You've got a small windfall in your hands, $5000 or maybe $10,000 - a generous tax return perhaps, a gift from a loving aunt, maybe the fruit of a long-term savings plan. There won't be many financial planners or investment advisers beating a path to your door for your business, but as they say, from the little acorn the mighty oak grows. That few thousand dollars could be the first seeds that could one day grow into a fortune.
Indeed starting out small and thinking through an investment strategy at this stage may well stand you in good stead if you ever do have access to a larger sum of money. Too often those faced with a big windfall - an inheritance, or say a lottery win - can fall into trouble simply because they have never had the opportunity to practice with smaller sums.
"Starting off small means that if you make mistakes it isn't going to be overly onerous," says Dianna Belbin, a financial planner with Shadforths Limited. "You're not taking on huge risks."
That means you can use this early stage as practice time, to put your toe in the water and get a feel for investing, how markets move, where the opportunities and the threats lie, and what's out there in terms of products. That's the theory anyway. Now what should you actually do with the money?
Sure-fire 16 per cent
Before you do anything exciting, one of the first things you should do, suggests David Raits, a financial planner with CIS Financial Services, is check whether you have debts that might benefit from having that amount thrown at them. A HECs debt perhaps, a credit card or a personal loan on a car. Boring as it may sound, getting rid of debt is the quickest and surest way to "make" money.
The equation is easy - retire a credit card debt, and you've instantly "earned" 16 per cent or so on your "investment". If you count the fact that you will have to pay tax on earnings on any other investment, it's unlikely you'll be able to do better.
And if you think of the repayments you'll be saving on each month, it's not such a boring idea after all. Retiring a $5000 personal loan that you'd otherwise be paying off over three years will leave you with about $160 extra a month (assuming interest of about 11 per cent). Channel those funds immediately into a long-term regular investment plan and you'll have the makings of the most sure-fire way of building wealth there is.
Indeed, setting up a savings plan to add funds to your lump sum is a good idea even if you don't have a debt to pay off. Even the highest returning investment isn't going to build that initial $10,000 or so up quickly. "The only way to generate real wealth is to save regularly," says Jason Andriessen, an adviser at State Super Financial Services. "It's the discipline that matters." So where should you put this sum of money to make it grow into your small fortune?
Sure and steady growth
Right now the best place might seem to be one of the high-earning cash management or online banking accounts that offer upwards of 4.5 per cent. At a time when other investments are going backwards, the fact that these accounts promise secure positive returns makes them look attractive. And if you're saving for a car or a deposit on a house and you need to access the money in a year or so, putting your money in an easily accessible deposit account might be the best strategy. If this is the beginning of a long-term fortune building plan, you're going to have to look past the current gloom about the market and think growth assets.
Growth assets by their nature have more volatile returns than a defensive investment like cash or fixed interest. They may return 15 per cent one year and drop by 8 per cent or more the year after, but, says Andriessen, over more than a few years they will outperform a bank account or a term deposit. "Regardless of the short-term economic indicators and political risks, in the long term shares and property will be the best performers - and if you are investing long term you can afford to ride out the fluctuations and volatility that is part of the short-term horizon," he says. Besides, Andriessen adds, while it is rarely a good idea to try to time the market, there are certainly some high quality assets out there going cheap right now.
"The number one issue for people new to investment is to work out their lifestyle objectives as well as their risk tolerance," says Andriessen. "That is what is going to drive your decisions in the end."
How many baskets?
One of the best ways to reduce risk is through diversification. Andriessen believes that diversification - spreading your funds across a range of assets or securities - is the next most important principle of investing after discipline. "It doesn't matter whether you've got $5000 or $500,000. I recommend diversification from the word go - otherwise you are taking on the specific risk associated with a particular asset or security."
With a relatively small amount to start off with, the easiest way to diversify is to invest in a managed fund. Managed funds give you the ability to diversify across a number of shares with an initial contribution as small as $1000, and many managed funds diversify across asset classes as well, investing in property, fixed interest and international as well as local shares.
But be aware that in the short term, individual managed funds can involve specific risk as much as individual shares can. Returns in the past 12 months have ranged from more than 20 per cent up to 20 per cent down - and further. Even the so-called "balanced" funds (that are diversified across asset classes such as international shares and property as well as Australian shares) vary enormously in their asset allocations. Their performance last year ranged from 7.2 per cent to negative 18 per cent.
Those variations are likely to even up over time. The poorest performers in the past couple of years were those funds that invested in international shares, and these may well make a dramatic turnaround in years to come. The so-called "value funds", which invest in good quality companies that are out of favor at the moment, have done well in recent years, but may languish when the market improves and growth stocks take off again.
If you're choosing an individual managed fund, then you'll need to make sure it suits your needs and your risk profile. Many fund managers now include risk profile questionnaires in their information brochures or their web sites to help you judge which products best suit your needs.
A way to eliminate the specific risk of individual managed funds is to invest through a master trust or wrap account. These allow you to invest in a range of managed funds within the one framework and the one payment, at a wholesale cost.
Also, you can switch between any of the funds on the list without having to pay any entry or exit fees. Most are targeted at high net worth investors and sold through financial planners, but some have been tailoring their product for entry level investors.
Snowball Financial Services, for instance, offers investors the ability to put together a portfolio of managed funds with no minimum contribution and regular contributions of as little as $100 a month or quarter.
One share or the whole market?
Another way to buy a diversified share portfolio is to buy exchange traded funds (ETFs) via the stock exchange. ETFs are relatively new to Australia, and don't come in as many flavors as they do in the US where they have been popular for some years. However, they are low cost (with management fees of less that 0.5 per cent compared with about 1.5 per cent for many managed funds), and allow you to track an index, say the S&P 200, as well as trade them on the stock exchange.
Buying shares in listed investment companies (LICs) like AFIC or Argo is another good way to diversify with a small amount of money. These companies invest in a range of shares, and the value of your shares varies according to the value of the LIC's underlying shares combined with the demand for the LIC itself.
The wisdom of diversification would suggest that it is not possible to buy direct shares with your initial $5000 to $10,000. A minimum recommended transaction for shares is $5000, and a properly diversified portfolio is usually about 10 shares. But Dianna Belbin says it can be possible to start with one "top quality blue-chip share" as the foundation for a more diversified portfolio. "You do have to factor in a higher degree of risk, but if you're starting off small it's not a huge risk that you're taking."
Borrow to invest more
Belbin also suggests using a margin lending strategy to boost your investment from the outset and build up a diversified share portfolio more quickly. Take out a margin loan - one that doesn't require you to draw down a minimum amount - and draw down an extra $5000 from the margin loan to match your initial $5000 lump sum (or $10,000 to match $10,000), using the total amount to buy two shares rather than one.
Then you contribute, say, $200 each month into the margin loan facility. After a year you will have accumulated $2400 equity in the margin loan (you should be paying off your interest on the $5000, which should be less than $100 over the whole year). At the end of the year you should draw down $2500, add it with an extra $100 to the $2400 for a total of $5000 and use the funds to buy another share.
"It's a slow way to build a portfolio but it keeps the risk factor low," says Belbin. In the 12 months while you're building up the extra funds, you can be researching the market and deciding on the next top quality share to add to your portfolio.
It might take you a few years, but over time you will have accumulated a tidy little portfolio. And once it starts building up, and your own income starts to grow, you'll no doubt be inspired to add further spare cash to the kitty, and more shares to the portfolio.
But even if you do decide to start with managed funds, it doesn't mean you have to miss out on the learning experience that this first foray into investing represents.
As Andriessen says, "there's nothing like the experience of looking at what is happening with the markets and with your funds". You can find out the major asset and shareholdings your funds are invested in and follow their movements on the sharemarket.
And if you follow these strategies, how much of a fortune could you make? Well, if you started with $10,000 and saved an extra $100 a month, after 20 years you'd have accumulated $108,783. That's if your money earned an average of 6.5 per cent a year. Increase those monthly payments to $500 and you'd have a very nice $387,973. Not a bad start to a small fortune.
Earn 33.5 per cent on your money - instantly
If you have a larger windfall - say $20,000 or $50,000 - one of the quickest ways to get a guaranteed 33.5 per cent return (presuming you are on the top marginal tax rate), is to ask your employer to contribute the maximum allowable deductible contribution into your superannuation via salary sacrifice, suggests Jason Andriessen at State Super Financial Services. For a 35-year-old that amount is $35,138, and for someone older than 50 it is $87,141.
What you do then is deposit your lump sum into an easily accessible but high interest bearing cash management account and draw on the capital to supplement your income.
Your total income won't be affected, but instead of being taxed at 48.5 per cent the portion of your salary that is "sacrificed" into super is taxed at only 15 per cent. That's a one-off savings of 33.5 per cent - before you account for any earnings on the super fund.
The scenario would be as follows:
Professional aged 35 years, receives salary of $80,000 a year with no other income sources, has an investible windfall of $50,000.
If he were to direct $27,000 into superannuation as a salary sacrifice contribution, it would bear $4050 tax. If it is taken as cash salary it would bear $12,745 tax. The annual tax benefit is the difference of $8695.
Directing the $27,000 into super will reduce take-home pay by $14,255 a year. That shortfall is taken from the $50,000 capital rather than income, which will last for about 3.5 years.
The tax effectiveness of the contributions, over the 3.5 year period, net contribution to superannuation, will have converted the $50,000 windfall into $80,325 before any earnings - without affecting the "income" of the investor.
Andriessen points out that readers should not act on these suggestions without seeking specific financial planning advice. There may be other considerations that would apply, particularly preservation, benefits taxes including the effect of the reasonable benefit limits (RBLs), and possibly superannuation surcharge.
First steps to building a fortune
Back in 1998, Joel Montgomery thought he had struck gold when he was issued employee options for the company he was working for at the time. He exercised and sold a number of the shares when he got the chance, but hung on to the rest hoping to see them rocket up like the rest of the dot-com stocks. Within a couple of years the value of those he had kept withered down to a fraction of their former value. "I certainly saw the highs and lows of the dot-com bomb," Montgomery says.
Four years down the track Montgomery, now aged 23, had scraped together $20,000 in savings and from what was left over from cashing in his options. This time, he determined, he wanted to do it right. "With the options I had no idea of what I was doing, but in the past couple of years I realised I wanted to do something that was geared towards my future."
What he wanted was fairly specific - to have built a portfolio worth $200,000 within 10 years. It was a sum he figured was ambitious but realistic. To achieve this he was prepared to take an assertive, but not quite aggressive, approach to risk, and he was prepared to save hard to add to it. "I wanted a good return, but I didn't want to stress about it too much."
The first thing, he decided, was to find himself a good financial planner - "one that I could talk to". Although he is interested in business and enthusiastic about shares, Montgomery conceded that he needed to learn a thing or two before striking out on his own again.
Coming across David Raits at CIS Financial Services, Montgomery learned two important lessons - the importance of diversification, and the value of gearing. "I'd already seen what can happen when you invest in just one industry, especially a volatile one - you can get burnt." Raits suggested that Montgomery invest his $20,000, matched with funds borrowed through a margin lending facility, into a range of managed funds through the Snowball account facility.
The funds were diversified across a number of asset classes, including Australian and international shares, property and fixed interest. Then using instalment gearing, Montgomery would contribute another $500 each month, matched with another borrowed $500. With a projected average annual return of 10 per cent, the portfolio is expected to grow to $200,000 in the next 10 years.
In a decidedly shaky market, that kind of return is yet to materialise, but Montgomery says that he's confident that his well-diversified portfolio and moderate gearing level has got him well set up for the long term. "This is the first test for me. I can't put any science into my forecast for the 'ups and downs'. I know there will be volatility. But I am looking at 10 years down the track."
Managed funds to kickstart your fortune
Advance Imputation Fund
Diversified shares
1 year -5.88%, 3 years 7%
Minimum investment: $2000
Portfolio Partners High Growth Shares Fund
Diversified shares
1 year -7.24%, 3 years 12.07%
Minimum investment: $2000
Perpetual Investor Choice Australian Share
Diversified shares
1 year -1.4%, 3 years 7.44%
Minimum investment: $2000
Colonial First State Diversified Fund
Multisector 70
1 year -4.5%, 3 years 3.8%
Minimum investment: $1000
ING Active Growth Trust
Multisector 70+
1 year -4.5%, 3 years 3.8%
Minimum investment: $1000
Source: Assirt
Five strategies to start your fortune
Pay off credit card debt and personal loans.
Use a wrap account or master trust to diversify across managed funds.
Buy exchange traded funds to diversify across the whole market.
Start a share portfolio with one or two blue-chip shares and add a share each year as you save up more.
Leverage your earning power with margin lending, but keep gearing levels down to 50 per cent and diversify well to avoid margin calls.
Each week financial advisor Noel Whittaker answers your
questions.
