Money Matters: Invest in tomorrow to free up your lifestyle

By MARY HOLM

Q: I was wondering how you would recommend I invest a $200,000 inheritance.

I am a young (early 20s) university student and have no dependents.

I am also fortunate that I do not have any immediate pressing need for the use of the additional investment income this inheritance could bring.

Maybe in a few years the situation will have changed, but in the meantime I am interested in making high returns and am willing to accept quite a high level of risk in achieving them.


A. Lucky you. You're in a perfect situation to take on a bit of risk.

Here's what I would do: take a couple of thousand dollars and celebrate with it. Have a party, go on a trip, buy a car.

Then pay off any student loans or other debt, particularly any high-interest debt from credit cards, hire purchase and so on.

The rest? You could invest it fairly conservatively and then draw on it as you need money, perhaps to buy your first home, or set yourself up in business.

In support of that is the strong argument that you shouldn't be borrowing any money if you've got funds invested elsewhere - it's a variation of the debate over whether people should repay their mortgage or save.

Still, in your circumstances I suggest you ignore that and invest the money with the idea that you won't touch it until you retire.

That would free you up, for the rest of your working life, to go for a more interesting job over a high-paying one, or to take a year off every now and then to travel or do something creative.

With a growing savings fund behind you, you won't have to be as cautious as other people.

How big will that fund grow?

Let's say you start with $190,000. Being conservative, we could say your money might grow by 2 per cent a year after inflation and taxes. After 40 years, you'll have almost $420,000 in today's dollars - meaning you'll be able to buy what $420,000 will buy today.

If you don't touch the money for 50 years, it will grow to more than half a million dollars.

Now let's get optimistic, and say your money grows by 5 per cent, after inflation and taxes.

After 40 years it would total more than $1.3 million. After 50 years, it would be close to $2.2 million - a nest egg nobody would sneeze at.

One great advantage of such long-term investing is that you can afford to take risks.

The value of your investment might drop for quite long periods, but in exchange for putting up with that, your average return should be higher. Over 40 or 50 years you will probably be quite a lot better off.

Don't, though, take on the risks that come from not spreading your money around.

Research shows that, on average, people are not rewarded for that.

The simplest, and probably best, high-risk, high-return investments are shares.

Even with a sum as large as $200,000, I think it's better to invest in a share fund rather than holding shares directly.

The costs in a fund are higher, but they're not too bad if you pick wisely.

Your investment will be easier to run, and you can get much broader diversification in many funds.

A worldwide index fund is one good possibility.

Index funds invest in all the shares in a sharemarket index.

The fund managers make no choices about what to buy and sell, so the fund is cheap to run, and fees are lower than in other share funds.

For more on index funds, see below.

If you really like risk, you might put some of your money into one or two of the venture capital funds springing up.

They invest in a range of start-up businesses, which tend to either go broke or do brilliantly.

If a fund spreads its money over several such businesses, its risk is reduced.

Talk to a couple of sharebrokers or financial advisers about the possibilities. Ask for information about both listed (on the stock exchange) and unlisted share funds.


Q. You should ensure your own advice is correct before criticising others.

In your articles in the Herald you seem to favour index funds and annuities.

You should be aware that index funds have no downside protection. What will happen to them when the next bear market comes (and one day it will)?

You should point out that index funds in a bear market, which can last three to four years, will be unsuitable for all but the long-term investor.

It is probably safe to assume that the bulk of funds invested in New Zealand belong to people over 65. Therefore, you should qualify who you think certain funds are suitable for.

Index funds do not suit too many of these people, as many of them have shorter-term horizons.

With annuities, you should point out that they are taxed at 33 per cent on income and capital gains, you lose access to funds when you buy an annuity (a one-way street), and to some extent they will disinherit your children as well. This is probably why hardly anyone in New Zealand buys them any more.

I think that your articles have been very useful to many people, but you must take care to qualify your advice.


A. I feel like a kid being told off by a teacher, with all those "shoulds" directed at me. Want me to do 100 lines? OK, here goes.

You're right, I do generally favour index funds over active share funds, in which the managers choose their investments. The above Q&A is an example.

One reason is index funds' lower fees.

Also, in New Zealand, active funds pay tax on capital gains, whereas index funds generally don't.

What's more, active fund managers' investment choices don't always turn out to be good.

It's true that the top-performing share funds are always active. But so are the bottom ones. And nobody can be certain, in advance, which will be which.

On average, index funds perform better, especially after taking fees and taxes into account.

Turning to your point about "downside protection," I am "aware" that index fund managers can't buy and sell shares when the market is falling in an effort to try to stop the fund's value from falling.

My first response is that nobody knows at the time that the market will continue to fall.

Whether it's been dropping for a day or for a year, today could be the start of an upturn. Making a "downside" move might turn out to be dead wrong.

Looking backwards, though, we can say that a certain period was a bear market.

And there's limited evidence to suggest that in bear markets, the average New Zealand active fund doesn't do as badly as index funds, says Kevin Turner, a consultant with investment consulting firm Frank Russell, who has researched this question.

On the other hand, the average NZ active fund tends not to do quite so well when the market is rising.

Mr Turner suggests this may be caused by a "Telecom effect." Active managers don't tend to hold as many Telecom shares as most index funds do.

Telecom has such a big impact on the New Zealand share market that when its share prices rise, the market often rises too, so active managers tend not to do so well.

But when Telecom and the market as a whole fall, active managers don't fall so far.

When you look at worldwide share funds, there has been a similar tendency in the past, says Mr Turner, with Japanese stocks taking the place of Telecom.

He also speaks of a psychological factor.

Research shows that people dislike losing more than they like gaining.

That suggests that, in a bear market, they might prefer an active fund, where they've at least got a chance of not losing, even though there's also a chance that their investment will fall more than the market.

In an index fund they will inevitably lose.

Another point: while index funds don't pay tax on capital gains in a rising market, that turns into a disadvantage in a falling market, when they can't claim a tax break for capital losses. All of this amounts to saying that you may have a point: index funds may be a worse proposition than active funds in a bear market.

But - and this is a major point - over time, share funds rise more than they fall.

Why else would we invest in them?

Given that index funds have done better than the average active fund in rising markets, they seem the better choice over the long haul.

Speaking of the long haul, you're quite right that index funds certainly are "unsuitable for all but the long-term investor." So are active funds or any other investments in shares.

But I don't need your "shoulds." I always say that.

Next point: I'm not at all sure that the bulk of funds belong to people over 65. They are, after all, using up their money, so their balances are dwindling.

In any case, many 65-year-olds expect part of their savings to last 10 or 20 years or more. It's therefore not at all inappropriate for them to have some of their money in index funds or any other share investment.

Regardless of age, if you need money in less than three to five years, you should probably avoid shares. If you're conservative, make that 10 years. Again, I've said this many times.

All your points about annuities are correct.

The taxation takes place at the insurance company level. Annuity holders pay no further tax. When you receive an annuity quote, that tells you what you'll get after tax (unless the corporate tax rate changes).

So everyone knows where they stand.

It's true that you can't undo an annuity and get your money back out. And that your heirs miss out on that money, unless you die within a guarantee period.

It's also true that I've said this before.

Despite their drawbacks, many people are highly satisfied with annuities, mainly because of the security they offer.

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