PORTFOLIO POINT: It's important to embrace risk in your portfolio, but you need to understand the relative safety of different investments in order to do this effectively.
“Is it safe?” is an unfair question to casually ask an investment professional. Aside from having to cut down a small forest to properly document any answer, no investment is absolutely safe – not even government-guaranteed bank deposits. All investments have some element of risk to them. Still, many investors wish to understand the safest investments they can make in the current environment. Here I will bravely share my view, to help you form your own. For those feeling bruised after last week’s RBA rate cut, note my top three safest investments don’t rely on interest rates.
Before laying these investments out, it is important to remember that you need to embrace risk in your portfolio, even just to preserve the purchasing power of your money. And while you may have in mind a return you expect to get investing, all you really can decide is which and how much risk you take on. In return, the market gives you its return, which in some years is good and others bad. Generally speaking, the more risk you take, the more return you should expect – and more still when times are gloomy and “risk premiums” are high. However, you can easily make a bad decision investing in something that from the outset won’t provide you with enough return for the uncertainty and chance of bad luck interfering. If you think about risk and return this way, we should really call investment managers “risk managers”, and asset allocation “risk budgeting”.
The world’s safest investment?
I consider the safest single investment in Australia today to be the Commonwealth Government Treasury inflation-linked bond number TI408. This is a tradable loan to the Commonwealth government which is due to be repaid on September 20, 2030. This bond guarantees that the bond holder will receive the inflation-adjusted purchasing power of the original investment made on issue in September 2010 – or 20 years earlier. Along the way, the investor also receives a rising inflation-adjusting annual income roughly equal to 2.5% of the inflation-adjusting value of the bond (now $105.44 after issuing at $100 about 18 months ago, but note now priced at an appreciated $120). Of course, I’m not wedded to this issue in particular – it’s just the longest one on issue. I would certainly consider this safer than owning for about 20 years its nominal, fixed-interest cousin.
There are two reasons to rank this investment as the safest in Australia at present:
1) The issuer is considered today the most creditworthy in the country (and perhaps the world);
2) This investment guarantees on maturity a real return of the investment.
Of course, this investment isn’t risk-free. In 18 years from now, the Australian government could have the creditworthiness of the Greek government. However, you can sell this bond to another investor if you start hearing Zorba dance music emanating from Canberra’s Treasury building. Further, the consumer price index (CPI) inflation adjustment may not perfectly estimate – and I suspect does slightly underestimate – cost rises faced by retirees. However, it does a better job aligning your wealth to inflation than do interest rates, which fluctuate with the whim of the Reserve Bank, as we saw this week. This is one of the reasons I put cash deposits lower in my list of safest investments.
Note that because these bonds fluctuate in price prior to maturity, they offer a less certain investment experience in the interim, and are not suitable for short-term “saving”. If your investment time horizon is shorter than 18 years, then you could buy a shorter duration bond or, even better, buy multiple issues with staggered maturity dates. If you think state governments are just as safe as the federal government, then you can earn about 1% more coupon by lending to them. You can earn a further 1% or more lending to banks and infrastructure providers, however I would only do that as part of a diversified portfolio (described later).
Second place – Government pensions or annuities
A defined benefit pension offered by the federal government, then a state government or related authority, is probably the next safest way to fund your retirement. While still generous, defined lump-sum benefits aren’t as safe, because it later becomes your responsibility to convert this into a market-linked income stream.
The reason I don’t consider a lifetime pension obligation to be as safe as government inflation-linked bonds is two-fold. First, there is always a layer of scheme rules that sit between you and your entitlement, which could be changed, and secondly, this isn’t a tradable entitlement (or not without plastic surgery and identity theft). That said, I wouldn’t pass on receiving this benefit if it was offered to me.
If, like most people, you’re not lucky enough to receive one anyway, then you can do the next best thing, which is to buy your own private pension annuity. Annuities are available only from CommInsure and Challenger. Professional rating organisations rank the security of an annuity from CommInsure marginally higher than one from Challenger. However, you’ll notice when you price these annuities that Challenger rewards you more – and both exceed returns from a Commonwealth inflation-linked bond. Both life insurer providers are regulated by the financial promise police, the Australian Prudential Regulatory Authority (APRA). You might take some comfort from the fact that in Australian history, we have had more bank and trust company failures than life insurance failures.
A pension or an annuity that pays you an income for life (or your beneficiary’s, if elected) offers “longevity risk” protection, which can be undervalued in its importance. Unfortunately, paying to offload this risk comes with reduced income. At the moment, if your investments run out before you do, selling your home and relying (more) on the age pension is your backup plan – a reality which no doubt weighs on the minds and empty pockets of government, and will drive future tinkering.
I would put pensions promised to be paid by municipal and non-government entities a few notches down in safety terms, simply because there may not be enough money set aside to meet those promises in difficult times. Canada’s version of sharemarket-dominant BHP, Nortel Networks (formerly Bell Canada and once a third of the value of the TSE index), went bankrupt in 2009 and was unable to meet its billion-dollar pension shortfall. Reportedly APRA advise that the top 20 defined benefit company pension funds it supervises are sitting on total funding losses of $7 billion dollars. Outside of the corporate sector, Unisuper pension fund members have been formerly warned by trustees that a possibility exists that future payment increases may be reduced owing to current market volatility. While no doubt a shock to many (and a concern to equity investors owning these companies), this shouldn’t be surprising as many DIY investors who have bought the same underlying assets have had also to reconsider their safe withdrawal amount or top-up funding in the wake of the GFC.
Fixed-interest government bonds then deposits
After inflation-linked investments, fixed-interest government bonds and deposits make up the next level of safe investments. While these are capital stable at maturity (bonds) or while on deposit (cash), in my mind these are riskier long-term “investments” as there is no promise interest rates will keep up with inflation. They do now, but they didn’t in Australia in the 1940s and 1970s, and they aren’t in the US and Europe today.
Bonds issued by the federal government have to rank ahead of deposits in terms of safety, since it is the former doing the guaranteeing and the latter are only guaranteed up to $250,000 per entity per institution. While the “Financial Claims Scheme” is quite simple and transparent – and promises relief payable in a lightning-fast seven days – those seven days could still feel like the longest days of your life and rules can be fudged during periods of severe stress. Banks are said to “borrow short and lend long” and can suffer from liquidity crunches, hence the need for a guarantee.
At present, there is a huge (about 2%) premium for lending your money to the guarantee (the bank) versus the guarantor (the Commonwealth government). I don’t think this reflects extra risk; instead I think it reflects a) different buyers (retail savers versus institutional wholesale investors) and b) bank needs for “sticky” retail deposits.
Fixed-interest bonds, held to maturity, are perhaps the safest way to meet a future known “nominal” liability and are more secure than putting money on deposit at varying interest rates. There is the danger that in the interim, the income you earn diminishes, whereas a tradable bond will let you lock in your income. It also gives you the option to change your mind by on-selling your bond to someone else if you change your mind – albeit at an uncertain price. The fact that term deposits don’t go up in value when interest rates fall (and often during economic crises, when shares fall too) is what differentiates bonds from at-call and term deposits, and earns their role in most portfolios. Of course cash, used as a floating rate investment as part of a broader defensive portfolio, has a role as I pointed out earlier in my preferred defensive portfolio architecture.
Some depositors wonder about the security of small “b” banks, such as member-owned credit unions, mutual banks and building societies, versus the big “B” banks, such as Commonwealth, Westpac, NAB, ANZ, Bendigo and Queensland’s banks. I’m not sure big is always better in this case, as big also means sometimes “too clever” in terms of complexity, and more reliance on skittish wholesale funding markets. The numerous small credit unions are simpler member-oriented organisations and a failing one could be quickly dealt with by a bank inspector through a forced marriage to another, which is much easier than having to repair a large institution. All of these are “authorised deposit-taking institutions” – deposits are covered by the same guarantee scheme and are similarly APRA-regulated. The historical differences between building societies and credit unions are long gone and you can learn more about them from the member organisation Abacus.
Diversified portfolios – a more optimal risk/return position for most
The most practical safe investment strategy for most people is to own a highly-diversified portfolio of multiple types of financial assets. As per the below graphic shared in a recent Eureka Report webinar, this can be done through a “DFY” (do for you) multi-sector fund or a DIY portfolio. While you should expect to earn a better return investing this way, it is important to point out that greater choice and flexibility don’t guarantee better investment outcomes. You can easily underperform cash or an annuity return through bad luck or bad management – the latter either yours, your fund’s or your adviser’s. In my opinion, investors shouldn’t worry about paying fees, they should just worry about getting a value-adding return on them.
In the absence of having a personalised allocation worked out for you, a varying life-stage mix of equities and bonds is a sensible starting point and so is keeping this in balance through difficult times. It is generally held that you need about 20 different shares (or growth investments) held in near equal-sized bites to properly diversify that part of your portfolio, and perhaps as many as 40 different investment-grade bonds. In practical purposes, you can achieve this kind of diversification through simple index funds, including ETFs, or with some hope or purposeful selection, higher-fee active funds. Funds holding listed investments administered through third party custodians are preferred to those investing in illiquid, sparsely-traded assets, as many unfortunate investors in unlisted property and mortgage trusts now realise.
It would be unsafe to just bet on domestic investments, as you risk a collapse in the Australian dollar depleting your internationally-priced, goods-purchasing power; you’ll probably need to invest through a fund to get your entry-level diversification. If you love bricks and mortar more than share and bond certificates (which are now electronic anyway and not very comforting), then you’ll want to have a Monopoly spread of property of different types in different places to better insulate you from local risks.
Some can take comfort in the security of a growing share-dividend income stream, which I wouldn’t disagree with. However, it can be profitable to have in difficult times (and a great sleep aid) monies set aside in complementary, income-paying defensive investments.
Cabins in the woods, shotguns and gold
The financial system, of course, has operated on trust ever since the first farmer was given a conch shell instead of bartered goods for his wares. Implicit in all of the above is your belief that the financial system will manage through all types of Armageddon. If you don’t agree with this premise, it is entirely reasonable to plan to retreat to your bomb-shelter or cabin in the woods where you grow your own vegetables, read by the light of your solar panels and enjoy farmed lamb once a week. Unfortunately, you may need also to buy a shotgun in case others want to share in your insurance policy.
At the risk of offending gold bugs, you have to question carefully which security you seek in gold. Since gold pays you no dividends (although it can if you buy it in hedged Australian dollars, as I pointed out earlier, you don’t invest in it – you just speculate that someone will pay you more for it than you did. This makes it a less certain store of wealth, but it can be a very good one in certain times, such as when there are bouts of electronic money inflation. Of course, if you are planning for a true disaster scenario then don’t own gold via an ETF; hold the physical bar and some in coins and small divisible pieces. Some suggest not locking it up in a bank safe deposit box, as that may become accessible to government or inaccessible to you in a crisis'¦sounds like you might need that shotgun again!
Doug Turek is the managing director of family wealth advisory and money management firm Professional Wealth.