Month: June 2023

As a 24-year-old, who’d just started investing, I was excited.

I wanted to put my hard-earned money to work.

I wanted to make money while I slept.

I wanted to invest as much as I could.

But…

I didn’t really know what I was doing.

I was jumping between individual stocks.

Buying ETFs.

And trying to build a ‘diversified’ portfolio.

But without knowing it, I was concentrating my risk.

I was not as nearly as diversified as I thought.

How could this be?

I owned several different stocks.

A few different ETFs.

But, my naive 24-year-old brain was missing something about my investments .

I had a big overlap problem

I bought some blue chip stocks.

Then I bought a financial sector ETF.

Then an index tracking ETF.

But what I didn’t realize is that some of the same stocks were in all three of these.

The index tracker was top heavy with banks.

The financial sector ETF had those same banks in it.

And I had also bought those banks again individually.

Did I really want to be so exposed to the banking sector?

Absolutely not!

But this is a common situation I have found when talking with passive investors.

Often, they don’t actually know what is inside the ETF they have bought.

By the time you buy a bunch of them thinking you are diversifying…

You end up like I did.

So how does an investor avoid this?

Know your ETF

When buying an ETF, do your research and find the list of stocks that are inside it.

From here it becomes pretty obvious if you are going to have an overlap problem or not.

For example, if you own a lot of Apple shares and the ETF you want to buy has a position in Apple as well, you need to decide if that is what you want.

And depending on your strategy, you may be perfectly happy with that.

But the point is, you need to know that this overlap exists.

Build your knowledge, build your portfolio

Back when I started investing I clearly didn’t have enough knowledge.

And look what happened.

I ended up concentrating my risk into a few stocks by mistake.

Losing money because that particular sector didn’t move much.

All the while, thinking I was diversified across the market.

Even though I harp on about strategies a lot…

This issue can still crop up even with the best of strategies.

The key here is building your investment knowledge.

Be aware of what you are buying.

Things on the surface can look great.

But diversifying is not always as easy as just buying ETFs.

Knowledge pays the best dividends,

Navarre

The Data-Driven Investor

There is an element to investing that people try to ignore.

It’s not fun.

It’s not sexy.

And it involves you losing a chunk of your hard earned investment gains.

Of course, I’m talking about tax.

I’m yet to meet a person who loves this aspect of investing.

Except maybe my accountant.

Yet, this is an area that you can not ignore.

I personally have ended up paying the government much more than was legally required.

Why? Because I didn’t like thinking about tax.

I didn’t want to know.

I didn’t optimize my investments for tax outcomes.

And, I paid for my wilful ignorance. 

If you’re investing, here’s what you must understand about taxation. 

Play a game of pass the parcel

In many countries, you have to pay capital gains tax when selling a stock.

This is a portion of the profit you make from the sale.

This is calculated by using the cost base of the holding and subtracting the gain by the cost base.

E.g. You buy some shares for $1000 (cost base) and sell them for $1500, you have made a $500 gain.

But what happens when you have bought the same stock multiple times (parcels), then sell some of it?

You get to choose a CGT strategy for calculating the gain/loss.

This can have a significant effect on what the end gain works out to be.

Let’s look at an example:

• I buy 100 shares of Stock ABC for $3 = $300
• I buy 100 shares of Stock ABC for $5 = $500
• I buy 100 shares of Stock ABC for $6 = $600

So all up I own 300 shares of stock ABC.

What happens if I sell 100 shares for $5 a share for a total of $500?

I could use the FIFO (first in, first out) strategy — I  sell the first shares I bought.

So that makes the cost base $300 and the sale $500 — a $200 gain.

I could use the LIFO (last in, first out) strategy — I sell the last shares I bought. 

This makes a cost base of $600 and the sale of $500— a $-100 loss.

There are other strategies, too. 

But you can see from this simple example how you can go from owing tax, to owning nothing.

And if all the CGT strategy options still result in a gain, there’s still moves you can make to mitigate. 

Turn a loss into a tax gain

When you pay capital gains tax, you pay it as a total of your entire portfolio.

Which means if you make a gain on one stock, you can cancel it out with a loss from another.

This is  tax loss harvesting.

Tax loss harvesting is a strategy that involves selling stocks at a loss to offset a capital gains tax liability, thereby optimizing your after-tax returns.

This concept is powerful enough to potentially kill an investment tax obligation. 

Tax Knowledge Pays Dividends

Even with just this basic investment tax knowledge, you can potentially save a lot of money.

There’s no excuse for not knowing how investment taxes work.

If I had known these tax basics when I started, I might have kept a lot more of my gains.

So before you do your next tax return, have a think about which CGT strategy you are using.

If you are an Australian tax resident and it starts getting hectic calculating cost bases and keeping track of parcels, remember we help with that.

Check out Navexa now.

As always, knowledge pays the best dividends.

Navarre

A lot of people talk about buying index tracking ETFs.

Finfluencers.

Gurus.

Friends.

Even Warren Buffett has promoted index tracking ETFs.

The idea behind this is that you get decent diversification relatively easily.

As we learn early in our investing careers, diversification is a good thing, right?

Right?

Well, it depends on how you define diversification.

Is it owning multiple stocks?

Is it owning multiple stocks across different industries?

Do these stocks need to be of equal value in your portfolio?

Do these stocks need to be from different countries?

There are many different ways to diversify.

Note: Absolutely none of what follows should be considered financial advice — merely a personal investigation into the numbers behind diversification. 

Don’t Underestimate Big Companies’ Dominance 

The ASX200 index covers the top 200 companies listed on the ASX.

And there are many ETFs out there that track this index.

Buying into one of these would give you broad diversification in terms of number of companies.

But how diverse is the ASX200 really?

With a little bit of digging, you will find that the top 10 stocks in the ASX200 makeup more than 50% of the index’s total market capitalization.

In other words, the ASX200 is very top heavy.

BHP is the number one stock in the index, with a market cap of ~$200 billion.

Compare that to the 200th stock in the index, with a market cap of $1 billion.

This means if BHP has a bad year, it can significantly impact the whole index.

So what does this look like in a real portfolio?

Meet The ASX10 Big Heavyweights

Let’s take a look at a theoretical portfolio made up of the top 10 ASX stocks in 2018.

Let’s call it the ASX10.

In the past five years, the ASX10 has outperformed the ASX200 index.

With capital gains and dividends included, the ASX10 achieved a return of 12.45% p.a. — outperforming the ASX200’s return of 9.81% p.a.

You can see from the chart that the movements were almost identical the whole way through.

But the ASX200 had 190 other companies influencing its overall performance.

So while you get diversification from an ASX200 index fund, is it the kind of diversification you want?

It Pays To Know What Comprises Index ETFs

To be clear, I’m not saying investors shouldn’t buy index funds. 

If it’s between doing nothing with their money or investing at all, then index funds might be a great idea.

They do, after all, track the performance of an index — most of which, over the long term, tend to go up. 

But for those of us who pay closer attention to what we’re investing our money in…

And those — like me — who unashamedly ‘nerd out’ on every detail of our investments…

It’s worth noting that there can sometimes be hidden costs — or rather opportunity costs — to simply buying an index fund versus investing in a particular cohort of companies. 

Diversity has become one of those pieces of financial jargon people perhaps automatically presume to be admirable. 

But, as I like to say, the numbers never lie. 

Always do your own research — this is not advice and always remember that past returns are never a guide for future performance.

Knowledge pays the best interest,

Navarre

The Data-Driven Investor