Is now the investment opportunity of a lifetime? Here are four strategies

There is no doubt this has been a devastating time for investors, and those most affected are people close to or in the early years of retirement.

But for people 15 to 20 years away from finishing work, it might be the opportunity of a lifetime. And last week’s powerful week-long rally on both the Australian and US sharemarkets should focus attention.

I think the current crisis presents a unique opportunity for people still some years away from retirement.

And I don’t think that people have to be aggressive to pursue the opportunity. Simply strategies such as making extra mortgage repayments, salary sacrificing $20 a week to superannuation or starting a regular monthly investment program into growth assets will provide a better outcome that 12 months ago; indeed, they should provide about double the benefit of a similar strategy 12 months ago.

Investing regularly into shares

I don’t want to be flippant about the valuations of shares at the moment; it’s easy enough to describe the current environment as being a “two for the price of one sale” following the 50% decline in sharemarkets, but the reality is that shares have declined for a reason; the economic environment is perceived to be riskier.

It is all very well to talk about a price/earnings (p/e) multiple of about nine times for Australian shares, making them an apparently cheap opportunity, but there is more to the story than that. Jeremy Siegel, author and professor of finance at the Wharton School of the University of Pennsylvania, talks about shares having a long-term p/e of 14 to 15 (using 200 years of US data), leading to an after-inflation return for investors of about 7% a year on average.

Before your commit – or re-commit – into these “cheap” markets there are two important qualifying statements that should be made about a market with an apparent p/e ratio of nine.

It relies on an estimate or measure of company earnings. If company earnings fall, then the p/e will not be as attractive as it seems.

The p/e of the market is low because it is such a risky economic environment with the credit crash and slowing economic growth. So, buying shares on a low p/e is not automatically a free lunch; it is buying shares in a riskier environment where investors are rewarded with more earnings per dollar invested.

Still, if we look at what happened historically to shares after other large market downturns in Australian markets (1929, early 1970s, 1982, 1987), investors buying after 40% to 50% falls were well rewarded over time.

For someone with a long time horizon, this would seem to be a great time to start a regular investment program into a low-cost, well-diversified investment option. Regular monthly contributions mean that if markets fall further, you continue to buy more shares at lower prices. A lot of academic research that looks at the performance of managed funds suggests simple index funds are as good an option as any.

Every dollar you invest today buys twice as many shares as it did 12 months ago; this is the 50% off sale that is likely to provide far more for participants than any post-Christmas sale!

But be realistic. Investing in shares is exposing your money to a volatile market (although one that has produced returns historically higher than cash, particularly after tax) and there is never a guarantee of a positive return over any time frame of less than 10 years. (Don’t believe the fund managers and financial planners who say a five-year time horizon is long enough for an investment in shares; you need something closer to 10.)

The mortgage is cheaper

Mortgage rates rose to about 9.25% at their peak. They have fallen about two percentage points, with another sharp interest rate cut expected in December. Reports based on the trading in futures markets expect interest rates to fall to at least 3% by Easter next year. Just today TD Securities is forecasting a cash rate of 2.5% by mid-2009.

For someone with a $400,000 mortgage, at an interest rate of 9.25%, initial repayments would have been about $40,000 a year. The scary part of this equation is that about $37,000 of this would have been interest on the loan. So, after a year a person only reduced their mortgage by $3000!

However, interest rates are now more like 7.5%. The interest for a year is $30,000. So, by keeping the mortgage repayments constant at $40,000 a year you now pay off $10,000 of the debt, not the pervious $3000. Your repayments are paying off your mortgage three times faster.

Let’s take this a step further and assume that interest rates fall by another one percentage point today (2 December). Suddenly your interest repayments on the $400,000 loan are $26,000 a year. Your $40,000 repayments now reduce the mortgage by $14,000 a year, making your mortgage repayments more than four times as effective in reducing your loan compared to when interest rates were 9.25%.

Your mortgage repayments are already twice as effective in a falling interest rate environment, providing an outstanding opportunity to get ahead with your mortgage.

Salary sacrificing

Yes, your superannuation savings have taken a beating. However, as discussed earlier, every dollar invested in the sharemarket buys twice as many shares as a year ago.

So while investment values have fallen so far, how about the strategy of saving some tax and investing a little more into superannuation via salary sacrifice? You will hardly miss $20 a week (it could come from the money you’re saving on petrol), yet it would enable you to take advantage of this market downturn and better position your superannuation for the future.

Again, you want to be realistic about the likely returns and the possibility of short-term volatility in markets. There is no guarantee over five or seven years, but for people at least 10 years from retirement this is not the issue. It’s the long term that matters and the $20 a week is highly likely to look like a smart strategy once you get to retirement.

Using a salary sacrifice strategy saves some tax as well. The average person (on the average income) pays tax at the rate of 31.5%. Salary sacrifice contributions to superannuation are only taxed at the rate of 15%. So, for every $1000 you take as a salary sacrifice you are paying $150 instead of $315.

A great time to start building a passive income stream

I see investing as building a passive income stream that supports you over your lifetime, and eventually replaces your “personal exertion” income.

When I invest, I see it as a passive income stream. With market dividend yields being more than 6% (when franking credits are included) I don’t see every $1000 invested as being $1000 worth of investment or spending foregone; rather, I see it as being a potential return of $60 a year, every year, for the rest of my life – increasing as dividend income increases over time.

I use this in making purchasing decisions. Do I want the $2150 flat screen TV, or am I happy with a $150 TV and a passive income of $120 a year, every year, for the rest of my life (by investing the $2000 difference).

My strategy

I probably fit into the mode of the younger person who might see this downturn as more of an opportunity (I am 34), so it might be interesting to know what I am doing.

My core strategy is to make regular investments of $1000 a month. I have kept this up since the age of about 18 (I started investing about $600 a month then – although in those days I used more direct share holdings in my portfolio, whereas today I often favour the simplicity and instant diversification of index funds).

I do have a little bit of borrowed money in my overall portfolio, being about 10% of the value of my investment portfolio and home. My focus has been sticking to my initial plan – started 16 years ago – of investing a regular monthly amount into growth assets.

Conclusion

There is no doubt that this is a difficult time for people financially. But for those younger people, still some way from retirement, there are opportunities now that simply didn’t exist 12 months ago – albeit in an environment with economic risks that we weren’t aware of 12 months ago.

Scott Francis is an independent financial planner based in Brisbane.

This article first appeared in Eureka Report