SMSFundamentals: How We Delude Ourselves

SMSFundamentals | Sep 14 2018

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Cuffelinks' Graham Hand makes note of a common error made by investors in assessing their returns.

Get real: How we delude ourselves about investments

By Graham Hand, Managing Editor, Cuffelinks

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 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.”

After I spent an hour in a major bank branch where they eventually accepted them, 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%, $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 2% a year, it’s a negative yield in real terms.

The Reserve Bank of Australia provides an excellent inflation calculator, linked here. 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%, with an annual inflation rate of 2.8%. If my coins had doubled in value, I could have deluded myself that turning $750 into $1,500 showed my investing prowess, but in truth, my money would not have retained its purchasing power.

Looked at another way, on average, what cost $1 in 1988 now costs $2.29. Therefore, what costs $5 now would have cost $5/2.29 or $2.18 in 1988. So my $5 has been eroded by inflation and now has the equivalent of $2.18 buying power. 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% 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% 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?

The All Ordinaries Index is currently about [6,300]. The all-time high for the index is 6,873 in October 2007, before the GFC. It then fell precipitously to a low of 3,112 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, 6,873 in October 2007 is 8,795 now in real terms. So when the news breaks one day that the Australian market is at an all-time high, you canwisely tell everyone that it’s a couple of thousand points or 28% away in real (inflation adjusted) terms – or whatever the number is at the time – and everybody should stop deluding themselves.

Graham Hand is Managing Editor of Cuffelinks. This article was first published by leading retirement website, YourLifeChoices, and some of the comments below are taken from there.
 

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