‘Investing in the index is like having a bet on every horse in the race’

At a recent seminar for prospective retirees, I mentioned that there were only three practical places to invest. The first is cash, the second is property and the third is shares. I explained that every one of these options had advantages and disadvantages. Let me share my thinking with you too.

If you leave your money in the bank, there is no risk of a capital loss but there is no prospect of capital growth and no chance of getting the tax concessions offered by franking credits. And if you leave it there a long time, the value of your capital will gradually erode due to the effects of inflation.

If you choose property, you will have a large chunk of capital tied up, and because you can’t sell the back bedroom, it may well become necessary to sell the entire property, possibly incurring a large capital gains tax bill, if you need money when you retire. Furthermore, the property is likely to age as you do and need increasing maintenance. And, as we all know, it can take months to sell the property and finally see the money in the bank.

I have written extensively about the benefits of shares, and pointed out to my seminar audience that one of the major benefits is the minimal buying and selling costs and another the ability to sell in part if necessary and have the money in hand within a week or so. This ability to sell in small parcels will be even more important if Labor gains government and effectively increases capital gains tax by reducing the present 50 per cent discount to 25 per cent.

Think about two retirees – one with a $1 million investment property and one with a $1 million share portfolio. If either one has a sudden need for, say, $50,000, the property owner has to take out a loan secured against the property – no mean feat when you are retired – or dispose of an entire property and possibly cop a huge capital gains tax bill. The share owner can sell any mix of shares in small parcels and pay minimal or even zero capital gains tax.

One audience member stood up and said he had put $20,000 into a parcel of shares in 1990 and virtually lost the lot – he said he would never touch shares again.

I told the audience that I believe picking individual shares is too risky for the average individual, and they would do better to use an index fund, that is, a fund which simply tracks a market’s index. I then showed them the calculator section of my website that enables anybody to pick a starting date after January 1980, invest a theoretical sum and find out what the portfolio would be worth on a given date if the portfolio matched the All Ordinaries Accumulation index, which includes income and growth.

Most people — especially the person who asked the question — were amazed to find that his $20,000, if invested in January 1990 into an index fund would today be worth $246,400 provided he reinvested all the dividends. That’s a capital gain of 9.05 per cent per annum.

Now, I appreciate that there is a range of managed funds which invest in shares, and some of these do better than the index. But the undeniable fact is that 80 per cent of managed funds do not beat the index. Investing in the index remains one of the simplest, safest, lowest-fee investments I know. As a financial advisor of my acquaintance pointed out recently, “Investing in the index is like having a bet on every horse in the race!”.

Just remember, it is normal for the index to have six positive years and four negative ones every decade. This is why you should always have a seven-to-ten-year timeframe in mind when you invest in any share-based investment.

Have you been burned by an investment in an individual stock? Did it put you off shares entirely?