For the last couple of months this column has covered various research papers on the (mis)behaviour of retail investors looking at common mistakes which it must be said are compounded at times by the profit maximising and pro-cyclical behaviour of the investment industry. It is of some comfort to know that irrational investing behaviour is an issue overseas as well. However local retail investors not only have to be alert to their own behavioural biases and the investment industry but they also need to be aware that the NZ taxation system is such that it rewards silly behaviour as well.
The government, the Reserve Bank, Brian Gaynor, just about everybody is telling NZ'ers to invest less money in houses and more in shares yet the tax system sends the opposite message. Yes, what we are talking about is the ridiculously named fair dividend rate of tax on international shares (FDR).
We have covered this giant step backwards for NZ investors previously but let's rehearse the basics again: simplifying things somewhat the way the FDR works is that the "it's our job to be fair" tax department assesses international shares for income tax on the assumption that the cash income is 5 per cent, after management fees.
Whilst on the face of it this might not sound particularly odious one needs to remember that the cash income yield of the world stockmarket is only about 2.5 per cent. So if you knock off from that number 1-2 per cent in fees and another 1.65 per cent in tax the after tax cash flow from international shares is likely to be zero at best and quite possibly negative. Mum and Dad, retired and focusing on income compare this zero figure with the 5 per cent yield of NZ shares, the 4 per cent available across the ditch and maybe 4 per cent from owning a rental property.
The love affair with things residential doesn't look so illogical in this light. The small number of investors that are told the truth about the cash flow generation attributes of their international share funds, when confronted with the negative cash flow reality, usually either revisit residential or opt for just NZ and Australian shares.
That an Australasian focus has been an inspired move recently cannot be argued but there have been long periods in the past where this strategy has been relatively unrewarding. Most importantly investors who limit their share portfolios to markets close to home are taking on more risk than they need to by eschewing diversification. We should also note that the benchmark for sensible asset allocation, i.e. what the average pension fund does, is a 67 per cent weighting of share portfolios outside of NZ and Australia.
It is a more than little ironic that a Labour government, which bravely floated the NZ dollar back in 1984 thereby permitting New Zealanders to invest overseas has, by originating the FDR effectively legislated against the practice. Make no mistake - the FDR is a quasi-capital gains tax on overseas investments that has fundamentally influenced the asset allocation strategies of many retail investors, for the worse.
By concentrating equity investment in just NZ and Australia portfolio risk is higher than it should be and completing a tax return is nigh on impossible for anyone except a chartered accountant thus history may well record the author of the tax, Dr Michael Cullen, in almost the same league as that of arch-market meddler, Sir Robert - carless days - price freeze - think big - Muldoon.
So what demons prompted Mr Cullen to introduce such bias to investment decisions? The original discussion document gave the ridiculous example of a hypothetical NZ investor who bought Dell shares in 1995. Ten years later this lucky person had apparently enjoyed a 50 fold increase in his/her wealth without paying any NZ tax. It was a great story but did this person exist anywhere but in the minds of Dr Cullen and his advisors? Hands up all those New Zealanders who bought Dell shares in 1995?
My guess is that you could get all of them into the back seat of a small Japanese car. What is more the world has changed considerably since then - US tech stocks are paying 2-3 per cent dividends and capital growth hasn't been anything to get excited about. In fact Dell shares today trade, even with the benefit of a takeover looming, at just 32 per cent of their level in 2005. Back in May 2005 Dell shares were $40 and today they languish at about $13.30. The Government should acknowledge that there is absolutely no reason today to inflict such a silly and expensive, in terms of compliance costs, capital gains tax on investors. The seriously rich more likely have structured their affairs so any earnings completely avoid the payment of tax in tax havens or they are cruising on "The World" with no domicile whatsoever.
There are more important issues that need addressing - the leverage of the banks which is an accident waiting to happen, the size of the finance sector and the high level of the residential housing market so here is a cunning plan: if the Government is serious about discouraging residential property investing why not extend the FDR tax regime to include residential property and assess all investment in residential properties for income tax as if they produce a 5 per cent yield irrespective of interest costs, rental income, expenses etc. This seems logical because if the fair dividend rate of tax is fair for Mum and Dad investing in international shares it must also be just as equitable for people investing in residential property and we wouldn't want them to feel left out.
It is a "fair" bet that despite FDR's "fairness" the extension of the regime to include local residential investment assets would see investment behaviour change in an instant followed by the government a short time thereafter. Additional benefits of this initiative might be that demand for residential mortgages takes a rather big hit, house prices, interest rates and the currency fall and the timeframe for shrinking the banking sector back to where it should be, in terms of a percentage of the country's GDP, is brought forward by a year or two.
Obviously this "cunning plan" isn't going to get implemented - politicians aren't so silly as to institute legislation that guarantees the end of their tenure in power. So if FDR really isn't fair let's put a stop to the nonsense, get that playing field more even and help retail investors to make sensible investment decisions.