Cracking the sads with the media, episode 426: The GFC and superannuation

Those who read this blog will know all about my thoughts on the media. Some of you will also be probably saying, “There’s been a GFC. Why have you been so silent?”

I admit to being busy with other stuff in meatspace, and I haven’t blogged in a little while, so shame on me. But finally, I’m going nuts again, and you can all shut up and read for all I care because there’s stuff that simply has to be said.

The media has been all over superannuation funds for quite some time. True, this is the biggest exposure Australians will ever have to volatile investment markets outside their own home. And yes, for those of you who like to read between the lines (you know who you are) there was a subtle dig buried in that sentence.

Part of the negative press aimed at super funds is simply unwarranted, and here’s the reason why: Chances are big that you need to shoulder what could potentially be the lion’s share of responsibility for that diminishing nest egg.

That’s right folks. You, or at least most of you who are reading, are almost fully culpable. Not your super fund. Possibly your financial adviser, if you have one, but this ain’t aimed at you if you have. That will be the subject of a different post, so if you have a financial adviser, you can consider yourself in the clear. At the moment.

For those of you who don’t use a financial adviser, I suspect that you are having a grand old time criticising your super fund for what is, for most of you, a year and a half of negative returns. Let’s face it; we love to have a go at stuff that shits us. As a nation, we love to stick it up the poms when they’re complaining, but to be frank; we’re a nation of whingers. Possibly even worse than the English.

We’re also a nation that hates to accept personal responsibility.

Put these two traits together, and you’re left with the kind of sensationalist reporting that sees the media (News in particular, but Fairfax is a close second) putting out tripe like this or this and Australians lapping it up like the sheep that that they are.

I’ve said it before and I’ll say it again: Australians are shithouse investors and it’s time that you were all told. As an investor, the chances are that if you’re reading this, you suck.

Permit me to now explain why you potentially suck.

Superannuation is not a type of investment. It’s a tax environment.

John Smith (not his real name) is 58 and recently retired. Naturally, he’s rather upset at his super fund’s return of -20% over the past year. And he’s only in the fund’s ‘balanced’ option.

He spots an ad for an online account in the newspaper paying 4.50% and thinks to himself, “At least this is positive.”

John empties his super fund and sticks the entire amount, lock, stock and barrel into this online account. John is, quite frankly, a goose.

On John’s current marginal rate of tax (30%), the rate of interest becomes less attractive at 3.15%, not including Medicare.

On top of this, John simply doesn’t want to know that he could have invested in a cash option in his super fund which is only taxed at a concessional rate of 15%. He’s that pissed off. In fact, the bank that offers this account also offers an identical account to self-managed super funds, thus yielding a superior return after tax of 3.825%.

And because John is not 60 yet, he’s going to be in for a fright at tax time when he finds himself hit with a tax bill in the tens of thousands of dollars on his lump sum super withdrawal.

Can it get any worse?

You bet. John also couldn’t care less that, had he switched to the pension phase of super, his assets aren’t even subject to tax on their earnings. Holding this online account within a self-managed super fund in the online phase would have yielded the full 4.50%.

Not only that, because John has withdrawn the amount from super he is going to have serious problems if he ever wants to start up a super pension, because he won’t be able to get the whole thing back into super if he tries. Amounts able to be contributed to super in a financial year are subject to contribution caps, which limits his flexibility in this regard.

John might be a retiree, but I have no sympathy for him.

Notice that I haven’t talked about John’s potential exit fees, John’s lost insurance coverage or the likelihood that he’ll miss a market upswing. Well I wasn’t going to, anyway.

You choose your investments (part 1)

Jo Phelps (not her real name) is 40 and a manager with an HR recruitment firm.

About a year and a half ago, she received her annual super statement from her fund. Jo was in the balanced option of her fund which had been performing quite respectably for the past four years posting regular returns of 15%.

Her balanced option is about 70% shares and property and 30% cash and fixed interest.

But when she saw the returns on the fund’s ‘high-growth’ option, her eyes lit up as it showed average returns of 25-30% regularly over the past 4 years. The high-growth option is predominantly shares with a smattering of property. There is about 3 or 4 % cash in the portfolio.

Jo rings up her fund and demands to have a switch form sent out. The staffer on the end of the line helpfully suggests to Jo that she speak to a financial adviser before going ahead with the switch.

Jo helpfully suggests to the staffer that she takes her offer of financial advice and sticks it where the sun doesn’t shine, because after all, all financial advisers only recommend stuff with kickbacks for them. “I don’t need a financial adviser,” she casually mentions, “please just post the form.”

The switch was processed and now Jo feels shell-shocked by negative returns of -35%.

Jo would like to know this:

1. Aren’t fund managers meant to see this sort of stuff coming and take action to stop it?
2. I mean, I know that there’s no such things as psychics, but couldn’t they have short-sold or something? and
3. Given that employers have to contribute into superannuation, how come the government can’t guarantee it like bank accounts? I mean really, all Australians should be protected from the downside, shouldn’t they? They guarantee bank accounts; superannuation funds aren’t really that different…

Jo had no idea that a high-growth option could go down as well as up. Mind you, if you’d told her a year and a half ago, I don’t think she would have given a stuff.

You choose your investments (part 2)

Brad Dawes (not his real name) works in a blue-collar job. He’s twenty-something.

When he started with his current employer, he couldn’t be bothered filling out the super forms. He did ask at the time, “So let me get this straight: I don’t have to fill this in. You’ll sort it out for me with this ‘default’ thingy?”

To which the answer was, “Yes”. Natch.

About the only form that Brad filled in correctly was the bank account details for where he wanted to be paid.

The super from Brad’s current job now goes, by default, into the balanced option of the default super fund offered by his employer. Brad doesn’t know how these funds are invested, and really couldn’t care.

Brad’s super is all over the place. All default funds provided by previous employers and all different.

All the negative press about super has Brad looking at the one or two statements (out of the six or so funds he’s ever joined) that he regularly gets. Brad now has the following criticisms of super:

1. I could invest my funds better than my super fund could;
2. What’s with all these fees coming out? This is a scam;
3. What do you mean, ‘Share prices have gone down?’ Isn’t super meant to be invested in property which never goes backwards? (This is Brad’s opinion, not mine)
4. I didn’t choose to have my super here. I shouldn’t suffer as a result.

About the only good thing you can say about Brad is that he’s finally shown some interest (even if only passing) in his super as a result of this.

But he’s dead wrong about not choosing to have his super where it is: He chose alright. He’s also not worthy of sympathy.

Retirees are not always worthy of extra sympathy

Let’s go back to John Smith again. Sorry John, but you’re particularly worthy of some stick.

About three years, John decided he’d retire when he turned 58.

John’s super was in the balanced option, which his super fund recommends for periods of 4-5 years or longer. That’s right: 4 to 5 years minimum.

John consciously chose to leave his super in the balanced option, because, “It’s doing pretty well there.” Unlike Jo, he looked at the more aggressive options and thought that they seemed pretty aggressive for him. That’s OK.

He looked at the less aggressive investment options and was put off by the lesser returns. And I’m sure you can see why.

But, looking at the recommended minimum timeframe on his balanced option, he thought, “Well it’s only a recommendation.”

Fast forward to a year and a half ago. John looked at his super fund again, and he thought the exact same thing.

That’s right. With a year and a half to go until retirement, John completely disregarded the recommended minimum investment periods and consciously chose an investment option suited to 4-5 years or longer.

John is now shitted off with his super fund when really, John should be shitted off with himself.

It’s probably worth mentioning that you should plan your exit strategy from the outset. John didn’t even do this with three years to go.

---

So what can investors learn from this?

1. You choose your investments. Read the sodding disclosure statements – they may look like slickly produced marketing paraphernalia (and to be honest, most are) – but they have to contain stuff you need to make an informed decision.
2. The default option isn’t some kind of magical tool that posts excellent returns while protecting investors from market downturns.
3. Read the bits about how your funds are invested. Also read the bits about recommended minimum timeframes. If you don’t understand how an investment option works, ask an adviser, ask the fund and if they can’t tell you, steer the fuck clear of it.
4. No one is psychic. Especially not fund managers.
5. Have you switched to cash? You may learn the hard way that markets can rise violently as well as fall. Chances are you’ll miss out and by gee, won’t it be costly?
6. No one rings a bell to let you know that the market has bottomed out. Think of this if you’re attempting to time your way back in.
7. Super investments are taxed at 15 %. Non-super investments are taxed at your marginal rate. This should be a no-brainer but you would be surprised at the number of people who couldn’t give a shit about this.
8. When you next whinge about your super fund’s non-performance, compare it to something that vaguely resembles it. Comparing a balanced option with anything other than a balanced non-super managed fund is only going to make you look like a moron. Even that is pushing it. Do not compare a balanced super option with an online bank account – geez do I have to spell it out?
9. Good, fee-for-service financial advisers are there to help out people who know bugger all about investing. There is a very good chance that you form a subset of the latter half of the previous sentence.
10. I’ve heard people whinge about their super fund’s performance who are in defined benefit schemes. I’m not kidding. If you don’t know what investment option you’re in, or even the fund’s design, find out. Number 3 above should help you.

That’s it. I’ve had a gutful. You can all get stuffed.

Disclosure: This blogger works for a service company that services super funds. He also used to work as a financial planner. And he most likely posted bigger declines in his superannuation balance than the lot of you (if expressed in percentage terms).

Standard but necessary disclaimer: This is not advice. Only a complete idiot would think that any of this constituted advice. It's not even vaguely reasonable to consider this to be advice. If you are in any doubt as to the content of this, see a good, independent financial adviser immediately. They do exist.

Are Fiscal Deficits Really That Bad?

We've been hearing a lot in the media about this subject at the moment. The Prime Minister, the Treasurer and the Opposition Leader are forthright that budgets should not slip into deficit.

Yet we heard the other day from the governor of the Reserve Bank, Glenn Stevens, that we probably shouldn't be so concerned should it actually happen, provided that increased government expenditure was being made in the right places. Presumably, his definition of "public investment" is a reference to increased expenditure in the regions covered under the heading, "infrastructure".

After this seal of approval from Stevens, it wasn't then, a real surprise that the Treasurer and the Opposition Leader voiced their disapproval of such moves. Deficits are seen by the electorate as a sign of fiscal irresponsibility and are considered political dynamite for an incumbent government, even if they can be defended on prudent economic grounds.

So, for the layman, why might a fiscal deficit be defensible and when might a government use it?

The answer lies in the government itself. Governments are traditionally the biggest business in a national economy. In most places, anyway - I know about countries like Finland where the domination of companies like Nokia almost relegates government involvement to "minor player" status.

Governments make money through taxation and then spend it through government expenditure. How much and where the government spends then becomes rather powerful as it can turn entire economies.

The power that government expenditure has was really only realised towards the end of the 1930s during the Great Depression, when an economist named John Maynard Keynes worked out that if people and businesses weren't spending, then governments had to pick up the slack.

Governments then went berzerk, borrowing and spending. In fact, the Australian Federal Treasury did not post a single fiscal surplus between the thirties and the late eighties. I was surprised that it took this long, given that Keynesianism fell almost entirely out of favour in the late seventies as stagflation thanks to rising oil prices took hold, and increasing importance was places on interest rates to sort economies out. This, incidentally was single-handedly due to the work of another economist in the sixties, Milton Friedman, who predicted the events of the seventies, and was lauded as an economic prophet of sorts, as a result.

The discarding of Keynesianism and the adoption of Monetarism was merciless. But the strange thing was that as interest rates started to play a greater role in regulating economic activity, a kind of reverse-Keynesianism crept in in a number of places, in particular, the US and the UK where Ronald Reagan and Margaret Thatcher launched a dual assault on the role of government spending. Consequently, in these places, the end result of cutting government services and slashing taxes was that more money was free to pump up these economies. This actually led, in parts, to the record inflation of the eighties, followed by the crash of 1987. And the resulting recession, which was a fierce one. Strangely though, Reagan and Thatcher are lauded by conservative politicos as visionary.

What a bunch of twats.

Reagan and Thatcher were reducing government participation in the economy and increasing reliance on interest rates which pumped more money into economies that eventually overheated as a result. The recession of the early nineties cost Thatcher and her successor John Major their jobs, as well as eventually ensuring defeat for George HW Bush.

Keynesian economics has a time and place. Using fiscal power to fuel the fires of booming economies is not it. Reducing the role of government fuels economies and is thus, despite what conservative economic pundits will tell you, Keynesian.

Over twenty years since the crash of 1987, it appears that the role played by government expenditure is back as a viable tool for getting economies moving again. In Australia, we're now in a position where we're seeing major economies like the US and the UK, possibly even Europe, moving into recession once more, and having to resort to spending their way out of the mess.

Australia isn't yet obviously moving into recession, hence the obstinacy on the part of the government and opposition, however, Stevens has a point, which he spoke about in another part of the same speech: If our economy slips downhill as a result of us talking our way into another recession - Stevens isn't the first to notice this - can't fiscal deficits be used by Australia as a sort of pre-emptive strike?

I don't see why not.

The Elephant In The Centre Of The Room

There's another reason why those of us outside the US want Barack Obama to win the US presidential election on Tuesday. Imagine the carnage that will eventuate on world markets if the McCain-Palin ticket gets up?

It's almost too frightful to contemplate.

Discuss.

Go Placidly Amid The Noise and Wait

Given the carnage on the markets over the last week or so, it was only a matter of time before the we got some irresponsible media reports.

So far, I give a qualified single thumb up to the media for restraining themselves from the kind of sensationalist and hysterical spectacle we saw during the tech wreck. At no stage have we seen the media, en masse anyway, hinting that everyone should sell up before (paper) losses get too great. At least, in Australia, anyway.

The reasons for this are twofold:

1. The tech wreck ended up as, by and large, a bit of a non-event in this country. We're not a hi-tech country. We weren't subject to mass IPOs of dubious quality floating on the market in the same way that countries like the USA were. Needless to say, those in the media who got a little crazy after the events of 2001 looked like geese, and probably felt a little sheepish afterwards as well.

Enough with the animal insults.

2. The Australian economy is in great shape. Our banks are totally not in need of "guaranteeing" in the same way as what is going on in Europe and North America at the moment. Never mind that, though. Our Federal Government guaranteed them today.

OK. Up until quite recently, we did have a bit of an inflation problem. On top of that, we did have a real estate bubble that, thankfully, appears to have sprung a slow leak thanks to our (still relatively) high interest rates. But in the overall scheme of things, we're doing OK.

We don't have a property price crisis like over in the States, though. Yet.

It did make me wonder though, during the week, when I turned on the news to see that some commentators are now starting to consider the distinct possibility that a housing price slump could hit Australia. I would personally welcome this, however, it could cause some grave havoc.

Consider this: In the 1980's, the median house price was set at around about three times gross household income, based on figures I saw during the week. Now, it appears to be about seven and a half times. In real terms, this is simply too much for most householders to afford, and should ring alarm bells anywhere, in the same way that the USA's foreign debt at around 350% of US GDP is at the moment.

By the end of the week, the massive spin doctoring machine that is the Real Estate guilds in each state had reversed this talk, and were even talking up their industry, with headlines like "Housing Prices Bottoming Out", amongst others.

You have to hand it to the RE guilds. The media is totally in their thrall. Media Watch, a couple of weeks ago focused on the attention that Sydney newspapers paid the sheer spin and dishonest figures that the Real Estate Institute of New South Wales like to put out to support their arguments. Figures that, when compared to those churned out by the Australian Bureau of Statistics, seem totally incredulous. The Daily Telegraph even held up the REINSW as being the "peak body" when it came to these figures.

I'm at the point that when I see a property story on the news, I simply don't believe a word of it if there is even only a one-word quote from anyone associated with these bodies. The fact is, the RE guilds represent real estate agents. They do not present fair figures honestly, and how the media don't see through the rubbish that they put out every week is one of life's little mysteries that we'll never see solved.

But on the whole, the media has been relatively controlled on the stampede for the exits that we're seeing in equity markets at the moment.

I did, this week, see something that made me wince.

Marcus Padley, a stockbroker, and regular columnist for The Age usually writes some insightful articles on finance.

Padley, for those who don't know, possesses a sharp mind and one of the silliest egos in finance this side of the late Rene Rivkin. He writes a tip sheet, which is relatively highly regarded, called "Marcus Today". Obviously, Padley was oblivious to the groans that went on around his office when he decided on that one.

Padley wrote an article in The Age which in my honest opinion, is the stupidest and most irresponsible op-ed piece during a financial crisis that I have ever seen. It was titled, "Take your money and run - it's worthless advice".

Cop a geek at this. Padley writes the following choice quotes:

"If I was still holding stocks, yes I'd still sell them... But I come at it not with an opinion about the direction about the sharemarket, but from a human perspective."

Padley has essentially held out a red rag to the bears and said, "Go on. Sell up. You know that you want to."

"But [don't hold on to your stocks] if you can't afford any more losses and are in pain. The definition of "can't afford" in my book is this, if I had to go home to my wife and tell her our expectations are going to have to be lowered."

(My emphasis)

OK. We're all going to have reduced expectations as a result of this. In Padley's opinion, everyone must sell everything, lock, stock and barrel.

"Who wants to play in a casino? The volatility has reduced the market to a casino. In a casino, no opinion has any value."

Your average investor might just as well give up at this point and shoot craps, because this is what Padley is suggesting that the market is no better than.

This is despite the fact that we know a great deal of market behaviour over the long term, which tilts the odds firmly back in the direction of an investor. Unlike our craps table at the casino, which is rigged against you from the start.

This is just the first third of an article which Padley manages to break every rule in responsible journalism. By essentially saying, "everyone should sell, without question," Padley has crossed the line into Personal Financial Advice territory, and should have the book thrown at him by ASIC.

Elsewhere Padley offers these little gems, which I have paraphrased:

• Avoid losses. Therefore, avoid the market as well. It doesn't matter if you are in it for the long term or not.
• I agree that the herd mentality is good. Stick with it and you can't go wrong.
• Optimism is just that. Even if it backed up by the sheer force of history that suggests that investing for the long term requires a buy and hold approach.

Honestly, the whole thing almost reads like a parody. If this is Padley's idea of a joke, it's not funny, and he should be hauled over the coals as soon as the moment arises.

On top of this, Padley is a stockbroker. This means that whenever another sale is done, he collects a commission from it. Ka-ching!

Out of 5 stars, I give this disgraceful effort a bitch slap. Padley needs to wake up to himself.

Standard but necessary disclaimer: Only a complete idiot would think that any of this plausibly constituted advice. It's not even vaguely reasonable to consider this to be advice. If you are in any doubt as to the content of this, see a good, independent financial adviser immediately. They do exist.

Brutal carnage!

We've seen a lot of action on the markets in the last few weeks, and I suppose that some of my regular readers are probably wondering, "Hey Dikkii. You've been awfully quiet on this."

And I suppose that I have. The thing is, I'm neither greatly spooked, nor am I greatly interested. I've had more important fish to fry at this point in time, but I have been following at a distance.

So I thought that I'd get my thoughts down on paper and attempt to try to put together some thoughts on the week that we've just had, because it has been a doozy. I'm not about to go the way of the financial media and suggest that the global market slide that we saw represents the death of capitalism, though. This has been some disgraceful irresponsibility coupled with a complete lack of knowledge about what capitalism really is. However it is interesting to note that where chickens have been coming home to roost, this blogger did see some of it coming.

1. The "Death of Capitalism"

This is just plain lazy reporting.

Capitalism is just the interplay between those two non-physical forces, Supply and Demand. Nothing more, and nothing less.

Supply and Demand, in turn represent the twin human emotions of greed and laziness.

Note that I haven't mentioned fear. Fear certainly impacts on Supply and Demand, but it is not an emotion on what they're built. Allow me to demonstrate:

Imagine that you are a buyer of something that we'll call "doo-hickeys". Greed and laziness suggest that you'll be more willing to buy more doo-hickeys when prices are low, rather than when they're high. Or to put it another way, you are susceptible to a good bargain, and you're turned off high prices. This, folks, is how the force of Demand works.

Let's now switch roles, and suggest that you are the manufacturer of the aforementioned doo-hickeys. It's via greed and laziness that you are willing to pump up production when prices are high, rather than when they're low. Essentially, you're paying in doo-hickeys for money, and when you can get more money per doo-hickey, you want to make the most of it. Which really makes Supply a sort of inverse Demand priced in commodities rather than money.

So how does fear impact this?

Essentially, fear attacks in waves. Usually, fear inhabits a small corner of one's mind, and is not sufficient in its own right to interrupt the greed and laziness emotions.

However, every now and then, the amount of fear that is there reaches a critical mass in an individual, and this will override the greed and laziness to the point where they fail to register. This is called panic.

So for a buyer of doo-hickeys who's financially fearful, they're going to not be so keen on buying those doo-hickeys, because the fact that they're parting with actual cash to get those doo-hickeys becomes worrying. They'll be worrying about the re-sale value of those doo-hickeys. They'll be worrying about whether the doo-hickeys are any good. In short, they'll be worrying. Or fearful, if you like.

Fear affects suppliers of those doo-hickeys as well, but in a different way. Remember how I said that Supply is a kind of inverse Demand? Well, imagine that you're seeing less and less dollars per doo-hickey sold. You may eventually start fearing that doo-hickeys will eventually be worth nothing. You might choose to dump your entire stockpile on to the market, as you fear that to delay might result in this stockpile eventually becoming worthless.

And even though prices are falling, you may even choose to ramp up production in the hope that prices fall even further, allowing you to buy some back later on to sell when prices stabilise, allowing you to realise a small profit for them.

You can see, just from these examples, that Supply and Demand morph into almost entirely new animals as a result of the introduction of fear, however at no point do they go away. Fear just causes greed and laziness to take on lesser importance in the whole system.

Fear also seems to throw rational thought out the window.

And so it is with assets as opposed to the commodity that we've called doo-hickeys. Supply and Demand work in almost entirely the exact same way. Except when fear comes along, and then it's panic stations.

Supply and Demand will not go away. They'll just take on a different shape for a while. The same can be said about capitalism - after all, it's really the same thing.

2. Complex financial instruments

A little while back, I bemoaned complex financial instruments, and how they appear to exist only to generate fees for the issuers of them.

Since then, we saw one capital guaranteed product issued by Macquarie Bank hit the wall and announce that under the rules that it operated under, investors would get their money back. In 2013. But no additional returns would be paid.

No returns at all until 2013 is a frightfully long time for your money to be going nowhere.

Elsewhere, outside these complicated little instruments that are designed to prey on investor fear, we have lovely little terms permeating the financial department stores, and catching investing novices and veterans out alike.

Frankly, people should fucking well go to gaol for Collateralised Debt Obligations, because these little bastards were designed to mislead. How the fuckety fuck can one bundle up a bunch of bad loans as an AAA-rated security I'll never know.

In Australia, we had all these capital guaranteed funds out there that were marketed a bit like this:

You could earn as much as 20%* (*based on market performance). What's more, we'll capital guarantee them, so if they haven't performed in ten years, you'll get your money back.

Investors now are pretty much locked into things that will now look only as good as what they paid for them in the first place. Which makes only the capital guarantee worth something - the representations on returns were something that should have never appeared in print to begin with.

Contracts For Difference - oh these are going to be fun. I'll come back to these a little further on, but I suspect that we're going to hear a lot about these in the months to come.

Look. The upshot of all this is this: If you can't get your head around how a particular financial product works, then for heaven's sake stay away from it.

3. Derivatives, Sub-Prime Loans and the US Housing Price Crisis

In March 2007, I made a throwaway comment in answer to a comment left by Einzige at this blog that we were yet to see the effects of the US housing price crisis.

I was not looking into a crystal ball, people. I was reading newspapers and watching TV, and if people were talking about it back then, then we knew that there was a problem.

Fast forward to September 2008 and we know now where this has lead. Sub-prime loans have basically now brought down nearly the entire US financial system thanks to an oversupply of housing and a sudden rise in interest rates. Is Alan Greenspan to blame?

Hardly, at least in the first instance. What is to blame is a banking sector that assumed that property prices never go down.

Property prices, just like shares, derivatives and commodities go down sometimes. Can you believe that?

Warren Buffett made the bold assertion back in 2002 that the sudden explosion in derivatives was playing with fire. Why, oh why, can't anyone see that if Buffett, the closest we have to evidence of minor deities, is critical of something then it must be bad?

I mean really. Did Orange County, California file for bankruptcy for nothing?

Hmm. Contracts For Difference. Why did that thought just pop into my head again?

4. Freddie, Fannie, Lehman and AIG.

This month has seen bailouts on an unprecedented scale.

Companies should not be being bailed out. Companies should not be so big that they need to be bailed out by governments.

If there is near total domination of a market by a particular company, this is bad. Back in the early part of this century, Standard Oil was broken up. It was too big to allow the market to operate effectively.

We haven't learnt anything from that. In financial planning, a lot is made of diversifying your investments in order to spread your risk. And granted, Standard wasn't about to go down, but no one benefits from this degree of market dominance.

Economies should also learn from this. How the hell could the US mortgage sector be dominated (I nearly wrote "denominated") by just two companies? Just like investors, economies need to spread their risk.

In Australia, banking is dominated by four companies. Five if you count St George Bank, but it's about to be consumed by Westpac, so really, it only is just four.

Once again, this lot are bleating about being allowed to merge further. This certainly shouldn't be allowed. "But it allows us to build scale in order to become globally competitive," they say.

"Go out and build scale in the rest of the world," I say, "You'll have to eventually."

A free market might be about letting companies build this kind of dominance over time. "Free market economics" also suggests that companies genuinely want to pay tax voluntarily, rather than being made to do so. I think you know where I'm going with this.

5. Stock borrowing and short selling

It's been argued that eventually, short-selling en masse will cause even respectable firms to be completely frozen out.

I applaud the efforts of some countries this week in banning the practice.

In Australia, naked shorts were banned. Rather than something out of Benny Hill, this now means that you cannot sell shares that you don't have. In other words, you will now have to borrow them or, gasp, buy them first.

I'm not actually sure how much naked shorting was going on. It must have been quite a bit because on Friday, the market reacted as though share prices had had a bomb fuse lit underneath them. In any event, I'm not sure that hedge funds are solely to blame.

Let's talk Contracts For Difference. Or CFDs, if you like.

In the early noughties, these were introduced on to the market as a mechanism for "spread betting" on the market. You could go long or short, and in later versions, you can now trade them on the market, rather then selling them back to an intermediary and you can get paid dividends on CFDs that you own if a dividend gets paid on the underlying security.

How do the intermediaries who underwrite the CFDs do it? Well, one would expect that they dabble in the market themselves.

And if there are suddenly a lot of their clientele shorting BNB, doesn't the underwriting institution have to short BNB as well?

What I'd really like to know is this: How many short positions on close of business Friday hadn't been closed out when the ban on naked shorts went through? And how are brokers, in the short term, anyway, going to police the ban?

Folks, we are going to see more carnage hit the markets in a big, ugly and undignified way. And even though we consider ourselves immune in Australia, we're certainly not.

I plan to be getting in and cleaning up on the mess that's left behind. But I don't mean fixing it.

Disclosure: This blogger owns shares in Macquarie Group Limited.

Standard but necessary disclaimer: This is not advice. Only a complete idiot would think that any of this constituted advice. It's not even vaguely reasonable to consider this to be advice. If you are in any doubt as to the content of this, see a good, independent financial adviser immediately. They do exist.

Dikkii's financial tips #6: Risk and inflation

Welcome to Dikkii's financial tips.

This is a series where I attempt to provide some sort of guidance to financial matters without breaching the Corporations Act by actually providing advice.

It's actually been quite some time since I last posted an update in this series, and since then, I've rejigged the order of my planned modules just a little.

So before I get too far into this series, I thought I'd touch on the single most important concept for any investor.

Risk.

Risk is such a fundamentally important subject, I reckon that it should be added as the fourth R in primary and secondary education. It is that important.

And sadly, a lot of the time, investors just don't get the whole risk thing until it's too late.

We're hearing a lot about risk at the moment.

Take the current credit crunch in the States, for instance. Risk existed there before the crunch just as much as it does now, even if a lot of professional investors failed to properly account for it. The whole concept of sub-prime lending revolved around lending money out to a demographic that was horribly risky in the extreme. So when it all went pear-shaped, there was suddenly a wailing and a gnashing of teeth that told the world that a whole bunch of financial journalists really dropped the ball on this one.

Prior to that, in Australia, we had issues with mezzanine financing when four medium to largish property developers went belly up leaving a whole heap of investors out of pocket.

And, although gaol is certainly beckoning for at least one of the miscreants who ran the show at one of the property developers in question, we don't appear to have learnt our lesson.

So let's have a look at risk, as it relates to investing. Back in the day, risk was really only discussed with my clients while they did their own self assessment as to where they thought they placed themselves on a basic risk profile.

This was a process, I felt, that was open to all sorts of biases and error. I'll go into this some more in a later post when I get round to looking at risk profiling.

Risk is a huge area. I'm sure that it's possible that you could get a subject stream out of it at university, but I'm really going to discuss one risk area in this post.

Specifically Investment Risk. And only the major ones that cover personal investment.

Investment risk really covers a broad area in itself, so I don't see how I'm going to give it justice here, properly, but today, we'll look at some risks that you really ought to be aware of before you go ahead with any type of personal investment plan.

Let's get started.

1. Market Risk.

Market risk is, ironically, the most understood of all investment risks by mug investors. In a nutshell, market risk is the risk that your investment value will suffer due to adverse market movements.

An example of being adversely affected by this risk might be this - you might have bought 100 shares in XYZ Company for $10 each, making a total investment of $1,000. If the share price drops to $9 per share, then you have, on paper at least, suffered a loss of about $100.

I know that many people who will steer clear of the stockmarket for this reason - yet strangely, they don't appear to see it as an issue in the property market. Odd, but I put this down to heightened transparency and liquidity in the stockmarket. If properties were traded on an open and transparent exchange, I think it would be a different story.

Market risk is managed through diversification. One ideally wouldn't just own shares (directly or beneficially) in XYZ, they'd own shares in plenty of companies.

This, of course, does not mean that you're immune to overall market movements. We can manage this a little better by diversifying between markets. This is the reason why people often have property and fixed interest portfolios in addition to shares. And cash - which is not subject to market risk.

Also, market volatility tends to smooth itself out over the longer term. So examine your investment time horizon, and ensure that your portfolio is not inappropriate.

2. Credit Risk.

Credit risk is fairly straightforward in theory. Basically, it's the risk that if you lend money to someone, they're either not going to meet their interest payments, or possibly not pay back some or all of your initial principle.

In practice, it's a veritable nightmare. Credit ratings for some institutions can change overnight, and when someone goes belly up and is unable to pay their investors, you just want to be sure that you aren't going to lose your life savings.

Credit risk affects cash and fixed interest investments, but not property, shares or much else for that matter. But this doesn't make it any less of a concern.

Again, credit risk is best managed by diversification, both by having a diversified portfolio of cash and fixed interest investments, and diversifying into different asset classes such as shares and property.

Credit ratings are certainly useful, but at the end of the day, 20 AAA-rated fixed interest securities are better than one. This is a false dichotomy, (though still a valid statement) but I'm sure that you understand why I'm not mentioning any other possible scenarios, of which there are many.

3. Currency Risk

I just love this one. Where you have an investment in a currency denominated in anything other than the one that you're used to, currency risk is the risk that the exchange rate changes and your investment reduces in value as a result.

Here's a good example. The Australian dollar has appreciated markedly against the US dollar over the past three or four years. Consequently, anyone in Australia who invested in a US dollar denominated asset at the start of that period might be looking at paper losses, if they convert the current value of those assets back to Pacific pesos. Assuming, of course, no (or a small amount of) capital growth in the US dollar value of the asset itself.

There are actually quite a number of ways that investors can use to guard against currency risk. Diversifying your asset base (I know I sound like a broken record here, but chant this one like a mantra, kids) is one. If you have international assets in your portfolio, don't just have ones from one country. Have many from many countries.

It would be rare for investors to have only international assets dominated in currencies other than their own. Most of an investor's portfolio will be denominated in their own currency. This is further diversification.

Lastly, where foreign exposure exists, do be aware that currency hedging exists. This can be offered relatively cheaply - quite a lot of international equity funds have a hedged version and an unhedged one. The hedged version will normally be slightly more expensive, fee-wise, but for additional diversification, you could very easily have some of your international exposure in a hedged portfolio and the rest in an unhedged one.

Note that when people talk about "hedge funds", it doesn't normally relate just to currency hedging, or international equity funds that use currency hedging.

4. Liquidity Risk

Liquidity risk is another that has reared it's ugly head throughout the sub-prime lending and mezzanine finance crises.

Basically, this is the risk you take that you will not be able to cash in your investment quickly either at the end of your investment horizon, or at any other time for that matter. Such as emergencies.

Liquidity risk pops up in a lot of places. Thinly traded shares in small listed companies are heavily subject to it - when you want to sell, will there be a buyer? Term deposits - you can't normally access these until maturity. Superannuation is another - it's no good if you're trying to get access before retirement. Residential property can have settlement periods of up to 180 days.

The best way to manage liquidity risk is to explore each of your assets in turn and know how liquidity risk might affect them. And then come up with strategies to avoid the risk itself taking into account your own personal circumstances.

For example, you could possibly choose to buy shares in blue chip companies that are heavily traded and minimise your exposure to smaller capitalised companies. Use term deposits for money that you know that you definitely will not need until maturity. Use superannuation for money that you know you definitely will not need until retirement. Selling a residential property? Try to negotiate a shorter settlement period if you need the cash, and so on.

The rule of thumb is to know the asset, and how it fits in with your overall plans for the money invested.

And did I say diversify? This helps, too.

5. Inflation

Well, inflation is a right bastard of a thing.

The risk here is a simple one, but overly conservative investors don't understand it very well at all, based on my experience.

Its best explained like this: Imagine that you buy $100 worth of groceries today. If we assume a rate of inflation of 3% per annum, this means that those same groceries will cost $103 this time next year, and about $106 in two years time.

Thus, if we invest in a bank account paying 4% during that period, the return on your funds as measured by the buying power of that money is going to be greatly reduced by that rate of inflation in the meantime. Add in the impact of taxation, and you stand to go backwards, not in dollar terms, but in purchasing power terms.

Again, diversification is the key here. Historically, cash and fixed interest investments have been heavily subject to inflation so it pays over the medium to long term to diversify into investments that have the potential to provide capital growth, such as shares and property.

In the short term, you may have no choice but to accept "losses" caused by inflation. Growth assets are generally considered hot potatoes in the short term.

6. Opportunity Cost

Let's say you invest in shareholding A over a period and that asset returns 6% consistently over that period.

But at the end of that period, you find out that you could have invested in shareholding B instead, which returned 7%. It may be ludicrous to suggest that you could have known about this at the start of that period, so let's just use a statement uttered by sensible investors everywhere whenever they hear about this:

"No one is psychic."

Needless to say, there is no way that you can control for what is, essentially, speculation in hindsight.

Accept your opportunity costs with good grace, and wish investors in shareholding B good luck. You didn't "win" today.

7. Interest Rate Risk

Interest rate risk is simply what might happen due to a rise in interest rates.

Fixed interest is really susceptible to this. Imagine that you have a portfolio of bonds. If interest rates were to rise unexpectedly, this has the disadvantage of making bond yields go up, which really means that your bond portfolio has just decreased in value, all other things remaining constant. In this context, this is another type of market risk.

Indirectly, this can also affect shares and property - companies will find it harder to remain profitable if the cost of their borrowings increases. Property becomes less attractive to buyers if their interest bill is higher.

Conversely, cash becomes more attractive - if interest rates increase, the income from cash investments will normally increase. Likewise also, international assets should increase in value in domestic pricing - all other things remaining constant, a currency's exchange rate with the rest of the world should go up if the central bank of that currency raises interest rates.

Diversification ensures that some of the risk that interest rates might increase is absorbed and also turned to an advantage in spots. Of course, knowing your assets helps as well.

And if you're invested via a gearing strategy? Well, I think you can work out what's going to happen in this scenario.

8. Reinvestment Risk

Reinvestment risk is the risk that your investment might come to an end sooner than you expect.

A good example is if you provide a mortgage to someone to invest in a property, and they pay it back sooner than what you expected. You then have to go ahead and reinvest the money again elsewhere.

Sometimes this can happen with other assets - a company you hold shares in might, for example, be subject to a takeover bid for cash, and you then end up receiving cash for your shares if the takeover is successful.

This can cause problems from a tax perspective.

Diversifying your portfolio will minimise the impact of such events when they occur.

9. Manager Risk

Your investment is subject to decisions made by the manager responsible for your investment's performance.

A good example of this might be where a managed fund (or mutual fund, if you're reading this from North America) that you invest in might suddenly terminate due to a decision by the manager of that investment. You might then find that they've redeemed your investment and you then have to do something with the proceeds of that redemption. This particular example is also a good example of reinvestment risk.

Another one is where the manager changes the methodology by which a particular fund invests. This happens occasionally, and can make it somewhat annoying when you have invested in a particular managed fund for a particular reason - say, for example, the managers's particular investment methodology.

This makes diversification imperative - if your reasons for investing in a particular asset evaporate overnight, or you end up receiving the proceeds of a forced redemption, this can play havoc with your own personal tax planning, particularly if you're relatively highly exposed to that particular asset.

Different fund managers of different management styles is usually considered prudent and is an excellent example of further diversification.

10. Fee Risk

Financial advisers who work on a commission basis will never discuss this risk.

Fee risk is basically the risk that any fees that you incur will reduce returns, and may even reduce the capital invested.

It's best to manage this risk through crunching some numbers yourself to see how exposed a position you find yourself in. I normally suggest taking your amount invested and working out a years worth of fees based on that figure. And then shopping around.

You would be surprised at the figures that you may end up obtaining.

The good news is that your fees might actually be reduced by a market downturn. Of course, we're talking in dollar terms. In percentage terms, they may actually increase as a result.

In addition, fees serve to exacerbate negative returns. Know your fees and how to minimise them.

11. Personal Events Risk and Property Risk

No discussion of risk would be complete without discussion of this. These are the risks that something might happen to you, or your personal property.

This might not directly impact your investing, but can certainly indirectly impact, particularly if you find yourself having to draw on your investments to fund an unexpected personal event.

Always ensure that you have adequate insurance in place covering personal property such as home and contents cover and comprehensive vehicle insurance.

Legal liability insurance is always good - in today's litigious society, you may need it when you least expect it.

Likewise you can't put a figure on the usefulness of private health and term life insurance. Mortgage protection and credit card cover is useful, but not as cost effective nor does it cover for as much.

Travel insurance is something that you should never leave home without.

Lastly, ensure that you have a valid Will and Enduring Power of Attorney in place, or at least accessible if anything happens to you. An Enduring Power of Attorney (Medical Treatment) or its equivalent is also a good idea.

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This list is by no means exhaustive, so don't rely on it being a be all and end all. For more information regarding the risk that you're facing specifically, your adviser should be able to tell you more details.

Just remember, that if you know your risk and how you're managing it, then the return side of things - the sexy bit - should be easier to manage.

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Dikkii's financial tips index

Standard but necessary disclaimer: This is not advice. Only a complete idiot would think that any of this constituted advice. It's not even vaguely reasonable to consider this to be advice. If you are in any doubt as to the content of this, see a good, independent financial adviser immediately. They do exist.

Great debacles of our time: The sub-prime mortgage meltdown

As Michael Bains might say - "Silly humans!"

Sub-prime mortgages were something on my radar, until one of my Facebook buddies (and former primary schoolmate) posted this on my FunWall.

I hate FunWall, but I love this. This says all you need to know about the whole stupid mess - and how financial engineers can sell anything.

And it's hilarious, too.

Personally, I think that there should be arrests to come out of this, but we won't see any. Enjoy.

Standard but necessary disclaimer: This is not advice. Only a complete idiot would think that any of this constituted advice. It's not even vaguely reasonable to consider this to be advice. If you are in any doubt as to the content of this, see a good, independent financial adviser immediately. They do exist.

Scalping and hedge funds

Here's one for you.

Is it beyond the realm of possibility that hedge funds use scalping as an opportunity for arbitrage profits?

Arbitrage is the activity where you buy something somewhere, knowing full well that you can offload it again somewhere else for a profit.

Consider this: Roughly about 40,000 tickets for the Big Day Out in Melbourne went on sale to the paying public at about $120 a pop. This translates at revenue (excluding freebies) of about $4.8 million.

They're currently retailing on Ebay at upwards of $200 each (buy-it-now prices).

This is a pretty hefty capital gain in anyone's language, and it’s not too hard to see where the attraction for an unscrupulous hedge fund operator might lie.

Working against the hedge fund manager is, if we use our Big Day Out example, a limit of 4 tickets per purchaser. This isn’t too hard to get around – it wouldn’t surprise me in the least if someone wrote something that automated the whole process.

Having said that, I’m unsure whether there was some kind of visual verification like what is required for my blog comments. I’m also unsure if these can be gotten around quite so easily.

And selling them on Ebay pretty much guarantees anonymity (for the hedge fund, at least)as well as the ability to conduct some kind of very basic future hedging through a reserve/starting price guarantee mechanism.

Of course, the 14 day limit on auctions also conspires against quick sales, but you can see where this is heading.

And, of course, we know that there isn’t much that hedge funds won’t do in order to churn a quick profit.

So I suppose that my question is this – what are the practical limitations that I'm not considering? I know they're there, I just don't know what they are.

Total carnage

July and August 2007 is proving to be one serious downer for investors, and this blogger, if he didn't exactly tip it, certainly knew that fall-out was imminent.

So far, in Australia, as we speak, markets are down about 12%, and it looks like it's going to continue for some time. The story is similar around the world.

So what's causing it this time?

When the markets had their last major quiver, back in March, this blogger tipped that it would pass and that things would soon be back to normal again, soon.

The reason for the volatility in March was a slide in the Shanghai Stock Exchange, and, as tipped by this blogger, there was absolutely no reason why this should have been seen to have had the major impact on markets that it did.

This time around, I'm tipping that markets around the world will have more lasting problems, and the impact from these will be a little more heavily felt.

Allow me to demonstrate.

The first thing that should be realised, is that this little bit of mayhem is being caused by problems in the US housing sector created by too much money being lent to people who shouldn't have been allowed to borrow in the first place. In delightful understatement, these are called, 'sub-prime' mortgages.

Lenders in the US were bundling up their loan books and then on-selling them on to the market in securitised packages. This had the double impact of raising further money for lenders to continue their risky activities, and re-locating the credit risk on the money lent to the new owners of the loans in question. The most common arrangement was called a collateralised debt obligation, or CDO.

This is not a new practice. Lenders have been doing this for some time. And not just lenders of 'sub-prime' mortgages.

A lender in Australia, RAMS, recently floated on the Australian Stock Exchange (ASX). RAMS floated at a share price of about AUD $2.50 back in July. RAMS' share price is now around AUD 89c and there is nothing that their management can do about it.

RAMS is not really exposed to 'sub-prime' activity (which is called 'non-conforming' in Australia). However, RAMS needs to be able to on-sell it's current mortgage book, otherwise, it will not be able to continue to lend money out to people.

And if no one is willing to buy RAMS' current crop of mortgages from them, then RAMS is going to have to discount the whole package until they can find a buyer. Hence the fall in RAMS' share price.

RAMS will have trouble selling the current lot of mortgages because the institutions that buy this kind of security from them are now reconsidering if this sort of security is worth the risk. And that is regardless of the quality of RAMS mortgage book - mortgages of any type, hell, fixed interest of any type is now being re-assessed across the board and investors are now expecting higher returns for the risk that they're taking on.

Anyway, RAMS investors really have to ask themselves could they have foreseen this? I don't believe that they could.

But this whole meltdown doesn't just end with the lenders, folks.

The debt securities sold by the lenders have been traditionally bought by fund managers for their mortgage and fixed interest portfolios. Normally, these are considered defensive assets - all other things remaining equal, mortgage and fixed interest funds are recommended as short to medium term investments within a portfolio, and form the defensive part of most Australians' superannuation funds.

But investment in CDOs is crystallising risks far riskier than what would normally be considered prudent.

So mortgage funds and fixed interest funds are going to take a hit. This is bearable. At least I would have thought.

But it turns out that quite a lot of buyers of these investments are a different type of fund manager again.

Hello, hedge funds. Fancy seeing you here?

Hedge funds, in their never-ending quest to satisfy investors seeking lower risks and greater returns for their investment whilst at the same time kicking a shitload of fees in the direction of fund managers have had their snouts in the trough for some time.

This was apparently a no-brainer for your average inscrutable hedge fund manager. Borrow at standard rates and invest in a fixed interest security paying well more than your standard mortgage or fixed interest rate of return. And then do it again. And again.

The end result of this was that some hedge funds, in their search for endless returns were geared several times over mainly as a result of idiotic risk assessments that had these sub-prime mortgages being seen as relatively low-risk, when the reality is substantially different.

So much money was whizzing round the economy and inflating asset prices that when the housing price crunch set in in the US last year, there was going to be problems. Bear Stearns was the first company to feel the heat and have advised that the investors in two of their hedge funds are unlikely to get anything back.

In Australia, we heard problems initially from Basis Capital, a fund manager whose products were actually rated AAA from Standard and Poors. Not long after this, Macquarie Bank have advised that some of their hedge funds are suspending new investment and redemptions, because they are having a hard time valuing their portfolios.

So what for the broader market?

Well a lot of the sell-off that we are seeing has to be driven by hedge fund activity. Hedge funds own other assets and it makes sense that they simply have to liquidate large sections of their portfolios just in order to ensure that their offerings are sufficiently liquid when the investors come a calling.

On top of that, because hedge funds are so opaque in their operation, investors in the broader market simply don't know the level of exposure of other businesses.

One municipal council in Sydney is facing losses of up to AUD 60c in the dollar due to some unwise investment in CDOs directly.

And all this is contributing to an environment where borrowing is going to be so much harder in the months ahead - which stymies investment by you, me and businesses. About the only people who should be rubbing their hands together with glee are going to be the banks - their main lending operations come from quality mortgages, and they don't relay on sourcing cheap funds by way of securitisation to do it.

This is going to be nasty, folks. For me, what makes matters worse is that all my money is currently invested and I don't have any more to plough into what appears to be a corrected market. And for most Australians, superannuation returns will be the worst this year that they have been in quite some time - probably about 7 years.

On the plus side, it does appear that that Australian stock market has fixed up the serious over-valuation that has been identified for some time by financial journalists. It means that some rationality has returned to the table.

But things may actually get worse before they get better. This is not like March, folks.

Disclosure: This blogger owns shares in Macquarie Bank Limited.

Standard but necessary disclaimer: This is not advice. Only a complete idiot would think that any of this constituted advice. It's not even vaguely reasonable to consider this to be advice. If you are in any doubt as to the content of this, see a good, independent financial adviser immediately. They do exist.