy but individual shares, so have a look at whether those individual shares offer investment value. During the Technology boom, the shares of many unprofitable companies sold at 10 or 100 times revenues. Frankly, common sense should have told people that even if the economy grew strongly and these companies were extremely successful, shares bought at 10 or 100 times revenues would probably never produce a reasonable return on their initial cost. In fact, few of those companies were even moderately successful. Most failed! (Of course, those of us who expressed such views at the time were ridiculed for “not understanding internet economics” – while perhaps understanding it only too well!)

Today we would suggest that investors look at a company like Integrated Research (and others). At 39½ cents this debt-free company’s shares trade on a Price/ Earnings ratio of 8½ and offer a Dividend Yield of 10.1%. The company has cash in the bank of $10.1 million (6.0 cents per share) and good growth potential for its software. Whatever might happen to the global economy or Sovereign debt or the US dollar, doesn’t that seem like a good share in which to invest a small part of your wealth?

Why lend your money to a government with negative cashflows (i.e. operating at a deficit) and probably a negative net worth (i.e. if future pension liabilities are included)? It is no surprise that there is a Sovereign debt crisis! Surely it will be better to invest in a range of profitable companies like Integrated Research which have strong cashflows from their business, intellectual property and cash in the bank?

In a previous article on why you should invest in the Sharemarket, I gave my top 10 tips for DIY share market investment.

One of my tips was as follows:

“There are innumerable share purchase recommendations for free and there are many individuals and organisations that provide recommendations to paying subscribers. They can be a valuable source of guidance and information but don’t follow them blindly. Do your own homework and come to your own decisions.”

Clearly some recommendation services are better than others, and I didn’t want to bias the article with my own personal opinions on the matter, particularly as there are probably some great services out there that I have never used and some that I have not even heard about.

I’m sure I’m not the only one who’d be interested to hear what services others are using and what they think of them, so here’s your chance to contribute!

Please post your comments on which services you subscribe to, how closely you follow their recommendations, what you think of them and why.

For some, the thought of investing in the share market is enough to make them go weak at the knees or worse. It conjures up thoughts of gambling and crippling losses. And it reminds them of the only two years in recorded history that they associate with a financial event: the share market crashes of 1929 and 1987. You would have to be nuts to even think about investing in shares.

Wouldn’t you?

Well, no actually. A better definition of nutty would be not thinking about investing in shares. Why? The answer is simple. Shares produce higher returns than other types of assets. Stock exchanges have been around for a very long time and innumerable studies have come up with the same result: over the long haul shares do best.

The phrase ‘over the long haul’ is important because occasionally there can be quite long periods when shares look as if they are not going to deliver the best long term performance.

A major reason that people lose money on shares is that when the market falls, as it inevitably will, they panic and bail out, usually after most of the damage has been done. When the market rises again, as it inevitably will, they are not there to reap the benefit.

When you commit to shares for the long haul you soon realise that it is not about share prices; it’s about companies. If you focus on the share prices you are likely to get caught up in financial ratios, trading strategies and a high-risk game of trying to predict (in reality, guess) whether prices are going to go up or down. And even if you are lucky enough to predict a price rise or fall, that will not help you much unless you can also figure out when. We all know it is going to rain sometime in future but unless you know when, you can’t be sure the washing won’t get wet.

We are not talking rocket science here folks. You DO NOT have to be a financial guru and you do not need a financial advisor to do well in the share market. All you have to do is focus on companies. Look for companies with a proven track record offering top quality products and services that you understand and that you think will be in strong demand well into the future.

Here are my 10 tips for DIY share market investing:

1. Plan to be in there for the long haul.
2. Only invest money that you are confident you are not going to need at a particular time in the future. Otherwise you might be forced to cash up your shares in a downturn before they have delivered the superior return you are looking for.
3. Start out small and increase your investment over the years as your knowledge and confidence grows. That way you also avoid the risk of investing all your money at a high point in the market.
4. Spread your investment over a number of different companies in different industries. For example, if you have $10,000 to invest consider spreading this over, say, 5 companies. Diversify further as your total investment grows. And remember it is as easy to buy Australian shares as those in NZ.
5. Read articles about companies of interest to you in news papers, magazines and online. You will be surprised how quickly your knowledge and confidence grows. You can use online tools such as Sharesight to check the historic performance of a company to help you with your investment decisions.
6. There are innumerable share purchase recommendations for free and there are many individuals and organisations that provide recommendations to paying subscribers. They can be a valuable source of guidance and information but don’t follow them blindly. Do your own homework and come to your own decisions.
7. Focus on companies not share prices when you make your investment decisions.
8. Don’t panic if share prices suffer a sudden fall. You know in advance that this is likely to happen from time to time just as you know that in the long run shares are likely to give you the best return.
9. Start using a good share portfolio management system such as Sharesight from day one. It’s important to keep a good record of the shares that you own because you will need this information to file your tax return. It’s also crucial that you can easily and accurately assess how well your shares are performing. Sharesight virtually eliminates the administrative work associated with owning shares. All the data you need for your tax return is provided automatically including your Foreign Investment Fund earnings if you are caught up in this nightmarish piece of legislation. And, best of all, Sharesight shows you the true, annualised financial return on your shares including capital gains, dividends and currency movements.
10. Have fun! Believe it or not, studies have shown that most DIY share market investors thoroughly enjoy managing their investments.

Well, and I’m sorry if you think this is a copout, the easiest way to answer the question is to discuss a business model that is demonstrably not sound. For example the one under which many, if not most, finance companies operate.

Finance companies do the same thing as the major trading banks – they lend money. So why have the big banks in NZ survived for many decades while finance companies fall over at regular intervals and have unacceptably short life spans? It’s all to do with the business model under which they operate.

In essence the major banks adopt a business model that calls for a risk profile that gives them a good chance of surviving a 1 in 50 or 1 in 100 year business downturn. On the other hand one could be forgiven for wondering whether some finance companies have any sort of risk strategy at all let alone clearly articulated business model. If they do, it is obviously calibrated, whether they realise it or not, to survive a 1 in 5 or 1 in 10 year downturn but not much more. This is just not good enough.

A number of finance companies demonstrated their inadequate business models very graphically in the late 1980’s and early 1990’s by collapsing and, for reasons best known to themselves, a further 20+ finance companies have decided to prove that history does repeat by collapsing over the last 2 years or so.

Put simply, the finance company business model involves lending money in circumstances that the major banks deem to be too risky. It is profitable business when the economy is booming but it is a recipe for disaster when one of the inevitable low points in the economic cycle arrives.

If you doubt what I’m saying look at the excuses finance companies trot out when the proverbial hits the fan. For example ‘Hanover, a New Zealand business with the size and strength to withstand any conditions’ is at a “standstill.” Apparently this is as a result of a number of factors, including a loss of investor confidence in the finance sector, a weak property market and the global credit crunch. These things have occurred repeatedly in the past and will do so again and, despite what the finance companies claim, they are not the problem. The problem is that their business models have not been designed to cope with them.

Hanover is not the only failed finance company to blame the property market. Some finance companies have a large percentage of their book exposed to property development. Others have a huge exposure to second-hand cars. And it is not uncommon for them to have 30-40% of their lending exposure to one or two clients.

Compare this with a major bank whose business model would severely restrict, if not totally forbid, any exposure to property development or second-hand cars and would not countenance an exposure of even 1% of its book to a single client let alone 10, 20 or 30%. And if the Banks do finance property development, you can bet your bottom dollar their business model will require first ranking security: not the second or third ranking position finance companies seem happy to accept.

Another crucial thing is that Reserve Bank demands that the major banks’ business models include sufficient equity to cover the losses that might occur in a serious downturn. This is not demanded of finance companies. It will be interesting to see whether the Hanover shareholders, who have the personal resources to inject enough equity to cover investor losses, actually do so.

There’s a lot more to a comprehensive business model than what I have mentioned of course. But the point is that, almost by definition, finance companies are likely to have a flawed business model with an unacceptably high credit, liquidity and operational risk profile. Otherwise they would end up in the same space as the major banks where they simply would not be able to compete.

I know it is a bit late now to say don’t invest in finance companies but if you are lucky enough to still be around for the next finance company boom in 10 years time or whenever, you will see history repeat – again. My advice is don’t be tempted to join the high flyers: keep your feet firmly on the observation deck.

So I should be feeling pretty smug apart from the fact that the share market hasn’t been too flash either, recently hitting a 3 year low. It would be fair to say that if finance companies are dogs then the share market is a lame duck. However, when it comes to pet selection, I’ll take the lame duck any day.

Here’s why. When finance companies are doing well, and they sometimes do very well indeed, all you get as an investor is the agreed debenture interest rate. When things go wrong, interest is not paid and your funds are frozen. To add insult to injury, you may lose some or all of your principal when the thaw sets in. You don’t get a higher interest rate during the good times but you share the pain when things go wrong. If you think that seems a bit like finance companies trying to have their cake and eat it then I agree. If a listed company does poorly dividends may dry up and the share price will probably fall. So isn’t that just as bad?

The short answer is ‘no, it’s not – not by a long chalk’. For a start you are most unlikely to have your funds frozen. If you get nervous you can sell your shares. More importantly, during the good times you get to share in the high returns that are generated through higher dividends and/or growth in the share price. History has repeatedly shown that this more than compensates for the bad times and gives you superior returns in the long run.

In theory, the fact that you do not share in the good times with finance company debentures the way you do with shares is justified by the fact that from a security perspective, debentures rank ahead of equity (shares) in a breakup. In other words sharing in the good times compensates for lack of security. In reality, history has shown this ‘benefit’ to be an illusion, with many finance company losses exceeding falling share prices.

Another benefit of shares is that you can diversify over a range of different companies in different industries and different geographic areas. Many people have lost money in several different finance companies recently. No doubt they were heeding the call to diversify when, in reality, they were doing the opposite – investing in similar companies all in the same sector.

And finally, investing in shares allows you to invest in companies that operate under a sound, sustainable business model. This is something that finance companies, almost by definition, do not have. I will explain why I make this claim in my next blog.

The fact is that shares have consistently provided the best return over time so I would have expected that all 4 (possibly 3 given one was a trader rather than an investor) would have made share investment their starting point. This is not to say everyone should have all their investment funds in shares of course but if you are going to recommend an investment that is likely to give lower returns then there is surely a need to explain why. And one would expect the reason for not investing in shares to be addressed by whatever alternative investment is recommended.

So how did the investment advisors do against my criteria? Well, I was pleasantly surprised to see that two did in fact focus strongly on shares. And where an alternative was suggested good reasons were given. So to mix a couple of metaphors, maybe the tide will turn, we will see light at the end of the tunnel and more kiwis will invest in shares.

I do have a couple of quibbles. One advisor suggested retired investors should generate all required income from fixed interest before considering shares. I think this is going too far especially for those with diversified portfolios which will generate reasonably reliable and consistent dividend returns. Some people will be retired for 25 years or more and this is a long time to be deprived of the higher returns shares are likely to provide.

Another advisor said that investing in managed funds rather than directly in shares usually provides higher returns at lower risk. I think this is a highly debateable statement to say the least. In my view a lot more should be being done to encourage Kiwis to invest directly in shares.

People often respond by saying they would like to invest in the share market but do not know where to start. One way to dip your toe in the water is through a share club. Share clubs offer an excellent learning environment and often draw together people with a wide range of skills and experience.

If you manage a share club or are planning to start one, please contact us and ask us how Sharesight can help. Sharesight is ideal for share clubs because it greatly simplifies the administrative work load of running a club.

Furthermore all members can monitor the portfolio in which they have invested by being given read-only access through Sharesight’s portfolio sharing system. This means they are kept fully up to date on every aspect of the portfolio’s performance with no effort required by the club.

I believe a significant reason why Australia outperforms NZ economically is that Australians are much more actively engaged in their share market than we are. There are 7.3 million Aussies who own shares. This is around 10 times the number of share-owning New Zealanders in a country that has only 5 times our population. And each Aussie invests far more on average than we do. As I noted in a previous blog, history shows that in the long run shares provide the best return so the Aussies’ willingness to invest in the share market creates a significant win/win/win for them.

The 7.3 million Aussies and their families who own shares win. Australian companies also win because the high level of share investment provides the equity that helps fund the rapid growth many of them achieve. And through this growth the Australian economy wins as well.

This makes the Aussies richer but does it mean they are smarter? Clearly, at least when it comes to the question of share ownership, the answer is a resounding “YES”. No ifs, no buts, no maybes, when it comes to understanding the value of investing in their share market Aussies are smarter than us -by about 200%!

I have not got time to discuss all the (spurious) reasons New Zealanders raise for not being more active share market investors. However one look at the graph below will go a long way to persuading you that whatever the reasons are, they simply do not stack up. I know the graph is 2 years out of date but this does not change the long-term story it tells. If the last 2 years were added the graph would show a further 18 months of rapid share market growth followed by a significant decline in the last 6 months.

The graph shows clearly that shares are more volatile and there are periods when you can sustain significant paper losses, but overall you are likely to end up well ahead if you take a long-term view. It’s true that history is no guarantee of future performance. But the wisdom of investing in the share market is supported by over 100 years of history and, in a world of uncertainty, I reckon that’s as good as you are likely to get.

Graph taken from publication by ING Australia. Data sources: ABN Amro, Reserve Bank of New Zealand, Quotable Value, Bloomberg.

Returns shown are in New Zealand dollars but do not take into account taxes, fees or inflation.

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Investors who place a significant proportion of their savings in shares are often more diversified than they think. They should not allow themselves to be railroaded or frightened into diluting their returns by diversifying further into lower yielding assets.

For one thing, if they have followed the old adage of getting rid of their mortgage before they start saving seriously, they are likely to already have a significant investment in residential real estate.

Secondly, shares in themselves are an excellent way of diversifying across a range of different companies operating in widely varying sectors such as infrastructure, manufacturing, retail, tourism, mining, telecommunications etc. It is easy to invest in Australian as well as NZ shares so you get some country diversification too.

As an aside, many people have lost money in several different finance companies recently. No doubt they were heeding the call to diversify when, in reality, they were doing the opposite – investing in similar companies all in the same sector.

So my contention is that people with a freehold home who invest a significant proportion of their savings in NZ & Australian shares can be adequately diversified. And they are likely to end up with a significantly larger retirement nest egg than if they had diversified into other, historically lower-yielding, assets. The only major rider is to only invest funds in shares that you are confident you will not need in the short or medium term – say within 7-10 years. That way you minimise the risk that you will have to sell your shares before they have been able to generate the higher returns you want.

As a final word on diversification let’s say that 10 years ago you decided to diversify away from shares by placing some funds in an ANZ term deposit (unsecured). I’m not sure what your average interest rate over the last 10 years would have been – let’s be generous and say 7% p.a. What I can tell you (by checking it out on Sharesight) is that if you had bought ANZ shares 10 years ago instead of making that term deposit, your return would have been 25.23% p.a!

Makes you think doesn’t it?
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In my view diversification to that extent is more likely to create retirement cash blues than beat them and would not result in a very effective portfolio. For one thing it is not practical for most investors to diversify to the extent recommended unless they invest in managed funds. And the long-term performance of almost all managed funds leaves a lot to be desired. Even a portfolio of randomly selected NZ and Australian shares is likely to out-perform most managed funds, particularly when their fees are taken into account.

Shares and property consistently outperform cash or fixed interest on a long-term basis (and retirement saving is a long-term project) so why would you want to erode your higher-earning share portfolio by diversifying into fixed interest? There are three main reasons often put forward.

First, diversification allows you to spread risk. The hope is that any poor performance will be confined to a small part of your portfolio.

The second reason has to do with liquidity risk. If you need your money urgently, will it be available when you want it and without suffering a loss or an early repayment penalty?

And finally, diversification reduces volatility.

These sound like good reasons to diversify. But are they? The problem with diversification is that while it can limit your losses, it can have a far greater limiting effect on your gains. It dumbs down your investment performance to a low average. As DIY investors we can do much better than that. Remember, the worst you can do is lose 100% your money, but on the other hand the share market gives you plenty of opportunities to earn far more than 100%.

Many people lose sight of the fact that the primary objective of a long-term savings plan should not be to reduce volatility or the risk of loss, but rather, to maximise returns.

There is another problem with diversification. It works on the premise that if one asset class is doing poorly this will be offset by others in your portfolio doing well. Unfortunately the opposite is more likely to be the case. In the last 12 months people have lost money from fixed interest debentures in finance companies and a decline in the share market and property prices are widely tipped to take a tumble as well.

So here’s the big question: Is there a way for the average DIY Kiwi investor to deal with diversification and maximise returns? Can you have your cake and eat it too? I believe you can. I’ll explain how in my next blog post.