Investment in one quick lesson

This article is intended to be a quick lesson that ought to give you a basic grounding in how investment works. Refer to other sections of the FAQ for more detailed information.

Growth assets vs income assets

"Growth" assets are assets that increase in value over time. These include shares and property, as well as other more exotic asset classes like timber plantations etc. The other type of asset is an income asset, like a bank account, a mortgage or a bond. These pay an interest rate, but the account balance itself does not grow (unless you reinvest the interest). Income assets are also called "defensive assets" because they are usually less risky than growth assets.

The advantage of growth assets is that they give better returns over time than conservative assets, in the long term they even give better income because the income stream will grow along with the capital value. Unfortunately, they are also riskier, they can produce negative returns from time to time, which is why you shouldn't buy them if you may need your money back in the short term.

Try to think of shares and property as something you should invest in if you have at least 10 years before you needed the money again. Don't go into the stock market for the short term, that is more like gambling than investing. If you do have 10 years or more though, the stock market is quite secure over that time frame, and investors who diversify and simply buy and hold almost always do well.

Defensive assets that pay interest usually offer relatively poor returns and very poor tax efficiency. If you want to maintain the spending power of your portfolio you have to overcome three barriers:

• inflation

• tax

• your own spending

Inflation is a virtually inevitable slow rise in prices that happens over time. When budgeting your spending you need to take into account that your expenses will be higher in a few years. Because of that you do need a certain amount of return just to keep your spending power where it is, so you can't spend all of your interest until you've set aside some to take into account the shrinking of your portfolio.

Tax is another obstacle that must be overcome. Interest paying investments have no special discounts on tax, every bit of interest you earn is taxable income, meaning you will have to set some of your interest aside to take this into account. If you bear in mind that you've already had to set some of your money aside to compensate for inflation, you can probably see that the amount left for you to actually spend is going to be quite low.

So after taking into account tax and inflation you still need to spend some money. You'll most likely find that there isn't much left, which is why it is generally a good idea to shoot for higher returns unless you want to draw down the capital value of your portfolio. This will necessarily involve taking on a bit more risk, how much risk you take depends on how you put together your portfolio.

Risk vs return

Imagine if you had a choice between a completely riskless investment that paid 10%, and a completely riskless investment that paid 5%. Which one would you go for?

You'd go for the higher returning one of course, unless you really don't like money. Everyone would, and in such a situation the lower returning investment would vanish through lack of takers. In a reasonably well informed market, any investment that offers inferior returns for a given level of certainty would just die out. Thus, within a certain amount of variation to take into account liquidity and certain other mitigating factors, all investments that offer a given level of return do end up having quite similar risk characteristics.

The only reason why there are a choice of returns is because different investments have different risks. While obviously in a well informed market you won't get terribly many investments offering dramatically better returns for the same level of risk, people may be encouraged to enter into a more risky investment if the return is better. This works both ways, risky investments would never exist in a well informed market unless they offered the potential for higher returns, just as low yielding investments would never catch on unless they offered a high level of security in return.

You can codify this into a rule:

Risk and return are linked. There are sufficiently many well informed investors out there snapping up mispriced assets to ensure this to be true in a practical sense. The higher the return offered by an asset, the higher the risk is likely to be. Nobody in their right mind would offer an investment for sale that really offered a vastly superior return unless it was very risky.

Portfolio construction

Ok, so individual assets are going to be risky in proportion with the return offered. There is no way of getting around this because nobody would sell a high yielding investment unless it was risky, and nobody would buy a risky investment unless it offered a high return. Can anything be done to improve the situation?

Actually, it wasn't until the 1950s that people really started thinking seriously about risk management, when a young economics student called Harry Markowitz wrote a thesis where he hit upon the idea of combining individual assets in such a way as to improve the risk/return tradeoff.

The idea was simple enough: if you could find assets that behaved differently to one another, assets that rose and fell at different times, then holding both of them would be less risky than holding one or the other.

Markowitz proposed that you might measure risk in terms of the variability of returns or volatility. A low risk portfolio would offer a certain return, a risky portfolio would have a less certain return. You measure variability with statistics, the spread is defined by the standard deviation of returns.

One standard deviation is roughly the range on either side of average that would include two thirds of all data points. So if you state that an investment has returned an average of 10%pa with a standard deviation of 15%, you know that roughly two thirds of the time this investment returns between 10-15=-5% and 10+15=25%. One third of the time the investment gives a return outside this range, but a standard deviation gives you the most common range of outcomes. (Note: this is a great oversimplification, but if you are bored with statistics and have no interest in the finer points of it then that explanation will do).

The clever idea Markowitz had was that when you bought these two assets that behaved differently, their combined volatility would not be the average of the two standard deviations, i.e. (15% + 20%)/2 = 17.5%, but something potentially lower. Another statistical measure is correlation, this measure defines how similarly the two assets behave. Correlations range between +1 and -1. Two practically identical assets will have a correlation very close to +1, two assets that are completely different (one always zigs when the other zags) will have a correlation close to -1. If you can find two assets with a correlation of -1, their risk will cancel completely and you'll have a portfolio with zero volatility.

That would be wonderful, except that no two real world investment assets have a correlation of -1, they usually have a correlation between +1 and -1, often closer to zero. When two assets have a zero correlation then it means they move totally independent of one another, as opposed to -1 which means they move together but in opposite directions. While unfortunately you can't find assets with a negative one correlation and thus the potential to cancel out all risk, the good news is that as long as the assets have a correlation anything less than +1 they will cancel out some of each other's volatility.

Since all real world assets have a correlation with all other real world assets of somewhat less than +1, then obviously any combination of assets is going to have a superior risk/return tradeoff to any single asset. If you add more assets to your portfolio, you'll reduce your volatility even further. Of course you can't reduce your volatility for ever, there is in fact a minimum volatility for any given level of return.

The minimum level of volatility for any given level of return is charted on a curve that Markowitz called the efficient frontier. The diagram I've drawn below shows you what efficient frontiers generally look like (though the shape can vary when you look at short term data). If you are good, you construct a portfolio that lies on the efficient frontier, the line that divides the white top part of the chart from the grey area under the curve. A portfolio lying right on this curve is "efficient".

When you set a computer to create a thousand portfolios based on past performance data, coming up with a huge number of combinations of assets including various categories of shares, property and defensive assets you do actually get a curve shaped like an efficient frontier. When you look at the left side of the chart you are looking at the lowest risk portfolios, and these portfolios usually tend to be all cash. At the extreme right is a portfolio assembled out of 100% of the best performing asset, which might have been small cap value stocks from emerging markets, or some similarly unpredictable asset class.

You'll note that from the left side of the chart the curve travels vertically, in fact often efficient frontiers curve up and to the left at first, as I've drawn here. This reflects that a very small addition of other asset classes such as shares and property can significantly boost the performance of a conservative portfolio without increasing risk substantially (sometimes it actually reduces volatility!). When you start at the right, you'll note that the line is practically horizontal. You can wipe significant amounts of volatility out of a portfolio by diversifying somewhat, without reducing performance significantly.

In between are going to be all the mixtures of assets. You can never know in advance which portfolios are going to lie right on the efficient frontier, checking your computer you might find that the most efficient portfolio for the level of return sought happened to be some weird mix of Japanese small stocks, Latin American bonds and European property trusts. The trouble is that when you repeat the test on new data some other equally bizarre mixture will be "efficient", and the other mix chosen might be highly inefficient. A perfectly efficient portfolio can never be constructed in advance, so if some adviser ever tells you his portfolios are designed to sit right on the efficient frontier you know the guy is either telling fibs or lacks that essential ingredient of financial advising - a clue.

Forget about trying to construct portfolios that lie right on the efficient frontier, efficient portfolios are chimeras that can never be knowingly constructed in advance. Instead all you can (and should) do, is include as wide a spread of asset classes as possible and alter your balance of growth assets to defensive assets according to your tolerance for risk.

The more shares and property in the portfolio, the better it is likely to do over the long term, but the more volatile it will be. Although you can't get a portfolio right on the efficient frontier, you can get it reasonably close by diversification. When constructing your portfolio, make sure you've got exposure to as wide a range of asset classes as possible, including domestic and overseas shares, property trusts, some conservative assets particularly if risk reduction is important to you. You can divide up your shares portfolio further with exposure to "value" type indexes as well as small companies and other sectors.

Don't listen to any of these silly arguments people make about shares vs property - you need to be in both of them! Contrary to what many salesmen say, property does lose big money from time to time, and some types of property almost always lose money for their investors.

Shares do well in certain circumstances, property does well at other times. Each has certain advantages and disadvantages that make them ideal complements to each other. There is also a strong case to be made for leaving some money in reserve. Despite the poor long term after-tax and after-inflation returns, they can significantly reduce the volatility of a portfolio, and for aggressive investors cash can be used as a strategic reserve, there to be called in when markets drop significantly for bargain hunting.

For more info on this topic, read the Portfolios FAQ.

Think long term!

I tell my clients all the time to look at shares and property as long term propositions. The good news is that in the long term we are almost certain of getting good profits from markets. The bad news is that in the short term markets fluctuate a lot.

A cruel trick that the markets play on the unwary is that trends tend to look very obvious on historical charts. The obviousness of these trends makes people assume that following them in real time is going to be easy, so you ought to be able to make even bigger profits by selling as soon as the trend goes down, and buying as soon as you see it turn up again.

The trouble is that in reality it is hard to tell the difference between a big trend and a small temporary fluctuation until the trend is virtually over. You may from time to time catch big trends, but more often than not you'll end up "churning" your own portfolio, being pulled in and out of the market by new trends that turn out to be little bumps and ignoring little bumps that turn out to be major trend changes.

All these transactions themselves will harm your profits because trading costs a lot of money in terms of brokerage and other trading expenses, not to mention that short term trading generates a lot of short term capital gains distributions, which are taxed at twice the rate of long term capital gains distributions. If trends were as easy to exploit as they appeared to be then we'd all be neck deep in money, unfortunately the only people that benefit from it are stock brokers that get significantly more buy and sell orders, and of course your fellow taxpayers who benefit from all that extra tax you are paying.

Try to think of all investments as income producing. Shares have a dividend yield of a couple of percent (at the moment), as their prices grow over time you'll still get a couple of percent dividend yields, but you'll be getting a couple of percent off a much larger account balance - which means the income will eventually exceed that generated by defensive assets which initially provide a higher yield.

If you think of shares as a way to create an income stream some day, then you'll welcome market drops as an opportunity to buy more at cheap prices (thus improving your long term yield). This is not the same as the way most people look at shares, they tend to think in terms of shares being something that goes up in value and you sell them.

To a long term investor, the only reasons to sell a share are because the company behind the share has significantly deteriorated since you bought it (assuming this deterioration is not fully reflected in the share price), or because you need the money to buy an even better share. If you train yourself to think of market drops as a good opportunity to buy, as opposed to the common view that market drops are a good time to panic and sell, then you'll end up holding a lot more shares over time and you'll do a lot better.

Why you should buy poor performing assets

In the portfolios section of this FAQ, I have written an article on contrarian asset allocation. In that article, I compare the returns of two strategies used by imaginary investors.

Investor A is a performance "chaser", starting in 1981 and ending in 2001 this investor rolled his portfolio over every year into whatever asset class has had the highest performance over the previous 12 months. In other words, this guy was looking at the one year performance of each asset class, hoping to catch any remaining momentum in them in case they did well for two years in a row.

Investor B is a performance "contrarian". This investor did the exact opposite of investor A, she bought last year's worst performing asset class. It seems like a dumb thing to do, always putting your money into investments with a rotten track record, but remember this is just a "thought experiment".

The chaser earned a respectable 12.28%pa over these years, losing money in 5 years. The contrarian earned 20.06%, losing money in only one year. For this particular 20 year period at least it definitely seemed to be a better strategy to put your money into assets with a lousy short term history than a good one, which is the opposite of what many people do.

I'm not saying that rolling over your portfolio annually into last year's worst sector is a perfect strategy (actually it isn't a good idea at all, the cost of all that selling, including capital gains tax, would wipe out much of your benefit.) A better strategy would be to establish a diversified portfolio as described earlier, and focus your future buying attention on whatever sectors have taken the biggest drubbings. Thus, you are doing a lot of buying in those sectors, but you can still be a long term investor and not sell unless forced to.

If you get one thing out of reading this article it should be that buying things just because their past performance is good is always a dumb strategy - so don't do it.

Value investing vs growth investing

There are two main schools of thought in investment, one is called "value investing". Value investors are professional bargain hunters, they are looking for stocks that are cheap and offer good potential to bounce because they have been sold down too low.

"Growth investing" isn't so much about buying bargains, it is about paying premium prices for premium stocks. Some companies are so good that their earnings are likely to increase at a rapid rate for the foreseeable future. Growth companies are high quality companies that "everyone" knows are good. (NB: don't confuse this usage of "growth investing" (investing in fast growing companies) with "growth assets" (assets that grow in value over time such as shares and property), they mean different things).

Properly done, both strategies are highly profitable. Value investors pick up stocks that have been irrationally sold down to prices so low they represent a great bargain, and value stocks can perform extremely well. Growth stocks can be profitable because these sorts of companies tend to enjoy the biggest rises during bull markets.

Which is better?

First of all, from a portfolio construction point of view, it can be a good idea to have aspects of both in your portfolio, naturally if you can diversify using two approaches you'll end up reducing the volatility of your portfolio, because totally different approaches will produce results that are not strongly correlated.

Growth strategies tend to do extremely well when markets are strong. It is during these times that high quality "blue chip" stocks rise and rise, sometimes to ridiculously high prices. The fastest rising of all stocks tend to be growth stocks. The trouble is that growth stocks are often the most rapidly falling when markets fall. Right now as I write this (July 2002) with quite significant uncertainty in the markets many formerly high flying growth stocks are dropping like stones.

Value strategies, primarily because they focus on stocks that have already fallen, often fall less than growth strategies during falling markets. In fact it is not uncommon to see value investors chug along slowly for many years during a bull (up) market, only to see them suddenly streak ahead when markets become expensive. I can think of a number of value funds right now that have returned around 20% in the last year, while international markets have actually fallen by the same amount, a 40% outperformance of the market!

Over a full cycle, there is some evidence to show that value tends to beat growth. Growth companies may make huge profits, but we aren't buying companies, we're buying the stocks of growth companies. Because the market tends to give growth stocks a premium price, this usually translates to low yields for investors. Growth stocks are often the types of stocks that you would like to hold at the start of a bull market, if only you can dump them before the market turns, a kind of musical chairs played by stock brokers.

Can you switch between value and growth to take advantage of their relative profit patterns? It is an interesting question, undoubtedly if you could pull it off you would make a lot of money, but you are only one step away from market timing again. Sell decisions are difficult to make, again I suggest if you are going to try this kind of strategy you should concentrate on buying whichever strategy has the worst short term performance. Sometimes value has two good years in a row, sometimes more. Maybe you would be better off looking at longer time frames, like 5 or 10 years perhaps. Try to avoid any strategy that calls for too-frequent selling, because the more often you sell the more often you'll be liable to pay for capital gains tax.

Academic support comes in for value as the better strategy in the longer term. If you define "value" with simple quantitative descriptions like "lowest price to earnings ratios" or "highest dividend yields", then value undoubtedly beats "growth", if you define growth to be the opposite. Researchers have long known about a tendency for portfolios of stocks trading with stereotypical value characteristics to beat growth stocks. (Read the stocks FAQ and the portfolios FAQ for more info).

If you are going to invest directly (buy your own shares), it is best to specialise in one form of investment, rather than try to be a jack of all trades. Some people are intrinsically more suited to a qualitative strategy (as growth investing tends to be), while others go for a more quantitative strategy (value investing often involves number crunching so you can value a stock). Once you have decided on which strategy you want to use, stick to it. You might want to delegate the other strategy to someone else, and the most convenient way to do that is to select a managed fund with the opposite style to the one you use.

Managed funds

In the managed funds FAQ I have written a number of articles on the subject. Some of them deal with the tricky subject of index funds vs active funds.

Before I start on the debate, I'll explain the difference between them: 

• An index fund is a passive strategy fund that tries only to buy all, or most, securities in an index like the All Ordinaries Index.

• An active fund is a fund that tries to "beat the market", by employing analysts to select the best securities to buy.

(I use the word "securities" rather than stocks because of course there are funds that buy bonds and property and other assets apart from stocks.)

Index funds don't try to beat the market because they are based on the belief that it is a more reliable strategy to simply keep costs low, rather than try to be too clever. Index funds tend to be very good at keeping costs down, often fees are less than half (sometimes a lot less than half) of what a managed fund charges.

Managed funds are based on the belief that through careful analysis, security selection and/or market timing that superior returns are possible. They are necessarily more expensive than index funds because they employ a lot more workers to carry out this research, often very highly paid ones. In addition, many managed funds have higher marketing expenses, because unlike index funds which compete on fees, actively managed funds compete with other managed funds to impress people with their performance and corporate image, which means index funds usually have low key marketing efforts since a good one "sells itself", while managed funds spend a fortune on TV advertising and glossy brochures, not to mention incentives to financial advisers such as trail commissions and marketing support.

Historically, on most world markets (except perhaps Australia, as I'll explain below), in virtually all sectors, index funds have beaten the vast majority (often over 75%) of all active funds. The reason for this is costs. I'll leave it to Nobel Prize winner William Sharpe to explain, read this article before proceeding any further: http://www.stanford.edu/~wfsharpe/art/active/active.htm

While undoubtedly there is tremendous merit in indexing (and hence in my opinion everyone should have at least some, if not all or most of their money invested in index funds), there are a few practical problems with them in Australia.

First of all, we aren't as lucky as Americans in terms of the range of indexed products we have. In Australia, unless you want to buy exchange traded funds on the US market via an international stock broker, we just don't have a particularly great range ofpassive funds.  If you want passive exposure to small value companies then you need to find an active fund, because we don't have an index fund in Australia that does that. Dimensional Fund Advisors do offer some interesting passively managed quasi index funds that give exposure to small companies and value companies, but in the USA they have dozens of different index funds to choose from. DFA only deal with approved independent financial advisers, not with the public, though you can buy their funds via some super funds and master trusts.

So not having a particularly exciting choice of index funds is one drawback for Australians, the second drawback is that as a matter of fact there does seem to be some evidence that active funds have beaten the All Ordinaries Index in Australia over the last decade. If you understood the above article by Sharpe, you'll find that quite puzzling, the average performance of all investors must necessarily be equal to a broad market weighted index, minus costs. Who is buying all the poorly performing stocks that drag down the index, if it isn't the Australian fund managers? It is impossible for all investors to be above average!

This is a very tough question to answer, but my own theory is that the performance drag on the indexes has probably come from a few large stocks like Newscorp, which are heavily owned by foreign investors. Our market is unusually concentrated in that half a dozen stocks make up around a third of our total market capitalisation. These big stocks haven't always had the best performance compared to smaller stocks, so our All Ordinaries index tends to be heavily biased toward large growth companies - a sector that hasn't done that well historically.

Since many Australian managers are nowhere near as enthusiastic as offshore investors about these big stocks, they tend to be underowned by Australian managers - for example as a group fund managers mostly stood by and recently watched the Newscorp price fall from nearly $30 to $10, dragging down the index with it.

While the fall in NCP was something of a windfall for any investor who didn't own the stock (compared to the index), I'm not sure that this is going to continue for ever. If the market for this stock reverses and Australian active fund investors still don't own any, then they will be beaten by the index funds again.

A second factor is that we don't have any index funds based on the All Industrials index, which has outperformed the All Ordinaries because it has no exposure to the generally underperforming resources sector. Many shares funds are industrial in nature, and underweight resources, so once again indexing seems to make less sense in Australia than it does overseas.

A third factor, which may reduce the performance advantage of active funds significantly, are two biases that conspire to make active funds look good: creation bias and survivorship bias. To read about these just read the index funds and active funds articles in the Managed Funds FAQ.

So, quite possibly, as much as it annoys me to say so, for the Australian equities sector it is possible to make a reasonably strong case for buying an active fund, and I myself have active fund investments primarily in this sector. Don't give up on index funds for Australia completely though, if I'm right about the performance advantage of active funds being simply because they own less resource stocks and less of the dominant few stocks then perhaps the future will be very different, after all for all I know the next 10 years could be a bonanza for resources and our biggest index stocks, so maybe the All Ordinaries would be the better index to hold than the All Industrials minus the top ten stocks. (?)

Apart from the one possible (?) exception of Australian share funds, index funds do seem to triumph in all other sectors. If you are thinking of investing in a bond fund, an overseas shares fund, a cash fund or a property securities fund then your chances are much better if you buy an index fund. If you want to you can buy an Australian share index fund as well, then go right ahead, but reality does seem to have overtaken theory in this one sector and you might want to give greater consideration to actively managed funds for this one sector.

If you do want to invest in actively managed funds, be sure to read my article on them in the Managed Funds FAQ.

Gearing

Gearing means borrowing to invest. Many people first hear the term used in the context of "negative gearing", many real estate seminars endorse negative gearing as a fantastic way to build wealth, which gives it something of an aura, so what is gearing, in particularly "negative" gearing all about, and why do real estate seminars talk about it so much?

There are obvious advantages to gearing:

• gearing lets you buy an investment portfolio you couldn't afford to buy with your own spare cash

• gearing allows you to get more money in the market than you otherwise would, increasing your returns if conditions are favourable

• gearing lets you diversify your portfolio without having to sell assets you already own

• there are also tax advantages to gearing, which I'll mention in the next section

The first point, as a matter of fact, is why property marketers go on and on about gearing. Few people, particularly punters that go to seminars, have the cash to buy real estate outright, so of course if you can sell people on the idea of borrowing money to invest then you'll do a lot more business.

What is "negative gearing"? Negative gearing is borrowing money and having a shortfall on the income you receive from the investment after you pay your interest bill. For example you might have $5,000pa in income from the portfolio you bought, and $10,000 interest costs, then after buying that investment you'll lose $5,000pa. What such an investor is hoping for is that the portfolio will have sufficient capital gains such that overall he or she makes money.

As you might expect, there is also "positive gearing", where the interest costs are less than the yield on the investment, so after buying this asset you actually end up with more cash in your pocket. If you manage to exactly balance interest and income so you get net income of zero, they call that "neutrally geared".

Anyway, before we talk any further, it is time to consider the disadvantages of gearing:

• gearing creates the possibility of losing far more money than you ever had. If you have $10,000 in the bank then you draw it out to invest in shares, then the shares fall in value by half, then you'll lose $5,000 and have $5,000 left. If you borrowed $50,000 from the bank and this halved, then you'd lose $25,000. After paying the bank what money you have you'll still owe them another $25,000.

• if you borrow money, you'll be vulnerable to interest rate hikes. If interest rates go up enough you might not be able to afford the repayments.

• some types of investment loan (margin loans) have an additional risk that you will

So gearing is obviously not something to be taken lightly, in fact it is a very dangerous thing in inexperienced hands. Gearing should only be considered if all of the following are true:

1. you have plenty of spare income, and your cash flow is fairly reliable, so you can afford the interest payments even if the investment itself doesn't pay for one reason or another (including losing a tenant if you have real estate). It might be a good idea to consider income protection insurance to keep your pay coming in case you get sick or injured

2. you don't need the money from the investment for the foreseeable future, at least ten years (never use gearing to fund a goal less than one decade from now, this is definitely for long term wealth building only)

3. you consider yourself an aggressive investor, and you are prepared for big fluctuations

4. you have diversified extensively

Note, it is silly to invest in cash and bond type investments on borrowed money, since these don't grow. I've seen lots of people buy "balanced" managed funds with borrowed money. When you think about this it is pretty dumb, since about a quarter of the portfolio is going to be invested in non-growth assets with lower returns than the interest on the loan. If you are going to borrow money to invest, only invest in stocks and real estate, not bonds and cash.

Tax efficient investing

As alluded to just a little earlier, gearing has tax advantages. Before I explain this specifically, I'll give a basic intro to the way investments are taxed.

When you sell a growth asset at a capital gain, you pay capital gains tax. There are two rates at which the gain will be taxed:

• if you've held the investment for less than 12 months, you pay capital gains tax at your marginal tax rate, which can be up to 48.5% for high income earners

• if you have held the investment for more than 12 months, you pay half your personal marginal tax rate

(note: for some investors who held the asset prior to 2000 you may have the option of using an indexed cost base instead of the 50% discount, I'll ignore that possibility for the purposes of this example but if you think this may apply to you then you should check with your accountant for details.)

Anyway, as you can see, capital growth investments become far more tax efficient if you hold them for a longer period of time. There is more to it than just the discount though, if you run the numbers you'll see that investments are more tax efficient if held for a very long period of time beyond just a year or two.

You might think it makes no difference, since the tax rate is the same, but actually timing of tax payments is important as well. You never become liable for capital gains tax until you sell. If you don't have to pay tax, then you get to leave that money in the markets growing steadily. Every time you realise a capital gain you have to send money to the tax office, but if there were some way to hang on to it and leave it in the market then you would be earning capital gains and dividend income on that money - effectively a tax-free loan from the Australian Tax Office.

So long term investment is a lot more tax efficient than short term investment.

Another thing you need to bear in mind is that interest paying investments, such as cash and bonds, attract no discounts or tax credits. The entire amount of interest is assessed as income, and you pay tax at your marginal tax rate. So after tax these investments give even worse returns, which is precisely why it is better if you are a long term investor to invest in shares and property. Excessive conservatism can lead to very poor long term returns, and for most people the risk of being underfunded in retirement is more important than the risk of having your capital fluctuate over the years.

Further tax efficiencies come with income from shares and property trusts. Along with your dividend, you may also receive a "franking credit". A franking credit is a credit for tax already paid (usually at the corporate tax rate, 30%). Your dividend is taxable at your marginal tax rate, but if it is "fully franked" then you get a tax credit for 30% already paid. This means that an investor with a marginal tax rate of 48.5% only needs to pay 18.5% tax on a dividend, and a person on a lower marginal tax rate than 30% actually gets a tax refund!

Direct property investors also get to claim extra tax deductions, for example depreciation, but as I point out in the Real Estate FAQ depreciation is an oversold benefit, because buildings do actually depreciate and require maintenance.

So the lesson so far, invest in capital gains assets and hold them as long as possible, and you'll pay out less of your profits as tax, compared to people with a short term trading style or investors in cash, mortgages and bonds.

There is another way to improve the tax efficiency of your portfolio, but there is a catch. If you invest in superannuation you'll only have to pay 15% tax on income and short term capital gains, and 10% capital gains tax on longer term capital gains.

The catch is that once you've put your money in super, it is very hard to get it out again until you retire past your preservation age. If you want to know what preservation ages are, look it up in the Financial Planning FAQ in the preservation article under superannuation.

This catch may or may not be a bother. If your savings goal is to fund your own retirement, then without question superannuation should play an important role in your retirement planning. If however, your goal is something more immediate, like funding your children's education, then you'll need to invest outside of super.

Gearing is often used as much as a tax strategy as an investment strategy. The reason why gearing is tax efficient is because you can claim a tax deduction (at your full marginal tax rate) on the interest you pay for the investment loan. At the same time, if you hold the investment for over twelve months you will only pay capital gains tax at half that rate. This is nifty because the full tax deduction vs the half capital gains mean that the capital gain you need in order to break even isn't quite as high as the rate of interest you pay on the loan.

Negative gearing will never ever make a bad investment into a good one, but it can make a good investment a lot better.

To recap...

• in the long term, shares and real estate outperform interest paying investments, particularly after tax

• risk is proportional to return, so if somebody tells you you can make a killing without risk - don't believe them

• diversification is an excellent way to reduce risk

• investment is more profitable and less risky if you think - and invest - with a long term strategy

• chasing last year's winner is a bad strategy, if anything you ought to be chasing losers instead

• different styles of investment give very different results at different stages of the cycle, switching between them is hazardous so you should diversify your portfolio and use several styles, but there is evidence to suggest that value investing has a long term edge over growth investing

• when selecting managed funds, consider using index funds as well as, or instead of, traditional actively managed funds

• gearing can boost returns significantly and is also very tax efficient, but is extremely risky. Only advanced investors with a high tolerance for risk should attempt it

• to pay less tax, focus on growth assets, hold them long term and invest with superannuation and/or gearing when appropriate