GARBAGE IN. GARBAGE OUT! PART 2

If I gave you the choice of two identical investments – identical in every way, same price, same risk etc the only difference, one was to return 20% and the other 50%.

Which one would you choose?

As investors it’s important that we understand the concept of returns and importance of compound interest.

“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it” Albert Einstein

See its compound interest that makes us our investment dollars, diligently working away making us money while we are sleeping.

My first trading mentor Robert Krausz used to say “Never buy anything that eats while you sleep. But if it works while you sleep that’s a different story”.

He’s right you know – I have two teenage boys who regularly eat while I sleep, (they also eat while I’m awake!) and they have proven to be a very poor economic investment so far… but I do love ‘em anyway.

Image by Nattanan Kanchanaprat from Pixabay

Robert was really talking about compound interest and it is this same concept that allows many investors to be hoodwinked into risking life savings on projects and investments that have little likelihood of ever achieving the “projected” figures.

In my previous Blog “Garbage In Garbage Out! Part 1″ I made the point that the world, which includes investment markets, doesn’t move in a linear fashion. It would be nice and a hell of a lot easier if it did, but it just doesn’t work that way.

garbage in. garbage out! part 1

In reality life and investment markets ebb and flow. Ying and Yang. With positive and negative. Good and bad.

Which means when it comes to investments, we have Positive returns and Negative returns.

Image by PublicDomainPictures from Pixabay

So, in this Blog I want to show you how changes in the underlying assumptions can make a material difference in the projections you are presented with and hence how you evaluate and feel towards that investment.

Let’s take the example of someone wanting to buy an investment property. As they undertake their due diligence the agent provides them with some cashflow figures which shows the property will provide $65 per into your pocket a week and a $480,424 capital gain windfall in 10 years time!

OK so it’s got your interest…

But your next question before you excitedly look to sign your name in blood on the contract should be what ASSumptions are these figures based on?

Because you don’t want these ASSumptions to end up making an ASS out of you!

So, in this example, let’s have a look at exactly what are the ASSumptions this cash flow is based upon:

  • Property Value as $500,000
  • Your Income as $100,000pa
  • Interest Rate 4.75%
  • Deposit 20% (ie 20% of Purchase + purchase costs)
  • Expected Inflation 3%pa
  • Growth assumed to be 6%
  • Rental set at $500 per/wk

We will refer to this as our Base Line Projections.

These seem to be “reasonable” ASSumptions, but do remember everything here is assumed to occur in a linear manner, which is not reflective in the real world.

So, what would happen if we “tweaked” these Assumptions a little?

This concept of “Tweaking the ASSumptions” is very important to understand so that when you are presented with any future projections, whether it be your Superannuation, Share or Property Investments you can make sure you understand what is going on.

Photo by Alex Knight on Unsplash and Carlos Diaz from Pexels

This “tweak” is just one of those tricks that those selling financial assets use to ensure that potential purchasers are presented with information that can create a “positive impression”. Of course, any such cashflow figures will always be accompanied with all sorts of disclaimers and disclosures releasing the provider from any responsibility or recourse if their hopeful cash flow projections fail to materialise.

So, I thought it might be interesting to have a look at what would happen to our numbers in the presented Base Line Projections should we just “tweak” a few Assumptions along the way.

  1. What if we reduce the assumed Interest rate from 4.75% to 3.74%:
Base Line ProjectionsAlternative Projection
After tax Cost per week$55 in your pocket$105 in your pocket
Equity after 10yrs$480,924$480,924
After tax return per year18.80%20.39%
  1. If we were to reduce the deposit required from 20% to 5% the effect would be:
Base Line ProjectionsAlternative Projection
After tax Cost per week$55 in your pocket$9 in your pocket
Equity after 10yrs$480,924$403,205
After tax return per year18.80%33.82%
  1. We’ll now assume the rent is $575 per week instead of $500 per week
Base Line ProjectionsAlternative Projection
After tax Cost per week$55 in your pocket$95 in your pocket
Equity after 10yrs$480,924$480,924
After tax return per year18.80%20.26%
  1. If Growth was presented as 9% Growth instead of 6%:
Base Line ProjectionsAlternative Projection
After tax Cost per week$55 in your pocket$56 in your pocket
Equity after 10yrs$480,924$769,182
After tax return per year18.80%24.04%

You can see how just a small change in the underlying assumptions can have a BIG effect on the “projected” outcome of the cashflows.

Garbage In. Garbage Out!

Photo by Paweł Czerwiński on Unsplash

This is why some investors get themselves into so much trouble. If someone was to be presented with cashflows where it is ASSumed the Interest rate was 3.75% and not 4.75% AND the example used a deposit of 5% and not 20% AND growth is assumed to be 9% and not 6% then we would get the following result:

Base Line ProjectionsAlternative Projection
After tax Cost per week$55 in your pocket$110 in your pocket
Equity after 10yrs$480,924$691,463
After tax return per year18.80%50.90%

Photo by Camylla Battani

Which brings me back to my initial question.

If I gave you the choice of two identical investments – identical in every way, same price, same risk etc the only difference – one was to return 20% and the other 50%.

Which would you choose?

In this case the investments are so identical they are actually the same. It’s the same investment being presented with different underlying assumptions.

Which would you have choosen?

Many investors would jump at the opportunity to make 50% on their money with an eager sales person only too keen to point out the superior investment performance and happily discard the other.

The points I’m trying to illustrate are several fold:

  1. Be VERY careful when comparing investments as the devil is always in the detail. The assumptions used will have a massive impact on the figures being presented to you.
  2. Don’t expect life to resemble the projected cash flows too closely. In life things change and never move in a linear manner. Regardless of how carefully the assumptions have been assessed, the reality will ALWAYS be different.
  3. Always understand the integrity of the person providing the cashflows and how realistic they are.
  4. Understand the sensitivities of any investments and how they could impact upon your own personal cashflows. That is, what will happen should different assumptions play out, how will that affect you, your lifestyle and decision-making ability.

Despite all this, it is important to always gather as much information as you can. Certainly, consider the numbers that are provided to you in any cashflow projections but understand the ASSumptions and the effect that any change to them will have on the outcome.

Personally, I’m not a big wrap for projections. I would rather understand and make an investment decision based upon the underlying asset with regard to the current Economic and Credit Cycle for example, where we are in the current cycle? What are the underlying drivers? Is it a buying opportunity for the particular asset you are considering? How does it compare with other assets?

Understand the cycle.

Understand the drivers.

Photos by, TheDigitalWay, Aditya Joshi, Jacek Dylag, _M_V_ and yucel-moran

Understand your Calnan/Flack Economic Action Plan

I cannot emphasise investment fundamentals enough; by understanding the cycle and the drivers will make the investment decision a whole lot easier than just examining the cash flow projections.

Always remember – Garbage in. Garbage out!

LET’S GET STARTED 

If you want to avoid the mistakes of not understanding the dangers of investing without an understanding of the Economic Cycle, then why not have a chat to us about how we could help?

You have nothing to lose except a few minutes of your time and everything to gain.

So… let’s get started.

IMPORTANT NOTICE

Disclaimer: Any opinions or recommendations expressed here do not purport to Financial Advice but rather should be considered General Advice and does not take into account your personal needs and objectives or your financial circumstances. You should therefore consider these matters yourself before deciding whether the advice is appropriate to you and whether you should act upon it. Should Financial Advice be sought, we suggest you seek such advice from an appropriately qualified advisor. Any yields, rental income, tax rates, interest rates, depreciation rates, inflation rates Dividends per Share (DPS) and Earning Per Share (EPS) etc shown are estimates only and should not be used as a guide to future performance. Past performance is not necessarily a guide to future performance and should not be relied upon for this purpose. Authorised Representative of PGW Financial Services Pty Ltd – AFSL 384713 ABN 15 123 835 441.
2019-07-05T15:57:20+10:00

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