Risk and Riches - 29th October 2003

Peter Freeman - Bulletin

The property boom has made many ordinary Australians a lot wealthier. Some have even become rich. For these people there is no doubting the claim that real estate is the way to wealth.

But is it? At the very least it is important to realise that the recent big gains generated by rising house and apartment prices are often illusory, if only because for most people the gains – even if sustainable over the long term – are the result of just one thing: their decision to buy a family home.

Except for that small minority who are genuinely prepared to trade down to a smaller or less desirable home, this sort of gain means little in real terms. For those who want to build spendable wealth, without selling their home, it is crucial to do what most of us don't do – invest.

"Most Australians buy a home and get the superannuation guarantee contributions from their employers, but that is about all," says Marisa Broome, head of advisory group Wealthadvice, who adds that this is the case even when account is taken of the recent love affair with property.

Unfortunately, while the surge in residential real estate prices has boosted the number of people investing in property, for many this is just as likely to end up leaving them with a loss as a gain.

This is not because property isn't a good investment – obviously, it often is – but because many of those who have entered the market in the past few years have merely been swept up by that latest Australian "gold rush". With prices surging and almost daily reports of property success stories they have simply jumped on the latest investment craze.

"A lot of people rushed into technology shares towards the end of that particular boom without having a sensible idea of the risks or any real investment strategy," says Peter Thornhill, a specialist in investment psychology and head of Motivated Money.

While Thornhill stresses he is not suggesting that residential property is set to suffer the sort of sudden slump that hit the dotcom sector, he does argue strongly that all investment decisions should be part of a properly worked out strategy that not only takes intelligent account of possibly the most important investment issue – risk – but also of your psychological ability to handle it.

"It is hard to build wealth reasonably quickly without accepting quite a bit of risk," he says. "What is really important is to understand this, to assess the chance of failure and then decide whether you genuinely have the temperament to handle it."

At the moment the outlook for residential property ­investors is more challenging than it has been for some time, partly due to the strength and length of the recent boom, partly due to the possibility of rising interest rates, and partly because most people buying real estate need to borrow, sometimes heavily.

"It is difficult to know where any particular sector is heading, and that is just as true of the various residential real estate markets as for shares or bonds or anything else," says Robert Mellor, a director of forecasting group BIS Shrapnel. "While we believe prices in several markets – particularly south-east Queensland but also Sydney and Perth – will keep rising for another few years, it is important to assess the cost if your assumptions are wrong and build that into your investment decisions."

All this advice – the importance of assessing risk, understanding your ability to handle it then developing a viable investment strategy – applies not just to real estate but to the whole process of wealth creation. If you don't take notice of it the chance of building even modest wealth will be ­seriously impaired.

Unfortunately, for many of us this process, if carried out properly, quickly reveals one sobering fact: our unwillingness to take on more than a modest amount of investment risk. What's more, many of those who think they can handle investment volatility often find out that, when markets suddenly turn down sharply, they are a lot less risk-tolerant than they thought.

"The recent slump by international sharemarkets was a hard lesson for many people who had bought in during the Wall Street boom," says Laura Menschik, head of Sydney-based advisory group Millennium Financial Services. "While they thought they had the temperament to handle major setbacks, in fact when share prices actually fell heavily they found out that the psychological pain, and the worry, was much worse than they had anticipated." This group learnt the hard way that accurately assessing your risk ­tolerance is often a difficult exercise.

The bottom line is that carrying out this assessment is extremely important mainly because the ability to take calculated risks when investing is a crucial factor affecting your chance of building significant wealth, especially of doing so quickly. If, instead, you are an inherently cautious investor you will need to set your sights lower and adopt a longer time horizon. For those in his group the main message is clear – start early (see below).

This, of course, is not an option for many people. Andrew Lowe, technical manager with ING Australia, argues, however, that it is never too late to start building wealth. While acknowledging that your pot of retirement savings may be smaller than it might have been, he stresses that by making sensible use of super, modest gearing and diversifying (see pages 64-65) you will unquestionably boost your chance of having a comfortable retirement.

Super can also be a good way to take an exposure to more volatile growth assets such as international shares. "The thing about super is that the rules mean you have to have a long-term view since you can't get your money out until you retire," says Broome. "Unless you are close to retirement, super is definitely a good way to take a reasonably aggressive, rather than a defensive, approach."

But even if you use super in this way, a diversified strategy is unlikely to result in you becoming wealthy quickly, a point stressed by Paul Clitheroe in his Make Your Fortune by 40: Fast-track your way to wealth (Viking). He argues that, while spreading your risk across a range of asset classes is often a good way to build up satisfactory retirement savings over the long term, the crucial ingredient for trying to build wealth quickly is the willingness to accept risk.

In particular, Clitheroe says, building wealth, especially quickly, often requires actively avoiding diversification and instead put all your eggs in one basket, be it a ­particular investment sector, developing a commercial idea, or building a business. It is, he notes, simply a case of accepting much longer financial odds in an attempt to get a bigger return.

Of course, the trouble with this approach is that quite a few who take big investment or business bets fail badly. The important thing to remember – and Clitheroe definitely appears to be right about this – is that, whether you win or lose, trying to build wealth in a hurry (in his words, by 40) means you will have to stick your neck out and take a few chances.

Thornhill says that, for those looking on in envy but who honestly know they are too cautious to adopt a similar approach, the bottom line is that they have little choice except to use diversification and cautious gearing in an attempt to get rich slowly, not quickly. This is because no matter how much they would like to, totally overcoming their natural caution is probably not possible.

This is also the conclusion reached by Proquest, the Sydney-based research and consultancy group that, among other things, provides risk-­profiling software for financial planners and investors. Based on its studies, including one of 11,000 investors between mid-1999 and early 2002, it concluded that once a person's risk tolerance has been set, it usually doesn't change much over time.

Precisely what determines how much risk you can take is debatable, although the way you were raised appears to be very important. As well, your current life situation (your age, whether you have dependents, and so on) is also significant. All these forces either cannot be changed or changed only with difficulty. The two main things all of us can change, however, are our understanding of our risk tolerance and our knowledge of investment issues.

Thornhill says that the main hope for those who want to be able to take more risk seems to lie in making an effort to become more financially knowledgeable. "Greater knowledge helps people to understand markets better, accept their inherent volatility and, quite often, be in a better position to handle it."

This is supported by a study by Proquest in 1998 which focused on more than 20,000 users of financial web sites – people who might be expected to be a bit more financially literate, even if only as a result of their visit to such sites, than the average adult Australian. Whereas the latter group had a risk tolerance score of 50 that for the surveyed group was 14 points higher. While this doesn't mean more knowledge automatically results in a greater acceptance of risk, it does hold out hope for those looking for a way to become less risk-averse.


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