Australian bank stocks have been good to sharemarket investors. So good that some – including many who might consider themselves risk-averse – have simply astonishing amounts invested in them.
It worries us – and we sincerely hope it worries you. But our hunch is that many of our members still hold more than 20% of their portfolios in bank stocks (see How much is too much? below). It's especially worrying because bank stocks are masquerading as the market's miracle-makers but they're riskier than they've ever been.
The solution is simple: sell down your bank holdings. There's no need to sell all at once; indeed you might pay less capital gains tax by staggering your sales. But more on that enticing prospect a little later.
- Don't be lulled into thinking banks are low risk
- Sell banks down to 20% of your portfolio (and preferably less)
- Your capital gains tax bill can be minimised with careful planning
So it's time to get serious. A 'she'll be right' attitude will only work until it doesn't. If you're having trouble selling banks, think carefully about your justifications for holding. For example, have you heard yourself say any of the following?
Banks have been fantastic investments – why would I sell? The past is the past but it's the future that matters. The rear vision mirror won't tell you what's looming in the windscreen. And, as you might have read in Property: So hot right now on 12 Mar 14, the clouds gathering on the horizon look pretty dark.
Bank stocks might keep going up. Nobody wants to miss out on an even larger capital gain from their banking stocks. Regret aversion – the fear you might be wrong – often results in a lack of action. So weigh up the risks; make a decision; then resolve yourself to accepting it.
Banks look cheaper than other stocks. Bank price-earnings ratios are traditionally 10%-25% lower than the market average (the discount is currently around 9%). There's a very good reason: banks are much riskier than most stocks. Owning a bank is a bit like taking out a mortgage for 95% of the value of your house, then re-borrowing the increase in value every year. It works while house prices keep rising but, if they fall, well, you can guess the rest.
|How much is too much?|
|Our maximum recommended portfolio limit for bank stocks is 20% in total, with no more than 8% in any one stock. But don't forget about correlated risks. If you own QBE Insurance, which has a mortgage reinsurance business, or have a residential property portfolio, your weighting should probably be much lower. Conservative investors should limit their bank holdings to less than 10% of their portfolios.|
Bank stocks have high yields – and I need income to live. You've no doubt heard that higher yield implies higher risk. Well banks are no different. Even during the global financial crisis – from which Australian banks emerged unscathed – they cut their dividends by around 25%. A local recession could result in capital raisings and a permanent reduction in dividends.
Australia's economy is strong. Banks perform well under favourable economic conditions. Australia has now avoided a recession for 23 years, so it's no wonder banks have prospered. But banks suffer enormously during economic downturns. Twenty-two years ago, in the wake of the last recession, no lesser bank than Westpac came close to collapse after writing off $2.7bn in bad debts.
Australian banks are too big to fail. If worst comes to worst, the Australian government will probably rescue the banks (at the cost of a major recession). But such a rescue would protect depositors, not shareholders, who will lose most of their money. Between 2007 and 2009, the share prices of major British, American, Irish and Icelandic banks fell by more than 90% before they were nationalised.
What else would I buy? Easy: There are 29 stocks currently on our Buy list. And our model portfolios have outperformed the market with negligible exposure to banks. It's just not a risk you need to take. You don't have to reinvest any sale proceeds immediately; it's better to wait patiently for the right opportunity. Our long-term recommendation to buy stocks with international exposure – or international stocks themselves – will also insulate your portfolio should the worst eventuate.
The capital gains tax bill will be too large. Australia has had a capital gains tax since 1985. So it's worth remembering that a portion of any gain you make has always belonged to the government. Be happy that you'll pay tax; it's the mark of a successful investment.
Of course the indomitable Kerry Packer was also right when he said: 'Anyone in this country who doesn't minimise their tax wants their head read'. And there are plenty of ways to minimise the capital gains tax you'll pay on share sales.
Making tax-deductible superannuation contributions might be one way. If you own your bank shares in a superannuation fund, converting it to an allocated pension is another. Advanced strategies like these are beyond the scope of this article but you could investigate these with the help of your accountant (or Intelligent Investor Super Advisor).
|Parcel 1||Parcel 2|
|Date||June 2014||July 2014|
|CBA shares at beginning||2,000||1,600|
|No. of shares sold||400||400|
|Profit per share||$50||$50|
|Capital gain per parcel||$20,000||$20,000|
|CBA shares at end||1,600||1,200|
A simpler strategy – and one you can implement over the next few weeks – is to stagger your sales over two (or more) financial years. This strategy takes advantage of the 50% capital gains tax discount applicable to investments held for more than a year in an individual's name. It works mainly for those on low-to-average marginal tax rates.
Let's consider an example. Assume that you bought 2,000 shares in Commonwealth Bank at $30 a share in 2004. At around $80 a share now, your holding is worth $160,000 and represents more than 30% of your portfolio.
So you decide to sell 400 shares now, and another 400 shares in July to bring the holding down to less than 20% of your portfolio. You can see the transactions in Table 1.
Table 2 shows the tax payable on the sale of each parcel of 400 shares depending on your marginal tax rate (using 2013/14 rates).
|Marginal tax rate#||0.0%||19.0%||32.5%||37.0%||45.0%|
|Capital gain on each parcel ($)||20,000||20,000||20,000||20,000||20,000|
|Less 50% discount ($)||10,000||10,000||10,000||10,000||10,000|
|Tax on discounted gain ($)||0||1,900||3,250||3,700||4,500|
|Tax as a percentage of sale proceeds||0.0%||9.5%||16.3%||18.5%||22.5%|
|* Assuming no other capital gains or losses, # Ignoring Medicare levy|
Unless your income is well under the tax free threshold of $18,200 a year, you will pay some capital gains tax on the sale proceeds. But, depending on your income – and you should calculate how any sale proceeds might affect your marginal rate – the tax won't be particularly onerous for many shareholders.
For example, you could earn up to $70,000 a year in other income, sell 400 CBA this financial year and next, and lose only 16% of your sale proceeds in capital gains tax using the example given.
It's hardly an outrageous sum for peace of mind.
While we're by no means predicting a banking crisis, the events of five years ago show it can happen. Statues might belong on pedestals but bank certainly don't. Both can be toppled by tremors, so taking precautions seems wise.
A sensible weighting to Australian banks will help you ride out any shakeout. Sell your bank holdings down now to keep your portfolio on a solid footing.