Doing the maths on investments

Graham Hand is managing editor of leading financial newsletter Cuffelinks. In his first column for YourLifeChoices, he explains investments and a lesson learnt after buying commemorative $5 coins in 1988.

In 1988, I bought $750 worth of special $5 coins, minted to commemorate the opening of Australia’s Parliament House. I figured it was a one-way bet to investment success. They were legal tender, costing $5 and would always be worth at least $5, and if they became sought-after by collectors, the sky was the limit.

I found the box of coins recently while cleaning the attic. They are made of aluminium bronze, so not only do they have no valuable metal content, but they also look slightly tarnished after 30 years. Eager to learn about my booty, I called a coin dealer to check their value.

“They are legal tender, so they’re worth $5 each,” he said with little enthusiasm.

“But they’re 30 years old, packed in a commemorative sleeve, marking a proud moment in Australian history,” I replied, realising my expectations of untold wealth were draining away.

He sounded rather tired. “They made millions of them, and please don’t bring them in here. We’d charge you a handling fee to take them to the bank and collect $5 for each.”

After that, I spent an hour in a major bank branch where they eventually accepted them, so at least I received my money back, right? Wrong.

 

The importance of real returns
Most of us delude ourselves about our investments. For example, we talk about our winners, while the losers sit quietly in the bottom drawer. 

The biggest delusion is not adjusting rates of return for inflation, using what is known as the real rate. Every investment return should be expressed in real terms, because it reflects the true purchasing power of money. Even with inflation as low as 2.5 per cent, $100 today will need to grow to $102.50 to buy the same basket of goods in a year. If your money is in a term deposit earning two per cent a year, it’s a negative yield in real terms.

The Reserve Bank of Australia provides an excellent inflation calculator. Every time you think about money or investments over a long time period, put the numbers into this calculator for a reality check. It’s simple to use. All you need is the year you bought something and how much you paid, and the amount is adjusted for inflation to a current day equivalent.

Take my $5 coins (yes, please take them). My $5 paid in 1988 adjusted for inflation would now be worth $11.46, up 129 per cent, with an annual inflation rate of 2.8 per cent. If my coins had doubled in value, I could have deluded myself that turning $750 into $1500 showed my investing prowess, but in truth, my money would not have retained its purchasing power.

Looked at another way, my $5 is worth 129 per cent less, or $1.78. I didn’t really get my money back.

Many people proudly boast of the increase in the value of their house or investment property. Let’s say you bought an apartment for $500,000 in 1998. Average inflation of 2.6 per cent compounded over 20 years reaches $838,000. Okay, property prices have done well in the last five years, but not only must you adjust for legal fees, stamp duty, maintenance and renovations, but the real price is 68 per cent higher or $338,000 more than you paid.

While it might sound good to say you doubled your money if you sold the apartment for a million dollars, it’s likely you earned little in real terms (of course, there are many other factors such as rent and loan payments to consider in calculating the total real return).

 

Are we close to an Australian share market all-time high?
At the start of August 2018, the popular measure of the value of the Australian share market, the ‘All Ordinaries Index’, was about 6400. The all-time high for the index is 6873 in October 2007, before the Global Financial Crisis. It then fell precipitously to a low of 3112 in March 2009, a period that destroyed the wealth of many Australians. Over the past decade, the market has clawed its way back, and a strong second half of 2018 may see the all-time high threatened. There will be headlines and celebrations of the good times across the media.

But the All Ordinaries is a price index, similar to the price of apples or bananas. To measure the all-time high in real terms, the 2007 level should be adjusted for inflation. Using the inflation calculator, 6873 in October 2007 is 8795 now in real terms.

So when the news breaks one day that the Australian market is at an all-time high, you can wisely tell everyone that it’s a couple of thousand points or 28 per cent away in real (inflation-adjusted) terms, and everybody should stop deluding themselves. Party pooper!

Cuffelinks publishes a free weekly investment newsletter, which will always be free for YourLifeChoices members, and includes insights from hundreds of market experts. Register here to receive it.

 

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