Building your exposure to shares and property

Two approaches to building investment wealth …

We see two common approaches to building investment wealth and, particularly, exposure to growth assets (i.e. shares and property) among couples in their thirties and early forties. These people have generally borrowed to purchase a residence, with all or most available cash being consumed by the mortgage and meeting the expenses of raising what may be a growing family.

The first approach we will call “conservative”, even though we don’t really think it is. It involves directing all savings, except perhaps superannuation contributions, to repayment of the mortgage. There is no deliberate increase in growth asset exposure until the mortgage has been cleared and surplus cash is available to buy shares or property, either directly or via managed funds. It is viewed as imprudent to invest in risky growth assets before all debt has been repaid.

The second approach may be thought of as “aggressive”. As soon as sufficient equity is available in their home, these people borrow a substantial one-off amount to purchase shares or an investment property. The decision is often driven by a desire both to accumulate wealth and reduce taxation, via negative gearing. While accepting that additional debt does increase risk, the view is usually that there is plenty of time to recover if the investments don’t do so well.

… But both are unnecessarily risky

We think both approaches are unnecessarily risky in the sense that they are unlikely to maximise your chances of achieving your desired financial objectives.

If you consider a “conservative” couple, it may take them ten to fifteen years of diligent saving before they repay their mortgage. Assuming this occurs in their mid-forties, they probably only have another 15-20 years of growth asset accumulation ahead of them.

But what if growth asset prices had risen strongly over the 10-15 year period while they were paying off the mortgage. They will be forced to purchase growth assets at much higher average prices than were available over the previous 10-15 years, with lower consequent expected returns.

Of course, they could be “lucky” and commence their accumulation after a prolonged period of depressed growth asset prices. A potential problem is that such “prudent” investors tend to shy away from risky assets when they are out of favour!

On the other hand, the financial futures of the aggressive couples could be badly impacted if share and / or property prices fall and stay low for an extended period after they have borrowed a relatively significant amount and invested in growth assets. They may have no additional available financial resources to take advantage of these lower prices, since future savings need to be directed to repaying their considerable debt. Again, they too could be lucky, and borrow to invest just prior to growth asset prices taking off.

But it seems to us that when it comes to your financial future, it makes sense to reduce the dependence on luck to a minimum. And both the above approaches are sub-optimal in that respect.

Building growth assets strategically

We start from the premise that neither we nor anybody else reliably knows what the future holds. However, if capitalism is to continue to work, over any 25-30 year investment period we would expect (but cannot guarantee) that growth assets (shares and property) will outperform defensive assets (cash, fixed interest). But the actual pattern of annual investments returns that comprise any 30 year investment period is, essentially, random.

How does a young couple that knows they are almost certainly going to need some growth asset exposure to give them a reasonable chance of achieving their desired lifestyle most effectively cope with such uncertainty? While it is beyond the scope of this article to explain our approach to this dilemma in detail, it is governed by the following three principles:

1. The timing of an investment (placement or redemption) should not be driven by the immediate availability of or need for cash;
2. Growth exposure should be built steadily over the period from now to an investor’s retirement, in a pre-determined manner. Many smaller and regular investments are preferred to delaying until the mortgage has been repaid or making large one-off bets; and
3. The growth asset accumulation program should be adhered to regardless of investment market conditions.
    

Our approach aims to reduce the range of possible retirement wealth outcomes by spreading growth asset “bets” as broadly as possible across time. We call it time diversification. Unnecessarily restricting the period you are willing to have exposure to growth markets or loading up at one particular time fails to take full advantage of a “free lunch” that has parallels to asset diversification.

But a consequence of the approach may mean that debt is outstanding for a longer period than “conservative” couples would consider desirable. And there is no room for scheduled growth asset purchases to be delayed due to concerns regarding current market conditions. If you are only willing to be a disciplined growth asset purchaser when things are buoyant, you will probably be better off not being a growth asset investor at all.