Chapter 3 - Lon term growth & the main asset classes
Negative gearing is not just for housing
Negative gearing is not just for housing
But the term ‘negative gearing’ simply refers to any situation where the holding cost of a debt-financed investment asset exceeds the income return. Income return is the return that you receive while you continue to hold an investment: it is rent for property and dividends for shares. It is quite possible to experience negative gearing when buying shares, if the dividends are less than the interest and other costs.
As long as the dividends that are received are taxable, then the interest incurred on money borrowed to buy the shares is also deductible. This means that negative gearing still leads to a net tax deduction for the investor, regardless of whether the asset was housing or shares.
There is a third broad ‘class’ of investment asset: fixed interest or a cash-type investment such as a term deposit. The interest on this type of investment will almost always be less than the interest paid on money used to finance the deposit. However, because there is no capital growth in this kind of investment, it would be foolish to borrow money to finance this type of investment. There is no point in borrowing money at 5% and investing it at 3%. So, negative gearing does not arise when people invest in this third class of asset.
Normally we don’t like to use sporting analogies to discuss investment performance. The reason is simple: investing is not a competition in which one person wins and another person loses. It is much more egalitarian than that.
Investing is more like personal fitness: the aim is to become wealthier, not the wealthiest.
But we can’t resist commenting about the ‘neck and neck’ nature of the performance of the share and property markets over the long term in Australia. The long-term performance of these asset classes is highlighted each June when the ASX/Russell Long Term Investing Report is released. You can read this year’s report here.
When the report arrives each year, we always turn first to the long-term comparison between these two major asset classes. The report compares the ten and twenty-year returns. (This is another reason we like the report – it stresses how holding investments for the long term is the best way to minimise risk). The ‘winner’ for the ten and twenty-year periods to December 2016 was property, as shown in Exhibits 1 and 4, drawn from the report (the return includes rent or dividends and capital growth).
As the extracts show, residential investment property outperformed shares over both the periods, although the relative gap between them was lower in the longer period.
Please remember that these are averages. As you may know, the property returns in markets like Perth have been lower than the national average. And within the definition of ‘residential investment property’ are some notoriously poor performing types of property, such as high-rise apartments.
Judicious selection of residential property achieved even greater returns than these averages over the period.
Please don’t read the above results as a reason to sell your shares and buy property! The outperformance of property over shares is not something that we see every year. Sometimes the share market ‘wins.’ Consider the performances reported by ASX/Russell just four years ago, in 2013:
The real point is that shares and property achieve similar returns over the long term, and that the long-term performance, which smoothes out the ‘bumps’ of individual bad years, is typically good for both of them. It does not matter so much whether you choose to invest in shares or property for the long term – as long as you invest in at least one of them for the long term.
It is a bit like whether you go for a run or a ride on your bike. Both will make you fitter. The important thing is that you do something.
There is also a basic logic as to why the two investment classes perform so similarly. When house prices rise, people feel more confident and they spend more. This drives economic activity, which lifts business profits and causes share market returns to also rise. This increase in business wealth is then used by its recipients to purchase more housing, and on it goes.
What’s more, Australia is in the very fortunate position of being a net recipient of international migration (that is, more people come to live here than leave to live somewhere else). This increases demand for housing, which gives a strong foundation to the whole cycle.
The ASX/Russell report is especially helpful when it comes to investing in shares. One of the reasons we love this report is that it underscores the importance of the long-term approach to investment. For example, if we go back a little longer and look at the 12 months between December 2014 and December 2015, the ASX 200 went from 5411 points to 5,295 points. That is a fall of just over 2%. If we add back the average yield on Australian shares for 2015 of 4%, then the overall return for the market was just under 2%. The CPI for the year was about that figure, meaning that the average investment in the share market did not gain or lose any purchasing power in that short one-year period. Shares treaded water in 2015.
Treading water is better than drowning. But you could have swum a few laps if you had simply used a term deposit at your local bank.
However, one year is way too short a period to gauge the success of an investment. If we extend the comparison beyond one year and go back ten and twenty years, a much different – and much more reassuring – story emerges.
For the ten years to December 2015, the average return on Australian shares was 5.5%. This is well above the inflation rate, and means that the average investor increased their purchasing power if they held their investment across that period. This is despite the fact that the Global Financial Crisis (GFC) occurred in 2007-2008. The GFC smashed share prices, and it occurred right at the beginning of the ten year period. Here is how the ASX Russell Report for 2915 shows the return.
An investment returning 5.55 per year for ten years compounds to a total return of 70% for that period. If the initial investment was $100,000 in 2005, at the end of 2015 it was worth $170,000.
When we extend the analysis back over the twenty years to December 2015, the news is even better: the long-term rate of return was 8.7%. This is even further above the inflation rate and means that the investor who was in it for the truly long-term became decidedly wealthier.
An investment returning 8.7% per year for 20 years compounds to a total return of 430% across that period. If the initial investment was $100,000 in 1995, at the end of 2015 it was worth $530,000.
This is why we always stress that investments must be made for the long-term. Ten years is really a minimum time frame; the longer the better. History shows that there are few, if any, ten-year periods over which the share market turned in negative returns. Canny investors make use of that fact to substantially reduce the risk of their investment not performing.
The dividend yield is a way of measuring the income return of share market investments. It is calculated by dividing the dividend per share by the price per share. So, if a share costs $10 and the dividend is 50 cents per share, the dividend yield is 5% ($0.5/$10).