Measuring Financial Wellbeing with Self-Reported and Bank Record Data (PDF)

The article, "Measuring Financial Wellbeing with Self-Reported and Bank Record Data," authored by Carole Comerton-Forde, John De New, Nicolás Salamanca, David C. Ribar, Andrea Nicastro, and James Ross, presents a comprehensive study on financial well-being using both subjective survey data and objective bank record data. The study involves the development of two financial well-being scales: the Reported Financial Wellbeing Scale and the Observed Financial Wellbeing Scale. These scales were created using item response theory (IRT) models to analyze self-reported perceptions and actual financial records, respectively. Key Findings and Contributions: 1. Scale Development: ○ Reported Financial Wellbeing Scale: This scale measures people's perceived financial well-being based on their self-reported experiences and perceptions. It includes 10 items related to the ease of meeting living expenses, financial security, and control over finances. ○ Observed Financial Wellbeing Scale: This scale uses five bank record measures, including account balances, spending habits, and payment issues, to objectively assess financial well-being. 2. Validity and Reliability: ○ Both scales demonstrate high reliability and validity, effectively distinguishing between different levels of financial well-being. ○ The scales are correlated but capture distinct aspects of financial well-being, with the Reported Financial Wellbeing Scale focusing on subjective perceptions and the Observed Financial Wellbeing Scale on objective financial data. 3. Predictors of Financial Well-being: ○ The study identifies key predictors of financial well-being through machine-learning analyses using LASSO models. Key predictors include savings habits, household income, education, spending habits, and credit card behavior. ○ Savings habits emerged as the strongest predictor of both reported and observed financial well-being. 4. Socioeconomic Characteristics: ○ Socioeconomic factors like income, education, and employment status are significant but have less impact compared to financial behaviors. ○ Financial well-being is attainable across various socioeconomic backgrounds through the adoption of sound financial behaviors. 5. Impact of Financial Behaviors: ○ Positive financial behaviors, such as regular savings and prudent spending, are strongly linked to higher financial well-being. ○ Negative behaviors, such as carrying credit card debt and gambling, are associated with lower financial well-being. Implications: For Financial Institutions: The Observed Financial Wellbeing Scale provides a tool for banks to assess and improve customer financial well-being through tailored products and services. It can also help measure the social impact of financial products. For Consumers: Both scales offer a means for individuals to assess and improve their financial well-being, potentially through financial education and counseling. For Researchers and Policymakers: The scales offer validated measures for studying financial well-being and the effects of policies and interventions. Conclusion: The study underscores the importance of integrating both subjective and objective measures to gain a comprehensive understanding of financial well-being. By focusing on modifiable financial behaviours, there is potential to significantly improve individuals' financial health across different socioeconomic groups. The adoption and widespread use of these scales could lead to better financial outcomes and more effective financial policies and products. the paper defines financial wellbeing as the extent to which people both perceive and have each of 1. financial outcomes in which they meet their financial obligations, 2. financial freedom to make choices that allow them to enjoy life, 3. control of their finances 4. financial security now, in the future, and under possible adverse circumstances this definition has several dimensions, including situational/temporal, functional, and subjective/objective dimensions Questions 1. What is the difference between the reported and observed financial wellbeing scales? Reported financial wellbeing scale measures people’s perceived financial well-being based on their self-reported survey responses (perceptions and experiences) and thus is mostly subjective. Observed financial wellbeing scale is more objective since it’s based on objective financial record data and can be independently observed (actual financial behaviours and outcomes) Similarity: both are normalised to the interval 0-100 2. What are some advantages and disadvantages of both reported and observed scales? Reported scales 1. In the last 12 months, how difficult was it for you to meet your necessary cost of living expenses like housing, electricity, water, health care, food, clothing or transport? How well do the following statements describe you or your situation? 2. I can enjoy life because of the way I’m managing my money 3. I could handle a major unexpected expense 4. I am securing my financial future How often do the following statements apply to you? 1. My finances control my life 2. I have money left over at the end of the month 3. Giving a gift for a wedding, birthday or other occasion would put a strain on my finances for the month. When it comes to how you think and feel about your finances, please indicate the extent to which you agree or disagree with the following statements. 1. I feel on top of my day-to-day finances 2. I am comfortable with my current levels of spending relative to the finds I have coming in 3. I am on track to have enough money to provide for my financial needs in the future Advantages Disadvantages Subjective Insights: Captures personal Bias and Inaccuracy: Subject to biases like experiences and perceptions, providing social desirability bias, recall error, and insights into how people feel about their framing effects, which can lead to inaccurate financial situation. reporting. Holistic View: Includes psychological and Inconsistency: Perceptions can vary widely emotional aspects of financial well-being, between individuals and can be influenced by which are crucial for understanding overall temporary moods or recent experiences. well-being. - Views the person as a whole rather than as a piece of finance Behavioural Indicators: Can reflect Less Concrete: Lacks the hard data that behavioural and attitudinal aspects that objective measures provide, making it less objective measures might miss, such as concrete for policy or financial product financial stress or satisfaction with financial development. management. Allows for a range of different ways to People can be pessimistic if they are view financial wellbeing - People differ in surrounded by people with large wealth or their preferences and attitudes, the same vice versa material resources and circumstances may lead to different levels of perceived financial wellbeing Easier to obtain data - more easily measurable than reported financial wellbeing Observed scales 1. Number of months in the last year with payment dishonours 2. Any payday loans in the last year? 3. Days in the last year with liquid balances below one week’s average expenses 4. Days in the last year during which customer had the ability to raise one month’s expenses from savings or available credit 5. Age-normed percentile of customer’s median savings balance over last year Other measures: Net spend, total interest payments relative to inflows, total loan payments to inflows, income volatility HL Advantages Disadvantages Objective Data: Uses actual financial Limited Scope: Does not capture the records, providing a concrete and accurate emotional or psychological aspects of measure of financial behaviours and financial well-being, missing out on the outcomes. subjective experience. * missing out on the emotional factor of human behaviour Consistency: Less subject to personal biases Data Gaps: May not include all financial and reporting errors, leading to more reliable activities if individuals use multiple financial data. institutions or cash transactions, leading to incomplete data. Actionable Insights: Offers specific, Privacy Concerns: Collecting and using actionable insights based on tangible financial personal financial data can raise privacy behaviours, which can be useful for financial concerns and requires stringent data institutions and policymakers. protection measures. Can be measured without input from a Data you need to measure financial person wellbeing is hard to obtain - conceptually and computationally it is hard to obtain Proper assessment of a person’s financial wellbeing requires data that are typically not readily available in one place 3. The figure on the bottom of page 25 displays the relation between the level of a person’s understanding of financial products and their financial wellbeing. What is the likely mechanism(s) through which the two are related? There is a positive correlation between a person’s understanding of financial products and their financial well beings (the more users understand financial products, the better their financial wellbeing). These two are related because a greater understanding allows for more informed decision making, avoidance of financial mistakes, effective use of financial tools, improved financial planning, increased confidence and control and better access to financial opportunities. Graphs show that people are generally around the 50-75 mark on both the reported and observed financial wellbeing, observed actually being slightly higher. There is a positive correlation between general health and financial wellbeing (the more financially stable, generally the more healthy) Financial decisions that people make - Consumption versus saving (buying things, putting money into savings account or contributions to superannuation) - Financing (pay by cash or credit or personal loan, rent or own, borrowing and paying off) - Investment (invest savings in term deposit, adding stock to portfolio, equities, art, property, managed fund) - Asset protection (life/car/etc insurance, family breakdown effect on wealth and finance, finances upon death) - Retirement decisions (when to retire, appropriate retirement funding strategies, how much money is needed, qualification for age pension and social security and its effects on assets and income) Main regret about financial choices is not saving enough money and not investing enough Main barrier keeping people from improving their finances is a lack of trust in financial institutions or advisers as well as thinking that their finances are overwhelming FInancial Decision-making and its challenges - Standard models in decision theory assume that decision makers choose such that the chosen action is the best action available to them and thus assume that decision-makers have preferences that rank the available option. The best option is the one ranked the highest in preferences, which is very individualised. - The “rational choice” is the assumption that observed behaviour reflects the most preferred action - In reality, acting rationally requires enormous cognitive/computational resources to determine optimal actions but people’s cognitive resources are limited. Therefore, full rationality is not realistically possible - Alternative models or frameworks take into consideration of cognitive resources limitation (bounded rationality, heuristics- mental shortcut, ecological rationality) - There is also always uncertainty regarding the future and fundamentally, all financial decisions are about the future Therefore, main challenges are limitations to rationality and uncertainty about the future The complexity barrier - encompasses both the different barriers listed and the effect of uncertainty - It exists in financial markets and products - Eg. complexity of products = managed investment funds, insurance policies - Complexity of contracts = standard-form contracts, products disclosure statements - Complexity of distribution= marketing, data/algo biases, dark patterns- exploiting users to maximise interests of online service providers without the user’s awareness - Size of search space = private health insurance, superannuation investment options - Choice overload - when providing more options to individuals becomes detrimental aka too many options Finance Theory and Personal Finance - Relevant concepts = consumption and savings, risk and return, diversification, mutual fund (Tobin) separation, efficient markets hypothesis, agency theory Financial planning - Wealth creation, asset protection, retirement planning and estate planning Wealth creation - Superannuation - Purchasing equities, bonds, property and other investment assets - Gearing (negative gearing will be tested) - Investment in the family home - Investment in your own business - Salary Packaging Retirement Planning - ensuring there will be adequate income to fund living in the non-working phase, in particular the generation of an adequate retirement income stream (RIS) - 3 stages (accumulation phase, transition-to-retirement, pension phase) - How much is needed to fund retirement? Is dependant on age, gender, life expectancy, existing debt, life-style objectives, hobbies, dependents, home ownership, other assets etc - Such aspects will determine the size of the superannuation lump sum to accumulate RIS - is generated by earnings from: 1. Superannuation assets - draw a pension from a super fund, purchase a term certain annuity, purchase a life annuity, apply a theory-based lump sum allocation strategy, use of a SMSF (self-managed superannuation fund) - which can enable all the others 2. Non-superannuation assets - rental income from investment properties, interest and dividends from cash, bonds and equity investments, royalties, annuities, non-superannuation pensions Estate planning - orderly and tax-effective disposal of your assets during or after your life - Main issue is the allocation of the estate as there are several variables to consider such as a bequest motive where assets are allocated via wills - SMSF can be an efficient vehicle of estate planning but subject to some restrictions - Aspects to consider: requirements for a valid will, intestacy and its consequences, issue of dependents (superannuation dependents and tax dependents), disposal of assets that are not will assets (joint and common tenancies, superannuation and trust assets) and business succession planning Asset protection - Adequate insurance cover (life, health, business, property) - Secure custody of assets - Mechanisms in place for asset protection in the event of family breakdown (divorce or death) - Business breakdown/succession contingencies in place - Risk Mitigation measures in place against investment exposures (especially in retirement phase) Tutorial 1 ⅔ australians worry about money Main driver of financial anxiety is financing requirement Aus has one of the highest household indebtedness and highest old-age poverty rates among the OCED About 95% of australian families are currently underinsured Week 2 LCH - describes the link between the savings and consumption decisions of individuals and those individuals stages of progress from childhood, through years of work participation, and into retirement Angus Deaton's article in the BNL Quarterly Review, vol. LVIII, nos. 233-234, June-September 2005, discusses Franco Modigliani's life-cycle theory of consumption. The life-cycle hypothesis posits that individuals plan their consumption and savings over their lifetime with the primary motive of saving for retirement. Young people save to ensure they have funds when they are no longer working. This theory is significant in understanding the distribution of wealth across different age groups within a population. Middle-aged individuals accumulate the most wealth, which they then deplete during retirement, passing assets to the younger generation. The theory explains that in economies with growing populations or incomes, there will be net positive savings because the young save more than the old dissave. Therefore, economic growth leads to higher saving rates, irrespective of income levels. This has been supported by empirical evidence over the years. Modigliani's work extended beyond individual behaviour, influencing macroeconomic policies and debates. It provides insights into the interplay between government and private retirement provisions, the impact of social security on savings and retirement behaviour, and the broader implications for economic growth and national wealth. The life-cycle hypothesis has faced challenges and criticisms. Critics argue that elderly individuals do not always dissave as predicted, and the theory's assumptions about rational planning and behaviour under uncertainty may not hold universally. Alternative models, such as those incorporating precautionary savings or liquidity constraints, suggest that consumption may be more closely tied to current income than the life-cycle theory proposes. Behavioural economics has introduced new perspectives, questioning the rationality of intertemporal choices and proposing concepts like hyperbolic discounting, where individuals' preferences change over time. These models acknowledge that people often procrastinate and fail to save adequately for retirement, providing a more nuanced understanding of saving behaviour. Despite these challenges, the life-cycle hypothesis remains a foundational theory in economics, shaping how economists think about savings, consumption, and economic policy. It continues to be a reference point for both positive and normative analyses of saving behaviour. What is meant by the life-cycle hypothesis? The life-cycle hypothesis posits that individuals plan their consumption and savings over their lifetimes for the primary motive of saving for retirement. What are some important factors associated with a household’s savings rate? - Age and life-cycle stage - Income level - Government policies and social security - Interest rates - Behavioural factors - Cultural and social norms - Access to credit: Availability of credit can influence saving behaviour. If households can easily borrow, they might save less, relying on credit to smooth consumption. Conversely, limited access to credit may lead to higher precautionary savings. - Economic growth: In economies with higher growth rates, younger generations tend to save more due to higher expected future incomes, while the dissaving of older generations is outweighed by the saving of the younger population. LCH hypothesised that in growing economies, there are positive net savings duke to higher expected future incomes - Population demographics - Precautionary savings: The age structure of the population affects national saving rates. A higher proportion of middle-aged individuals can lead to higher overall savings rates, while a larger elderly population might reduce the national savings rate. What keeps people from behaving according to the life-cycle hypothesis? - Hyperbolic discounting (individuals’ preferences change over time) - Procrastination towards saving adequately for retirement) - Choosing sub-optimal short-term payoffs - Repaying low interest loans quickly - Regular deposits to low interest special purpose savings accounts - Buying low cost, energy inefficient appliances Consumption expenditure - Comprises of both a variable and fixed portion - When income increases, so will consumption expenditure, but on less than a 1:1 basis - The less you earn, the closer the ratio is to 1:1 - There is a specific (minimum) amount that an individual consumes, regardless of the level of income (therefore negative saving is possible) The retirement phase: the accumulated sum is converted to a Retirement Income Stream (RIS) for consumption over the remaining lifetime. Ideally, there should also be a cash reserve to meet unexpected expenses The obvious difficulty in applying a theoretical model to practice is the existence of uncertainty in the real world. Practical issues that have an impact on personal financial decision making include risky income flows and assets, age and life expectancy, portfolio allocation choices, inheritances and bequests, changes in preferences over time, family circumstances, taxation and other government transfers, etc. To simplify, i) no children, ii) children about to arrive/baby, iii)children growing up, iv) children grown up, v) retirement - Characterised by low earning capacity Phase ii and iii can represent times of financial stress and taken together these these stages are relatively long term Phase iv is the consolidation phase - ‘empty nester’ - children start to leave home, mortgage under control - Issues that may arise during the phase include absence from workforce (travel, child raising), divorce, death/incapacity of a partner, retrenchment, pandemic etc and such issues may result in savings downfall - Planning mechanisms that exist include binding financial agreements (in relation divorce - to plan for the contingency of divorce), life insurance and term life insurance Phase v - retirement - income from investments and possibly social security (age pension) - Income from assets built over a lifetime of working - Major debt repaid - the key issue is that there is an adequate RIS (preferably indexed) Tutorial 2 Intertemporal choice = a choice relating to different time period Income = consumption + savings Savings = disposal income - consumption Consumption = constant + marginal propensity to consume X disposable income Saving rates Low or negative in early life, high in midlife and negative in retirement The basic objective of financial planning is to maximise financial wellbeing by ensuring that there is adequate lifetime income to meet lifetime consumption (budgeting, debt management, investment decisions) Phase i is characterised by low earning capacity - good strategy is for a couple to live off only one person’s income An assumption is that consumption stays the same, when in reality consumption is sensitive to income 1. The life cycle hypothesis describes the link between the savings and consumption decisions of individuals and those individuals' stages of progress from childhood, through years of work participation, and into retirement. The main prediction is a lifetime of savings which results in a hump shaped curve 2. Although some of the assumptions do not hold in practice the model is still relevant for financial planning. Largely the objective of financial planning is to ensure there is adequate income to accommodate for a lifetime of consumption 3. The main factors that impact a household’s savings rate is income and level of interest rates 1. Empirical evidence does support the LCM to a certain degree. For example, the 5 phases described are quite accurate however some assumptions don’t hold to practise. 2. Eg. The theory suggests that as income rises, consumption stays the same. However, empirical evidence shows that consumption is sensitive to income levels. 3. Furthermore, in finance, we generally assume rational decision making but in practice we find that people often exhibit irrational behaviour, for example paying for purchases in cash instead of taking advantage of free credit (eg. 24 months interest free and investing money for the 24 months). A closely related concept is anomalous personal discount rates in assessing cash flows 4. An implicit assumption of the CBT is that people save purely to fund consumption in retirement but this isn't always true as many people have the additional objective of wealth accumulation to provide for bequests for their heirs. There is also the issue of longevity risk (living for too long) 5. Assumption is that people retire around 65 but empirical evidence suggests that people can retire at a large range of ages and also suggests that people don’t save enough (insufficient saving) 1. How does financial advice in recent years deviate from the standard economic model? The theory represented by standard economic models suggests that savings rate should be average/low in early life, high in midlife and neg in retirement. Popular authors advice an alternative to the emphasis on smoothing consumption that has become more popular in recent years, is to instead focus on smoothing savings rates for: - Usefulness of establishing saving consistently as a discipline - Simple savings rules that have the virtue of requiring minimal computation (since many don’t have so much finance knowledge) - The power of compound interest Current authors also champion rules that seek to address cognitive biases such as anomalous discount rates, mental accounting and framing Lecture 3 Money = 1. medium of exchange (eliminates inefficiencies of barter & facilitates financial transaction) 2. Store of value = can be stored and used for future consumption (eg. crop doesn’t last very long to trade vs money) 3. Unit of account= enables valuation of different elements using a common unit & can be used for calculation, valuation, comparison (amount of money can be very exact) Fiat currencies = currency is declared by government as ‘legal tender’ = meaning it can be used to acquire goods and services and meet financial obligations Key characteristic is that it has no intrinsic value Hyperinflation = eg. Venezuela and zimbabwe - when currency becomes practically worthless-> often a result of too much paper money which causes the value of money to fall Income - Either earned in the form of salary/wages; passive ie return on investments (interest, dividends, rent) or other receipts - Some receipts like capital amounts (sale of assets), gambling winnings and gifts are not income in the traditional sense (however there are certain rules defining income for tax purposes) - Income is the main source of spending and saving Salary/wages - Main source of income will be salary/wages from employment - Nominal wage growth currently positive and increasing wage growth - However, the most informative measure is that of real wages (inflation adjusted) - Real wage growth shows that it is not good, (using base level at March 2020- set at 100) - it is now coming down (our buying power now is comparable to Dec 2008) - Practical implication is that first few years in workforce, there will be a need for a catch up Credit and debt - Credit is the earlier portion of a debt transaction - you need to get credit to take on debt (a borrower should obtain credit prior to taking on a debt) - Eg. i need a new car, go to the bank and ask for 20k. Credit = asking lender to approve the request, debt = when transaction has occurred (cash has changed hands) - Expected return is a function of the financial risk - Credit: fixed payment loans (repaid in instalments) and revolving credit - Fixed payment loans = personal loans, car loans, buy now pay later and home mortgage loans - Revolving credit facilities (borrow fund from a lender at some point in time to a certain amount) include credit cards, overdraft (arrangement set by borrower and lender to draw money from bank account and balance goes negative - rates are usually very high as it is inconvenient for the lender) and lines of credit (credit is available and you use it if you need it) - Variable interest rates -> used by banks because risks for lender changes/ they pass the risk onto borrower - Fixed interest rate - borrower is excused of risk of volatile interest rates - Secured or unsecured - security is an asset - secured loans require collateral - relates to events of default - unsecured loan carries higher interest rate as it is more risky from the lenders’ perspective - Home loans - the property acquired forms security for the loan, they generally require repayment of principal and interest for terms between 10 and 30 years Credit cards with interest-free periods may seem attractive but their effectiveness relies heavily on the holder’s discipline in making payments. Hidden costs and upfront fees are critical factors that can turn a seemingly good financial deal into an unfavourable one Debt can be used to fund consumption (lifestyle) expenditure - The use of debt to fund short-term consumption - eg. nights out, CLUBBING, DRINKING - is considered financially irrational - Bad use of debt - no asset being purchased, interest paid is not tax deductible, once spent, there are only intangible benefits (if any) gained from debt - Funding long-term consumption is not as bad (depreciating assets with a useful lifetime (white goods = cars or furniture) Funding assets - Non-investment appreciating assets (home, vintage car, boat, holiday home, renovation) where the asset is expected to increase in value., can generate a capital gain upon eventual disposal, which will result in a positive return if it covers borrowing/interest costs - Investment assets - appreciating assets, where the returns will cover the costs to provide a positive net investment return Paying off non-deductible debt - Fact: home mortgage loan typically takes up to about 20-40% of disposable income but sometimes even more (now in high end due to high mortgage rates) - source of financial stress - A low risk strategy is investing by paying off home mortgage loans (the interest saved) - However, the return from savings outgoings is not tangible compared to a cash return on an investment (less sense of gratification) - Paying off the mortgage is not subject to market volatility, although there is some variability of return with variable rate loans, so in a sense the saving of mortgage interest is a risk-free return - Paying off non-deductible debt can often provide better reuters than taxable investment income Tutorial 3 Money, income, credit, debt and taxation Income -> main source of spending or saving - Earned income -> salary or wages -> nominal wage growth vs real wage growth (with respect to inflation) - Passive income -> return on investments (interest, dividends, rent) or other receipts Credit vs Debt - Credit is earlier portion of debt - Fixed payment loans (personal loans, car loans, BNPL, home mortgage loans) -> secured vs unsecured -> fixed payments over finite period of time -> annuity formula - Revolving credit -> credit cards, overdrafts, lines of credit - Good debt is used to build assets and fund investments -> in expectation to gain returns to offset the purchase price - Bad debt is purchase of short-term consumption (considered financially irrational) -> once spent, there are only intangible benefits -> eg. using credit card debt to pay rent (immediate consumption) Taxation - Individuals are subject to marginal tax rates - Companies pay a flat rate of 30% - Taxable income = assessable income - allowable deductions - Assessable income includes earned income - Allowable deductions includes gains and deductions - Medicare levy is 2% for any income over 29k - Taxable income is reduced by the mandatory superannuation contribution - Superannuation is taxed 15% (remember this when calculating total retained) Bitcoin is money. Discuss - It is a store of value -> whether it is a good way to store value is up to debate - It isn’t a good medium of exchange - Whether it is a good unit of account is debatable - Bitcoin serves none of these functions particularly well. - Given the volatility of its price, it is not a particularly useful unit of account - Money must fulfil the 3 criteria of medium of exchange, store of value, unit of account Describe what typically happens if you use a BNPL service to purchase foods such as a laptop - BNPL pays the merchant and extends the credit to you, the buyer - You then repay BNPL in 4 instalments of equal size - The instalments are typically You missed last instalment and did a delayed payment for a purchase worth $1000-> charged a late payment fee of $17 - Amount due is 250 - The period over which credit is extended to you is 56 days plus a weeks delay, 63 days in total - F - C + I = c(1 + i/365)^d - c= repayment amount - D = number of days over which interest is paid - I = late payment fee Fixed rate of interest -> no interest rate risk Saving from paying down mortgage is return of 4.4% after tax and risk free as she it is a fixed loan rate To get equivalent AT return, she needs to generate a higher investment return on shares Assume she is in the 47% tax bracket The new shares would need to generate 4.4/(1-0/47) - She needs to generate 8.3% on shares - This takes on much more investment risk Lecture 4 - Financial planning industry exists due to the need of individuals to access expert advice to build ‘portfolios’ tailored to their personal situation - Why does this exist: because of inadequate financial knowledge, differing expectations of earned or investment income tax situations, family circumstances, investment horizons and even insufficient illiquid assets (shortened: don’t know much about finance, personal circumstance, bad managing) Recall: main areas are wealth creation, asset protection, retirement planning, estate planning AFSL: the licence that covers those who carry on the business of providing financial services - Carrying on a business = activities that are systemic, continuous and repetitive - Reporting obligations under the AFSL regime = breaches and events, changes in licensee’s particulars, authorisation of representatives and financial statements and audit - Any person providing financial advisory services, any person who issues or deals in financial products, the principals in a financial services business must hold as AFSL - Authorised representatives, directors, employees of the business and any other person acting on behalf of the principal are exempt from holding an AFSL Basic standards: - Rationale for minimum FP standards is that clients are considered vulnerable - Financial planning industry in Australia has been plagued by poor, incomplete, inappropriate or incorrect advice because of : inadequate regulation by the Financial planning Association (FPA) and the prevalence of commission-based remuneration - Fiduciary duty = best interest duty = advisers act objectively and solely in their client’s best interest -> introduced under the FOFA reform program on 1/7/2013 - Duty has been met if - 1. Reasonable level of expertise in the subject matter (perform a detailed investigation of the client and research the client’s needs) - 2. Exercised reasonable care - 3. Objectively assessed the client;s relevant circumstances - 4. Acted in the client’s best interests Best practice also requires advisers to act efficiently, honestly and fairly - Efficiency = providing a plan and documentation in a timely manner - Honesty = ethics, conduct and fiduciary principles - Fairly = clients are treated equally (no discrimination between clients) Competencies, experience and training of advisers - 3 types of training 1. Training in investment principles, preparation and formulation of suitable personal advice, knowledge of how the business operates 2. Ongoing learning: keeping up-to-date with economy, financial markets, legislative and regulatory environments and changes 3. Product training: provided by the principal if the principal is the issuer, otherwise usually by the issuer Any adviser must be adequately supervised by the principal, who should provide advisers with written directions they must implement Remember: training = investment principles, ongoing learning, product training Reform to the industry (because fiduciary duty was not being met) -> changes to statutory, general law, ethical and corporations law - People seeking financial advice must be protected - Reforms were enacted to ensure that financial advisers must be compelled to act in the best interest of their client - There is now a statutory, as well as general law and ethical (mandated by the FPA regime), fiduciary duty on financial advisers to act in the best interests of their clients - Legal duty was introduced into the Corporations Law under the Future of Financial Advice (FOFA) reform program (2011, effected 1/7/2013) - It incorporates a ban on “conflicted” remuneration structures - It is necessary for FPs to: - 1. Perform a detailed investigation of the client and research the client’s needs - 2. Carefully record all relevant aspects of the client - 3. Formulate clear advice for the client - 4. Obtain the client’s decision and implement it - AKA (KNOW YOUR CLIENT (KYC) AND KNOW YOUR PRODUCT) - KYC = know client’s circumstances and do sufficient information gathering - KYP = have appropriate level of understanding of financial products (have expertise) and have appropriate grounds for making the recommendation to the client, based on KYC) - Products include investment strategies and assets (wealth creation), insurance policies(asset protection), superannuation alternatives (retirement planning), estate planning tools (estate planning) Finance service - Providing financial advice - making recommendations and providing a statement of opinion or written advice report - Dealing in a financial product - Making a market in a financial product - Operating a registered scheme - Providing a custodial or depository service General advice - Not based on knowledge of client’s circumstances and objectives - Indicate that the client must consider the advice in this light if inclined to act - Suggest a product disclosure statement should be considered before acting - Sufficient warning (eg. This advice is general; it may not be right for you) Personal advice (subject to regulation) -> Takes into account knowledge of client circumstances and objectives Duties apply to the provision of personal advice to a person as a retail client (someone who is not a wholesale client) 1. The adviser explicitly offered to provide advice (provided appropriate documentation) 2. The adviser had an existing financial relationship with the client 3. The client requested personal advice 4. The adviser requested details about the client’s personal circumstances 5. Personal circumstances are referenced in a recommendation 6. The adviser had received or already possessed information about the client’s personal circumstances - It may still be regarded personal even if: not given face-to-face, no direct contact, relates to only 1 product, advice is given in a seminar, client is a body corporate, the adviser did not intend to provide personal advice Must satisfy 3 elements outlined in RG 175 1. Reasonable enquiries have been made into client’s relevant personal circumstances 2. The provider gives considered advice, the subject matter of which has been investigated and is reasonable in all the circumstances 3. The advice must be appropriate for the client Risk assessment - Examination of client’s previous investments - By use of a questionnaire Disclosure to the client 1. Conflict of interest 2. Limitations of operating capacity 3. Methods of remuneration, especially fees payable by client (including trailing commissions) -> eg. trailing commisions 4. Internal and external complaints resolution system 5. Identify services that can be provided upfront Principals - The holder of a dealer’s or adviser’s licence - Any person who obtains a licence under FSRA - A registered life insurance broker - A life insurance company When providing financial services to a client, an adviser must operate under AFSL and provide: - A financial service guide (FSG) - offered at the start of negotiations and discloses the services offered to the client - A statement of advice (SoA) - given prior to any action and sets out the advice provided to the client by the adviser - A record of Advice (RoA) - Product Disclosure Statement (if applicable) - Complaints resolution process must be explained - (some instances) a 14-Day cooling-off period FSG 1. Must be called a “Financial Services Guide” but can be referred to as an FSG and must be dated 2. Name and contact details of the adviser; any special instructions (eg. feel free to email) 3. Similar information about the authorising principals or each of them 4. The kinds of financial services provided and the financial products to which they relate 5. Who the adviser acts for when the services are provided 6. The remuneration and other benefits that the principals, the adviser of any other associate person will receive for providing the financial services (maybe eliminate COI) 7. Information about any business relationships or associations between principal and issuers of any products 8. Detail of internal and external complaints resolution mechanisms (one page may be sufficient) 9. A statement that the FSG has been authorised by the principal SOA - Sets out the advice provided to the client by the adviser - Must be given when providing personal advice, prior to the action required to be taken to implement the advice - Obligations and example provided by RG 90 Must contain: 1. the title ‘Statement of Advice’ on the cover 2. the advice 3. the basis on which it was given 4. Adviser’s name and contact details 5. name and details of the authorising principal (stating that the adviser is an authorised representative of the principal) 6. Information on remuneration and benefits anyone may receive (fees, charges and how and to whom they are distributed) 7. Information about any associations which might reasonably be construed as influencing the advice given) 8. Warning if the advice is based on inaccurate or insufficient information 9. Information on replacing one produce with another - In the past, it was too length and complex, key location was often located in an appendix, too repetitive, not tailored to client’s financial literacy, no cross check with FSG for consistency with the SoA What is required (explained in RG 175) 1. Information elicited from the client (circumstances, expectations) -> should be recorded, agreed upon, signed by client, forms the basis of the resulting financial plan, should notify the client of this at the outset 2. Information on the feeds (eg. may be divided into progressive parts, commission) -> should be disclosed in the first meeting as part of the Financial Services Guide 3. Recommendations made by the advisor that address client needs in the 4 main areas or as limited by the agreement - Under circumstance that advice is to recommend disposing or reducing interest in replacing a product, the SoA must contain additional information including: 1. Client’s existing product has been considered 2. Costs and charges payable on reduction or disposal 3. Benefits the client may lose as result of disposal or reduction 4. Entry or ongoing feeds attaching to the replacement 5. Any other significant consequences of the switch - Not required when: advice consists solely of an offer to sell a product, client makes it clear that they don’t want to buy, no issue or sale result from the offer, advice relates to a CMT where the client is not retail, a basic deposit product or traveller’s cheques, where the advice relates to general insurance, advice over the telephone on traded products, subject to client’s approval RECORD OF ADVICE is an alternative for SOA in some circumstances such as - SoA has been provided previous with client’s circumstances - Relevant circumstances have not changed much - The relevant basis has not changed much Neither of these are required when the advice is for investments less than 15k Product Disclosure Statements (PDS) - Given before the client invests - Designed by an issuer of a product -> gives sufficient information to make an informed decision - Must include: 1. Title of Product Disclosure Statement on the cover but PDS can be used elsewhere 2. Details of significant risks of the product 3. Fees, expenses, charges and taxation implications, any other information that would influence a client Penalties Jail sentences and fines apply when advisers fail to give FSGs, written SoAs, PDSs or provide defective documents that: - Do not comply with Corporations Act - Have not been authorised by the principal - Have unauthorised alterations - Have not been prepared by a proper person The defence is if the financial principal has proof that they took reasonable steps to ensure a document was compliant etc (shows the importance of documenting compliance) Consumer production is to protect against - Misleading and deceptive products - Restrictive trade practices - Corporations act 2001 requires advisers to provide services efficiently, honestly and fairly - other miscellaneous relevant laws ACC administers the TPA generally for consumer protection ASIC (Australian securities and Investments commission) administers provisions in relation to financial services Misleading (leads one to believe something is false) and deceptive conduct - Making or writing a statement - Doing something - Failing to say or do something which is needed to prevent someone from being misted Penalties up to 15.65 million for a company and 1.565 million for an individual - It can be intentional or inadvertent - Not necessary that someone was actually misled - Only necessary that there is a real chance that they might be (it is enough that a naive person is misled) - An accurate statement can be misleading because of context - A disclaimer does not absolve responsibility when the conduct as a whole is misleading Complaints proedures -> 8-step princess for identifying complaints and resolving disputes (at all times, adviser must keep the client fully informed in writing fo what is happening, disclosing the likely timetable of activities) 1. Is there a complaint? Assist the client to put it in writing 2. Can the adviser satisfy the client immediately 3. If the complaint cannot be resolved immediately: - Internal system: adviser and client state their case - Decision by principal 4. Make decision and advice the client 5. If complaint is justified, amend procedures, apologise in writing, and pay compensation if applicable 6. If client not satisfied with decision, advice client of external procedures 7. If client not satisfied with external procedures, client may need to go to court 8. Court or regulator action Financial Ombudsman Service (FOS) - Independent body existing to handle complaints In relation to investment advice to a retail client or insurance constants On handling of a complaint by a member About the operation of managed investment or superannuation schemes sold to retail investors - Aims to consolidate any dispute between members, but if necessary, can then move to arbitration and adjudication where it has powers to make decisions - Arbitration consolidates disputes and makes decision but is more private than open court Tutorial 4 Financial advice = expert advice to build portfolios tailored to personal situations Fiduciary Duty: best interest duty = advisers act objectively and solely in their client’s best interest KYC = information gathering KYP = have appropriate level of understanding of financial products (have expertise) and have appropriate grounds for making the recommendation to the client, based on KYC) Quality of Advice 1. The suitability rule: KYC and KYP - it includes consideration of products alternative to those suggested (there should not only be one product as the only available solution) - Reasons for the recommended product should be augmented by comparisons with competing products - An assessment of each client’s risk tolerance (this can be controversial as attitude to risk cannot be considered ‘constant’) 2. Informed Consent: - Advice to the client must be communicated in a clear and concise manner - Advice is not misleading, deceptive, incomplete or provided in a pressured environment - If the adviser is responsible for implementation of the plan, a written signed statement to the effect that the client understands the projected course of action and agrees to the adviser’s implementation of it, should be obtained and kept Not obtaining a written signed statement from client = advice is invalid Question 1: What is a fiduciary duty in the context of providing financial advice? Advisers need to make sure they are acting in the best interest of their clients and not for their own personal benefit. A fiduciary duty exists when there is an agent-principal relationship, the agent cannot make decisions that benefit themselves unless they can prove that the decision was also in the best interests of the shareholders. Question 2: Explain both the “Know Your Client” and “Know Your Product” rules. Why are they the required standards in ensuring a financial adviser’s fiduciary duty has been met? They arise as a result of the now statutory fiduciary duty KYC: know client’s personal circumstances (where they are at in life cycle, risk tolerance, income, etc) and do sufficient information gathering KYP: have appropriate level of understanding of financial products (have expertise) and have appropriate grounds for making the recommendation to the client (based on KYC) These tests apply at a high level, in the sense that you are required to know substantial details about the client so that the advice provided is suitable for all of their circumstances. Question 3: Who is a principal in relation to providing financial services? Who is an adviser? Principal: any one of - A holder of a dealer’s or adviser’s licence - Any person who obtains a licence under FSRA - A registered life insurance broker - A life insurance company An adviser is the principal and any person who acts with the principal’s express authority, including authorised advisers and paraplanners Question 4: Discuss the difference between general and personal financial advice General - Advice given that are not tailored to yout personal circumstance - The adviser did not consider any of the objectives, financial situation and needs of the person - Different to factual information - Eg. advertisements, how super works information, The adviser must: - Warn that the advice is not based on knowledge of client circumstances and objectives - Indicate that the client must consider the advice in this light if inclined to act on it - Suggest obtaining a PDS before acting on the advice Personal - Recommendation or opinion tailored to your personal circumstances - The adviser has considered one or more of the objectives, financial situation and needs of the person - More specific than general advice and takes into account personal finances and goals - Eg. how your specific super works, advice on other super funds, wealth protection insurance, advice on non-super investment, growing personal wealth, debt repayment In RG175, ASIC advises that advice may be personal even when: - Not face -to-face - No direct contact with the client - Relates to only 1 product - Client is a body corporate - Adviser did not intend to give personal advice Question 5: ‘Quality Advice’ is arguably more than just industry jargon. What are the two key components of Quality Advice? Adduce does not have to be ideal, perfect or even best It just needs to have 3 elements - Reasonable enquiries have been made into client’s personal circumstances - The provider gives considered advice, the subject matter of which has been investigated and is reasonable in all the circumstances - The advice must be appropriate for the client 2 key components of Quality Advice - Suitability rule: KYC, KYP - Informed Consent: agreeing on the basis of the plan, its nature and in particular, its implementation if applicable Question 6: What is a ‘conflict of interest’ in financial planning? Give an example. How are conflicts of interest to be avoided? Conflict of interest: when there is opportunity for the FP to put their own interests above those of the client Example: advising a client of a certain product solely because you earn commission, rather than make an objective recommendation How to be avoided: to disclose commission and make sure the recommendation is still based on the personal circumstances and objectives of the client, regardless of any commissions or other outcome for the FP personally Question 7: Answer the following in relation to the Statement of Advice (SoA): a) What is a Statement of Advice (SoA)? - Sets out the advice and advice context b) When must a SoA be provided? - When personal advice is given, prior to any action that would implement the advice c) What must it contain? - The product details: why it was recommended instead of alternatives - Important details about the adviser: the name, their qualifications, contact details, the name of the authorising principal (needs to state that the adviser is an authorised representative of the principal) - Information on remuneration and benefits anyone may receive (fees, charge and how and to whom their are distributed) - Information about any association which might be construed as influencing the advice given - A warning if the advice is based on inaccurate or insufficient information - Reasons for replacing one product with another d) Under what circumstances can advice be provided without a SoA? - If the investments/basic deposit products/super amounts are less that $15,000 - If the advice consists solely of an offer to sell a product - when client makes it clear that they do not intend to buy - no issue or sale results from the offer - advice is given over the phone on traded products (subject to client approval and that the adviser will supply an FSG) e) What extra detail must be provided when the SoA recommends replacing one product with another - Benefits of changing to an alternative - Benefits of the client may lose from the disposal original - Charges for disposing of one product - Charges for changing to another product - Ay other significant consequences of the action Question 8: a) What is a PDS? When is it required? What should it contain? - PDS: Product Disclosure Statement - Required before the client becomes bound by a legal obligation to acquire the financial product pursuant to the offer/before the client invests in the financial product - Information about the product recommended (very factual): risks of the products, tax implication, fees, expenses and charges, any other information that would influence the client - Doesn’t have to be given physically (eg. can be digitally sent, emailed) b) What is a financial services guide (FSG)? What must it contain? When must it be offered to clients? - FSG: discloses the services offered to the client - offered at the start of negotiations - Must contain: on the cover it must be called: ‘Adviser Financial Services Guide’, but can be referred to as an FSG - Name and contact details of the adviser; any special instructions - Similar information about the authorising principals or each of them - Who the adviser acts for when the services are provided - Information about any business relationships or associations between principal and issuers of any products - Details of internal and external complaints resolution mechanisms - A statement that the FSG has been authorised by the principals Lecture 5 Asset Allocation - In general, different investments perform given their relative risks (for example shares/equity>real property>bonds) -> Expected return is a function of risk - In aus, long-term returns on equities have averaged 10 =11.5% p.a but have much short-term volatility - The equity (risk) premium has historically been in the vicinity of around 4-6% - ‘Real’ (inflation-adjusted) rates of return have remained relatively constant over time Investment portfolio construction 1. Asset allocation (macro decision) - Percentage of available funds invested in the different asset classes - Based on risk tolerance, financial goals and investment horizon 2. Security Selection (micro decision) - Selection of, and investment in, individual securities within each asset class (eg. if you want to invest 60% of funds into equities, this step is which stock or funds to invest in) - Based on company performance, market trends, valuation and personal investment strategy. Also considers individual risk tolerance as some stocks are more volatile than others 90% of portfolio return arises from asset allocation Strategic Asset Allocation - SAA is based on setting target allocations amongst asset classes - Objective is identify efficient allocation amongst the classes then “buy and hold” Buy and hold also minimises transaction costs - Efficient Market Hypothesis: SAA assumes that the aggregate asset classes (like all stocks or all bonds) are efficiently priced, meaning that the prices of these assets already reflect all available information. Under this belief, it’s assumed that no abnormal profits can be consistently earned by frequently switching investments between asset classes. Therefore, sticking to a predetermined allocation and holding it long-term is considered a rational strategy. - Most managers will periodically rebalance the portfolio back to those targets as investment returns skew the original asset allocation percentages Tactical asset allocation - Represents the asset allocation that managers would choose if they belief that certain asset classes are relatively misprices (often temporary mispricing and it is relative) - Managers attempt to outperform a passive benchmark by engaging in market timing, however most times this is done poorly - active/aggressive application of the asset allocation decision Dynamic asset allocation has 3 possible meanings 1. Periodic rebalancing in SAA and TAA -> regularly adjusting the portfolio back to its target allocations as the values of different asset classes fluctuate in SAA or frequent and responsive rebalancing to short-term market opportunities or risks in TAA (still involves adjusting the portfolio’s weightings back to some form of predetermined targets) 2. Market timing in TAA -> deliberate and opportunistic adjustment of asset class weights based on predictions about short-term market movements -> goal is to capitalise on expected changes in the market by moving funds between asset classes at the right time 3. Strategy to replicate return distributions -> replicating specific return distributions, such as those found in financial options -> might involve shifting funds between asset classes in a way that mimics the payoff of an option, such as a protective put or a stop-loss order -> For example, in a declining market, a DAA strategy might involve moving more assets into safer investments (like bonds or cash) to protect against further losses, similar to how a put option might limit downside risk. DAA can be seen as a defensive strategy as it focuses on managing risk and ensuring certain return characteristics, rather than actively seeking to outperform the market through frequent adjustments. In summary, the four broad strategies range from fully passive to fully active management: 1. SAA and Buy & Hold: Fully passive, maintaining both asset allocation and security selection. 2. SAA and Trade: Semi-active, with fixed asset allocation but active trading within classes. 3. TAA and Buy & Hold: Semi-active, with dynamic asset allocation but passive security selection. 4. TAA and Trade: Fully active, with both dynamic asset allocation and active security selection. Active management seeks to exploit market inefficiencies for potential gains Passive management focuses on long-term growth with minimal trading Mutual Fund Separation Theorem: investors can achieve their desired risk-return profile by combining a risk-free asset (like cash or government bonds) with a market portfolio of risky assets (like equities and property). The idea is that any investor’s optimal portfolio can be represented by some mix of these two funds. When given an example what to do: 1. Asset Allocation decision: how much of the funds should be allocated to different asset classes. Guided by the fund’s overall risk-return profile, current market conditions and research or economic forecasts 2. Consistency with Mutual Fund separation Theorem: whether there is a mix of risk-free and risky assets The allocation is consistent with the theorem if it suits the specific risk preferences and objectives of the investors of the fund Fund managers might adjust the proportions based on their analysis of market conditions, regulatory constraints and investor needs 3. Stock Selection Decision: decide how to invest the funds within each asset class Dependent on risk profile of the fund, regulatory restrictions, ethical guidelines, sector preferences or economic forecasts 4. Active vs Passive Management of the Portfolio Active management involves frequent buying and selling of securities to capitalise on short-term price movements. -> Objective is to “buy low and sell high” to maximise gains. Passive Management involves a buy-and hold strategy, based on the belief that markets are generally efficient therefore it is difficult to consistently outperform the market through active trading -> objective is to achieve long-term growth and holds them without frequent trading Cash/Bonds Bond: a contract between the issuer and the investor, evidencing the issuer’s obligation to make specified cash payments to the investor on specified future dates Specified cash payment obligation = the principal + interest (payment for using the fund) Types of bonds (other than coupon paying and zero coupon): convertible, callable, annuity, asset-backed, indexed, and junk *non-investment grade) Low risk: hold to maturity, fixed return that ranks before return on equity High risk: trade bonds on the basis of interest rate forecasts; buy and sell prior to maturity, lading to profits or losses on capital Risks of bonds include: interest rate risk, reinvestment risk, inflation risk, credit/default risk, liquidity risk, rating downgrade risk Investment-grade bonds are considered safer investments with lower default risk, making them attractive to a wide range of investors. They offer issuers lower borrowing costs and improved access to capital, while investors benefit from better liquidity, stability, and the potential for lower volatility in their investment portfolios. Being classified as investment-grade is crucial for maintaining investor confidence and accessing broader capital markets under favourable terms Coupon paying bond - Regular fixed payment of interest (C) + repayment of principal at maturity date (F) - C are often paid bi-annually and determined by the face value of the bond (interest rates) - Eg. - Valuation of coupon-paying bonds needs to consider the timing and amount of coupons - C is not necessarily the market interest rate It is very close to it to make it attractive to investors, market demand supply (If the coupon rate aligns with the market interest rate, the bond is more likely to match investor expectations, facilitating its sale) and expectation of fair return ( the new bond issuance does not appear to be over- or under-valued compared to existing bonds) It is not necessarily because the market interest rate (or yield)fluctuates over time due to changes in economic conditions, inflation expectations, and shifts in the supply and demand for credit. In Australia - Governments are low default risk borrowers -> they can always print out money - Corporate bonds are higher risk/higher return (many corporate bond issues obtain a credit rating to enhance creditworthiness of the issue - As of now, the value of non-government bonds outstanding is around 1.4 trillion, equivalent to a little of 50% of the value of companies listed on the ASX Zero-coupon bonds /Pure discount securities - No payment of interest (C), just face value at maturity - Issued at a discount to par, the interest = F-P - Most common types are commercial bills and treasury notes Issue with entering into Bond Investments in the past was that there was a high minimum investment (eg, purchase of a bank bill where the minimum FV was 100k) as well as, a lack of diversification as a result of paying so much for one bond This issue was resolved with cash management trusts (CMT) which is a managed fund comprising a pool of investors’ funds applied to investing in money market securities of various maturities (spreading/minimising the risk through greater diversification). - They also have lower entry requirements than direct bond purchases, making them more accessible to small investors. - They are managed by professional fund managers who make decisions based on factors like interest rates, credit quality and maturities - They also have daily interest/dividends. This interest can be either withdrawn or reinvested, providing flexibility and a steady stream of income - They offer high liquidity. Investors can usually withdraw their funds at any time, making them suitable for those who need quick access to their money - Investors can also withdraw funds at any time ETF vs CMT - Bond ETFs have become more popular due to their greater flexibility, lower costs, ability to trade throughout the day, diversified exposure to a wide range of bonds, and lower management fees Debt - Imposes a contractual obligation on the firm to make regular payments of interest and principal to the lenders Equity - Represents a residual claim on the cash flows generated by the assets of the firm (less obligation for payment than debt) - Dividends are paid after interest - Capital is returned after borrowings are repaid - There is an equity risk premium - May be generated from both internal (retained earnings) and external (new issues) sources 1. Long-Term vs. Short-Term Returns on Equities Long-Term Stability and Higher Returns: Historically, investing in equities (stocks) has provided stable and higher returns compared to other asset classes (like bonds or cash). Many studies have confirmed that over the long term, equities tend to outperform other investments. Short-Term Volatility: However, in the short term, investing in equities can be risky due to market volatility. Stock prices can fluctuate widely, sometimes leading to significant losses. For example, during the COVID-19 pandemic and the Global Financial Crisis in 2008, stock markets saw substantial declines. In 2008, the S&P/ASX200 Index (a major Australian stock market index) fell by about 50%, causing significant losses for investors, particularly retirees. 2. How Risky Are Shares? Investing directly in shares involves several practical considerations and risks: 1. How and Where to Buy Shares: Shares of public companies are listed and traded on stock exchanges, like the Australian Stock Exchange (ASX). To buy shares, investors need to contact a broker and set up a trading account. The ASX also provides educational resources for new investors. 2. Which Shares to Buy: Choosing which shares to buy is a key decision. This involves researching companies, understanding market trends, and considering diversification to reduce risk. 3. Finding Share Price Information: Investors need access to reliable and timely information about share prices to make informed decisions. 4. Use of Brokers: Brokers facilitate the buying and selling of shares. Investors can choose between full-service brokers (offering advice and research) and discount brokers (executing trades at lower fees). 5. Transaction Costs: Buying and selling shares incurs costs such as brokerage fees and commissions, which can impact overall returns. 6. Documentation of Ownership: Proper documentation is essential to prove ownership of shares and to manage tax and legal obligations. 7. Taxation of Share-Related Income: Income from shares (like dividends) is subject to taxation, and capital gains tax applies when shares are sold at a profit. 8. Valuation of a Share: Understanding how to value shares is crucial for making investment decisions. This involves assessing a company’s financial health, future prospects, and market position. 3. Direct Investment in Shares in Australia Public Companies: Shares of public companies are easily accessible through the ASX. Investors can buy and sell these shares with the help of a broker. The ASX also provides educational resources for beginners. Private Companies: Investing in private companies (unlisted companies) is more challenging because these shares are not publicly traded. This typically requires a personal connection to the company’s owners or principals. 4. Which Shares to Buy? Deciding which specific stocks to buy is part of the "micro" decision in portfolio construction. There are several methods investors use to select shares: 1. Fundamental Analysis: This method involves analysing a company’s financial statements, earnings, growth potential, industry position, and economic factors to determine its intrinsic value. The idea is to find undervalued stocks that have strong growth potential. - They also evaluate current management - Compare with similar companies in same line of business - To be efficient, the market requires that fundamental analysis has been undertaken - However, the EMH assumes that information has already been impounded into share prices (the paradox of the EMH) 2. Technical Analysis (Charting): A ‘time series’ prediction technique (uses price history charts and other indicators). Chartists take the view that there is additional information contained in the movement of the price over time (and sometimes in the volume of trade ie. Japanese Candlesticks). Price, Volume of trade and open interest are required sources of information - It implicitly refutes the weak form EMH - Technical analysis study charts or financial time assets, evaluate patterns and indicators derived from time series, analyse trends and evaluate “bull/bear dominance” and similar jargon 3. Random Selection: This method involves selecting stocks randomly, without any analysis. This approach aligns with the idea of diversification in portfolio theory, which suggests that spreading investments across a wide range of assets can reduce risk. Implications of Each Method: Each method has a different finance theory implication. For instance, random selection is consistent with portfolio diversification, while fundamental and technical analysis rely on identifying specific stocks that are expected to outperform. 5. Diversification and Portfolio Theory Diversification: Investing in a range of different stocks across various industries and markets helps spread risk. On the ASX, investors can access stocks from numerous industries, such as banks, retail, mining, biotechnology, etc. Diversification can also be achieved by investing in international equities, which provide exposure to different markets and industries (like aeronautics). Why do share prices move? - New information (in relation to the particular share/stock), economic cycles, herd mentality - Individual company shares -> the main drivers of price movements are general market ‘drag’ and new information (efficient market hypothesis says that all information available to a share or a company will be impounded into the share price instantaneously) - In theory, the value of a company’s shares is the present value of the firm as assessed, divided by the number of shares on issue - In practice, the efficient market hypothesis holds quite well (in the semi-strong form) - When information is released to the market, participants will interpret it as they will - The consensus interpretation will essentially drive the direction and degree of movement in the company’s share price Getting share information - Quotes in real time on the ASX website (along with other listed securities like rights, options and futures) - Daily financial press gives price listings - ASX and financial press give research in relation to individual companies and sectors - Overseas stock exchanges - Brokers can transact (buy, sell) on your behalf and also provide research on equities (many have dedicated teams of analysts that produce regular reports with buy/sell/hold recommendations) Transaction costs: transacting online is the cheapest and company/sector advice and research is most expensive Documentation: - Contract note (to evidence purchase) - Holding statement -> 1. Holder Identification number (HIN) 2. Specifies company and number of shares held - Dividend or distribution statement (if relevant) Buying Shares: - Find broker and set account - Plenty of choices available and most often you can get started via your current banking arrangement - Decide on your investment strategy (function of available savings and investment philosophy/relative risk aversion) Eg. fixed regular savings, one-off transactions or preferred technique: random, fundamentals or charting Investing in individual shares is the micro decision - There are different outgoing strategies to be employed: Buy and hold (fully passive) Maintain the percentage-value allocation, by making appropriate balancing adjustments over time(essentially passive) depending on movements of market prices Regularly make active adjustments to asset classes and/or individual assets (these changes are based on current and forecast economic environment and active management/market timing in pursuit of abnormal returns) Valuation of Ordinary Shares - Theory: depends on all future expected cash flows (dividends), appropriate rate of return required by investors, k, based on relative risk (beta) - Investors need to make some assumptions about future cash flows and the required rate of return depends on the risk associated with the shared - The most popular pricing method is CAPM Earings, dividends and share prices - Price to earnings ratio (P/E) ratio - - Identifying the P/E ratio is used in valuing privately held companies -> the earnings of the private firm can be multiplied by the P/E ratio of a similar publicly held firm to obtain an estimate of the private firm’s ‘market’ price - Systematic risk is not diversifiable (cannot be avoided) - Unsystematic is diversifiable - Total portfolio risk is a function of the number of assets - More diversified shares = less risks - Try to look for negative or no correlations to diversify risk - Should invest in pools of shares -> explains the proliferation of equity investment funds Tutorial 5 Lecture recap - Equity > property > bonds - Different types of asset allocation (strategic, tactical, dynamic) - different types of management strategies (active vs passive) - Bond: inverse relationship between price and yield - Debt = contractual obligation between issuer and the bondholder - Equity = residual claim on the cash flows generated by the firms - Methods by which firm conduct equity capital raising: IPOs, right issues, private placement and dividend reinvestment plains 1. In the context of portfolio construction, identify and describe the 3 main asset allocation strategies. When combined with the “micro” decision, identify the different overall strategies that a portfolio manager may apply Macro Strategic: setting target percentage allocations amongst asset classes -> objective is to identify efficient allocation amongst the classes, then “buy and hold” -> managers belief that aggregate prices are relatively accurately priced Tactical: belief that there is asset classes mispricing, capitalise on the mispricing Dynamic: term applied to the periodic rebalancing of portfolio weights under SAA and TAA strategies Micro SAA and stock selection - buy and hold -> long term asset allocation is stable SAA - buy and hold ; stock selection - trade -> long term asset allocation is stable but frequent stock trading to capitalise on short-term opportunities TAA - active; stock selection - buy and hold -> active adjustment in asset classes but stock holdings may not change -> change for economic conditions or asset price forecast TAA - active; stock selection - trade [active] -> active management of both asset allocation and stock holding 2. Risk of investing in bonds - Interest rate risk -> if coupon yield the potential risk where future cash flows (eg coupon payments, must be reinvested at a lower interest rate - Credit/default risk -> issuer of the bond may not meet its repayment risk - Liquidity risk -> if bond is not traded or thinly traded, you are holding an illiquid investment - Exchange rate risk - Inflation risk 3. CMT: a managed fund comprising a pool of investors’ funds applied to investing in money market securities of various maturities - They also have lower entry requirements than direct bond purchases, making them more accessible to small investors. - They are managed by professional fund managers who make decisions based on factors like interest rates, credit quality and maturities - They also have daily interest/dividends. This interest can be either withdrawn or reinvested, providing flexibility and a steady stream of income - By investing into market securities of various maturities, there is greater diversification therefore minimising risk - They offer high liquidity. Investors can usually withdraw their funds at any time, making them suitable for those who need quick access to their money Bond ETFs are exchange-traded funds that invest in various fixed-income securities such as corporate bonds or Treasuries - In basic terms, CMT are mutual funds and are actively managed that try to outperform the market, ETFs try to match the benchmark of those securities/tracking a bond index (more passive) Bond ETFs have become more popular due to their greater flexibility, lower costs, ability to trade throughout the day, diversified exposure to a wide range of bonds, and lower management fees 4. Discuss the relevance of the Efficient Markets Hypothesis in relation to daily share price movements on the ASX - It hypotheses that markets are efficient, leaving no room for extra profits by investing - Asset prices fully reflect all available information at anytime - Stocks always trade at their fair value on exchanges, making it impossible for investors to purchase undervalued stocks or sell stocks for inflated prices - It should be impossible to outperform the overall market through expert stock selection or market timing - The only way an investor can obtain higher returns is by purchasing riskier investments - However, inefficiencies do occur (eg. dotcom sector) 5. The Flaws: - The expected return is more volatile (high risk assets are more susceptible to loss in value as risk, standard deviation measures variability around mean, or expected return) - Purchasing too quickly means that she hasn’t considered time horizon (probs short time horizon) - Short time horizon should in fact take on low-risk investment 6. Factors: - 20th of August they released their annual report (good news) -> in line with EMH - The results was higher than had been expected in the market -> seen as positive news, price increased accordingly - General stock market movement, economic or industry factors and herd mentality Managed Investment funds - The proliferation of equity investment funds - Enable investors to take advantage of the pooling of funds - They are available for a broad range of shares including local shares, international shares, fixed income products, foreign currencies precious metals and commodities - ETFs -> type of managed investment fund that can be bought and sold on securities exchange market (can buy on ASX and CBOA) -> usually have lower fees than other managed funds -> you don’t own the underlying instruments, you own units in the ETF and the ETF provider owns the assets -> ETF units can be created or redeemed Index funds - Passive investments that track a benchmark such as market index -> “passive investing” - Many managed funds (ETFs) are in the form of index funds - They do not try to outperform the market, rather, their goal is to match the index/benchmark performance (return) -> you can invest in the market portfolio - Their value will go up or down in line with the index they are tracking - It gives you the opportunity to have a broad-based exposure to an adversity portfolio in the particular market and replicating the return on the class - Actively managed funds mostly have not been able to beat the benchmark returns on a consistent basis after fees, taxes and costs - Rational investors choose to invest in index funds - Empirical evidence shows that index funds have consistently outperformed most actively managed funds after fees, taxes and expenses Actively managed funds reduce performance (return) through excessive trading and high fees Winners rotate - there is no correlation between last year’s winners and this year’s winners for actively managed funds The data strongly shows that it is very difficult to beat index funds on a consistent basis after all fees, taxes and expenses Equity investments - tax issues - Most dividend income is assessable to income tax, but subject to tax imputation (franking) rules under the dividend imputation system -> there are some investments where tax is reduced/not applicable - Transaction costs are tax deductible - Capital gains are taxable at marginal rate, but in many cases after a reduction in the taxable amount (depends on the holding period) - Non-capital losses can be carried forward to future tax year - Withholding taxes will apply to foreign distributions *A capital gain refers to the increase in the value of a capital asset when it is sold. Investing in property - Property investment may be undertaken in either of 2 forms 1. Direct (residential, commercial or land) 2. Indirect (property trusts, property index funds, etc) - Objective: generate returns in the form of rental income (residential or commercial), and/or capital gains (again residential or commercial, plus land) - Residential property is also commonly acquired for occupation purposes (family home) Direct property -risks - Income risk -> vacancy rates (no tenant = no rent) -> usually there is a loan against the property, therefore need rent to pay for interest and capital - Property damage -> repairs and maintenance costs - Interest rate risk on borrowings -> rate could go up -> if you borrow a substantial amount this is a great risk - Market risk -> since capital gains are not assured and can be negative (ie capital losses may be suffered) - Liquidity risk -> property is an illiquid asset (asset rich but cash poor) - Time and cost of buying and selling Negative gearing - What is relevant to investors is the net return in a period after all expenses relating to the property are deducted (interest on the loan, rates, agent fees, insurance, maintenance, etc) - Negative gearing = when an investor borrows to acquire an investment property and the interest and other tax deductible costs exceed the income received from the investment - Where negative hearing (expenses exceed income) is undertaken, there is an implicit assumption made as to future capital growth How does negative gearing pay off? Not net tax saving, it’s net outgoing Assume the property was purchased for 650k Most capital gains will be halved This just means that the property would need to increase in value by an annual average of 1.38% - Indirect property investments - Property companies (listed entities in the business of investing in properties and property EFTs - Property trusts (listed or unlisted), commonly known as Real Estate Investment trusts (REITs) and property ETFs -> listed Australian entities are A-REITs -> income is often tax-advantaged (some properties will have capital allowance, meaning tax concessions and thus tax is reduced eg. only 70% taxable) - Property syndications -> relatively uncommon in Australia due to a number of problems experienced by syndicate operators, and very few have been established since the GFC REITs - Unit trusts that raise funds from the public in a manner similar to companies issuing shares - In a listed REIT, units are bought and sold on a stock exchange (liquid secondary market) - Comparable to managed index funds -> they comprise a number of individual assets of the same class, purchased with pooled investor funds - Commonly used to invest in commercial properties (CBD office buildings/supermarkets/shopping centres, factories and other industrial sites, hotels/holiday resorts) - Issues Tax advantages must be assessed Are they property or equity investment? The underlying assets of a REIT are property, so on that basis they can be classified as property investment. However, REITs that trade on the ASX do so as a business and tend to be priced along equity valuation principles. This must be considered for asset allocation purposes!! Taxation of income - Accessible income - allowable deductions - Income tax is levied on taxable income - Taxable income is made up of assessable income less allowable deductions - Assessable income of individuals includes: earned income, interest income, dividends and distributions, rental income, royalties, short and long-term capital gains Treatment of expenses - Allowable deductions include losses and outgoings (expenses) incurred in gaining or producing assessable income or in carrying on a business (protective clothing, home office -> prevalent when people work from home, travel -> business trip) - Expenses that are not tax deductible include those of a private or domestic nature (not incurred in producing accessible income or in a business) Personal tax rates - Marginal rate is always higher than the average rate - Medicare levy is charged at 2% on income above $29,033 - The amount of tax payable is dependent upon the investor’s marginal tax rate, which is determined by other income of the investor Taxation of Capital Gains - If gains are classified as long-term (asset held over 1 year), a discount applies to the amount that is subject to tax (generally 50%) - $11 buying in $11 buying out Taxation of dividends (imputation system) - Ensure that the tax rate applicable to dividends will be the Marginal Tax Rate of the recipient shareholder - The amount of corporate tax that was paid before dividends are paid is added to the net dividend to get to taxable income (gross up), and it is also the amount of a tax (franking) credit that reduces individual tax - The net dividend received by a shareholder is ‘grossed up’ by the amount of corporate tax paid, to bring it back to the pre-tax corporate income - Used to avoid double taxation (classical taxation system) IMPUTATION CREDIT IS ALWAYS 3/7 MULTIPLIED BY DIVIDEND Tax-free income threshold is the first 18200 of income - Important exception: unearned income of a minor (threshold is 416) - The Low Income Tax Offset (LITO) applies to reduce tax (but not Medicare Levy) for taxpayers earning up to 66667 There is a maximum reduction of $700 for income up to 37500 An individual can earn up to $21884 before any income tax is payable Home Ownership Financial considerations include - Rent vs buy - Savings discipline - Capital appreciation - Tax treatment of owner-occupied housing (CGT exemption) Non financial considerations - Locations, functionality, efficiency, ambience (internal/external), mobility, safety Home purchase process - Determine your pierce range - Approach selected financier (typically require evidence of income, savings (deposit) - Consider financing alternatives - Find an appropriate dwelling - Make an offer (section 32 and “cooling off” period -> not for all purchases like auctions) - Await the outcome - Additional costs (other than purchase price and mortgage interest): loan application fees, State Government stamp duty on both the transfer of property and the mortgage, establishment fee (up-front fee for lending), Registration fees, transfer fee, title and search fees, legal fees, mortgage insurance, fee for valuation of the property, solicitor’s conveyancing fees (legal transfer of a property’s ownership between parties), indirect costs, including moving expenses Home Mortgage - Borrower is prevented from disposing of the property or from using it as security for another loan of equal priority - The market for providing home mortgage loans is very competitive with may available providers - Lenders require: 1. Details of employments such as evidence of salary/wages sufficient to service the portage (pay interest and principal as regular payments over the life of the loan) and proof that employment is ongoing They often incorporate a stress test using a higher interest rate than the current one, to assess your capability to handle interest rate rises 2. Evidence of a savings discipline history (statements) 3. Evidence that you have the required deposit for the loan 4. A credit check may be necessary to prove that no default loans exist 5. A valuation or other proof that the purchase price of the desired property matches its value - They will often require a deposit (they will not finance the full purchase price) - May lenders require a deposit of at least 20% of the purchase price -> most mortgage loans are for about 60-80% of the purchase price of the property The loan can be for a higher percentage but mortgage insurance, which protects the lender against default on the loan, will usually be payable The borrower pays mortgage insurance The cover required increases as Loan to Valuation Ratio increases It is nearly always compulsory on loans with a LVR greater than 80% - Insurance covers an event of default by the borrower - The insurer would compensate the lender for the loss incurred - The mortgage insurance premium can usually be capitalised into the loan principal (payment deferral, but interest accrues) - A lender will require that the property over which it holds a mortgage is insured (property insurance) as well as maybe contents insurance The cost of these will depend on the size, type of structure, location, contents etc of the property Stamp duty -> state governments levy land duty (also referred to as stamp duty) - Roughly proportional to the price paid (eg, the more expensive the property the higher the stamp duty) - You can reduce the amount of stamp duty payable by purchasing land, then building on it (paying only duty on the land) - Special reductions of duty apply to first home-buyers, and where the property is purchased “off the plan” (when building has not yet been completed) Alternate home loans - Fixed rate mortgages - Interest only mortgages - Mortgage offset accounts -> (everyday bank account that is linked to your home loan) you can deposit your salary and savings into the account and the balance is then offset against the amount owing on your home loan -> genuine concession that results in tax savings to mortgage holders - - Low-start loans - Capital indexed loans - Cocktail loans -> part fixed and part variable rates Rent vs Buy - Buy: pay a mortgage and eventually own the property - Rent: invest the difference in an investment portfolio or superannuation The amount of deposit paid typically influences the outcome One element in favour of the buy decision is that the rent choice requires a savings discipline

Measuring Financial Wellbeing with Self-Reported and Bank Record Data (PDF)

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