Since most large commercial property companies in the UK such as Land Securities and British Land have converted into Real Estate Investment Trusts (REITs), many UK investors are receiving Property Income Distributions (PIDs).

PIDs are a special kind of dividend, related to a property company’s REIT status, which enables the REIT to pay out most of its rental income without it being taxed twice by the Government.

PIDs are treated by the UK tax system as property letting income, not as the ordinary dividend income we looked at previously.

Not all property companies have chosen to become REITs – some may still be paying ordinary dividends.

Also, property companies may pay a combination of PIDs and ordinary dividends, just to complicate matters.

As with ordinary dividends, the tax you’ll pay on your PID income depends on whether you receive the income within a tax shelter (i.e. an ISA, CTF or pension), and also on your personal income tax rate.

PIDs within a tax shelter

You do not pay tax on PIDs held within tax sheltered accounts.

However, unlike ordinary dividends that are paid gross (i.e. with no tax deducted), PIDs are generally paid with 20% tax deducted.

This means the tax already paid needs to be clawed back.

Your tax-sheltered account should be issued with a 20% tax credit associated with your PID income, which the company that runs your ISA, CTF or pension should use to reclaim the tax paid from the taxman.

Do watch to ensure your PID tax is being reclaimed by your broker, as sometimes they forget. It can take 4-6 weeks after the PID is credited to your account for the reclaimed tax to turn up as cash.

I’ve heard that brokers can ask for PIDs to be paid gross to shareholdings in tax shelters, but I’ve no knowledge as to how widely this is being done.

PIDs outside of tax shelters

You’ll work out what tax is due on your PIDs and other share income when you submit your annual self-assessment tax return. (Avoiding the resultant tedious paperwork is reason enough to justify an ISA!)

PIDs are paid net of 20% tax, as mentioned, and with a 20% tax credit associated with the PID payment.

But unlike the ‘notional’ tax credit we saw with ordinary shares, the PID tax credit is a ‘real’ tax credit, representing money that has actually been transferred as tax to the Inland Revenue.

PIDs are taxed at letting income rates:

• Basic rate tax-payers – 20% tax due on PIDs

• Higher rate tax-payers – 40% tax due on PIDs

PID income that is taxed at the basic 20% rate incurs no further tax charge, since the PID was paid Net of the 20% tax that’s due.

If your PID income is to be taxed at the 40% rate, you have more tax to pay. You’ll therefore pay another 25% tax on the PID income you receive (representing another 20% on the original gross PID income, i.e. before 20% tax was deducted).

If your income is such that your PIDs aren’t liable to be taxed at all, you can use the PID tax credit to pay other income tax that’s due, or else reclaim the tax paid from the Inland Revenue as cash.

Further reading:

1. How UK dividends are taxed
2. Commercial property: I’m buying
3. Commercial property is an attractive asset to own

Most times in life, it pays to think long term. There are a few exceptions:

• If you’re trying to decide whether to kiss her, kiss her

• If you’re wondering whether to go to the party, go to the party

• If he’s big and mean and about to hit you, duck out and live with the shame

• If given the chance to stop over, stop over (I’m thinking cities here, but do extend this rule to suit your own personal level of debauchery)

That’s about it for times when short term thinking should overwhelm long term goals. If you’re not about to kiss, party, be hit or hit New York, look to the far horizon.

Long-term thinking is especially important if you’re planning to escape the rat race. This famous scrabble is aptly-named in honour of experiments in which the hapless rodents pull levers for sweets and run nowhere in wheels to avoid electric shocks.

I doubt the rats think for more than two seconds beyond their next tasty treat or miserable let down. What an apt metaphor for today’s wage slaves and Saturday morning consumer warriors.

If only the rats got together, thought about it, and pooled their resources to break the code or form a little rat pyramid enabling one of them to vault to freedom! Alas, they go on eating bad food and getting shocked, stumbling from second to second.

We can do better than the rats, surely.

Shopping

• Short term thinking: I want that cake / music system / house I can’t afford.

• Long term thinking: A moment on the lips, a lifetime on the hips / it’s all free on Spotify on my PC / I’ll buy a smaller house and pay off the mortgage early.

Debt

• Short term thinking: If I spend £2,000 buying this sofa at 14% on my credit card, I’ll be more popular and have more girlfriends, like the guys in Friends. (Whoops – it costs nearly £4,500 in total at the minimum 2% repayment rate and I’m still paying for it 26 years later).

• Long term thinking: If I lend the bank £2,000 at 4% for 26 years, compound interest will help me, not the bankers, and I’ll end up with over £5,500. (Whoops – I’m looking too smug).

Investments

• Short term thinking: Darn! The stock market has dropped by 20%! Time to sell my investments like Cramer off the TV and buy lottery tickets!

• Long term thinking: Great, the market has dropped by 20%! I’m still buying, so cheaper is better, and I can only hope to hit those 11% average annual long term market returns by buying low in the bad years.

Pensions and old age

• Short term thinking: I’m young and immortal, and I look amazing in tight designer jeans. When I’m old I’ll be sitting about with nothing to do – better to live for now.

• Long term thinking: I’m young and I’d look amazing wearing a bin liner. Better to save and compound my money for when I’m old yet shockingly still sentient, and when even using an escalator is a giddying ride of excitement that requires a minder. Wine, women, song and growing old disgracefully don’t come cheap.

How long is long term?

Obviously you’d don’t want to do this to excess and become a tightwad. Cooking baked beans on a bonfire of free newspapers while checking your portfolio on an ancient laptop powered by coal and dreaming of 2042 when you’ll finally crack open your piggy bank – that’s taking things too far.

But a lot of short term thinking is actually driven by a desire to placate unhelpful emotions like boredom, envy or impatience.

We buy expensive things we don’t need to try to plug a hole that isn’t thing-shaped at all.

Living in the moment, savoring the here and now, can bring the smallest and simplest pleasures to life:

“When walking, walk. When eating, eat.” – Zen Proverb

Easier said then done (that’s pretty much Zen Buddhism in a nutshell) but more likely to bring you satisfaction than an attic full of useless clutter that you don’t need, bought with money you could have instead put towards replacing your salary and being truly, eventually, free.

Finally, here’s my favourite Greek Proverb about thinking for the long term. Once you hear it, it never quite leaves your head (but unlike Britney Spears that’s in a good way):

“A society grows great when old men plant trees whose shade they know they shall never sit in.”

(Image by Powi)

No related posts.

Income from ordinary dividends is taxed more favourably in the UK than interest on cash savings or fixed interest such as corporate bonds or gilts.

However, working out the tax you’ll pay on your dividend income can be complicated.

There are several factors to consider, including:

• Your income, and so your rate of income tax.

• Whether you gain the dividend within a tax shelter or outside.

• Since 2007 certain property investment companies called REITs now pay Property Income Distributions (PIDs). These are treated differently to ordinary dividends, and are classed as property income.

Further complicating matters are the tax credits associated with both dividends and PIDs.

• Ordinary dividend – There is a ‘notional tax credit’ equal to 1/9th of the dividend, which effectively reduces the tax you pay, but which isn’t actually paid to the tax man by you or the company. It’s there just to complicate matters, as far as I can tell.

• PID – There is a 20% ‘real’ tax credit associated with PIDs paid, which really does reflect money paid to the Inland Revenue, and which can in some limited circumstances be reclaimed.

In this post I’ll explain how UK dividends are taxed. In a separate post I look at tax on PIDs.

UK dividends: What tax will you pay?

Dividends are generously treated by the current UK tax regime compared to savings, presumably on the grounds that the company has already paid tax once on its earnings.

Whereas savings interest is taxed at 20% or 40%, the effective rate of tax on dividends is either 0% or 25% (see below for what I mean by ‘effective’).

Companies in the UK pay dividends gross: i.e. without any tax having been paid. There is also that notional tax credit, which is equal to 1/9th of the dividend associated with the dividend.

UK dividends inside a tax shelter

A tax sheltered account may be an ISA, a Child Trust Fund or a pension.

• No tax has been paid or is due on your dividend income in a tax shelter.

UK dividends outside of a tax shelter

Dividend income outside of a tax shelter may need to be taxed further.

You’ll work out whether you need to pay tax on your dividends and if so what tax is due via your annual self-assessment tax form.

You will be taxed on the dividend paid plus the notional tax credit; but the tax credit is used to pay some or all of the tax due on its associated dividend. (The tax credit cannot be used to pay tax on other income, such as savings income).

I know this tax credit business sounds stupid. It is – I didn’t make up the rules!

On a brighter note, it does reduce the tax you’ll pay.

Theoretically, the tax rate on dividend income is 10% if you’re a starting or basic rate tax payer, and 32.5% if you’re a higher rate tax payer.

In reality, the tax credit reduces these rates down:

• Starting/basic rate tax payer – No more tax to pay

• Higher rate tax payer – Dividend income taxed at 25%

Since dividends are effectively tax-free if you’re a basic rate tax payer, it may be sensible for you to favour using your ISAs allocation for cash savings, since interest will be taxed, over your shares, since you’re not paying tax on dividend income anyway.

Keep in mind though that you may become liable for capital gains tax if you sell your shares.

Also remember that if you build a substantial portfolio of shares, it could start to contribute significantly to your annual income. This could push you into the higher tax bracket by itself!

The higher rate of income tax begins at £37,400 at the time of writing.

• Further reading: See the DirectGov page on taxes on UK dividends.

Note: New rates of tax on savings and dividends are due in April 2010.

Further reading:

1. Tax and costs will eat up returns

My regular Saturday comment followed by this week’s blog and financial site links.

I missed doing the Weekend Review last Saturday due to being away for work, and then by Sunday I was coming down with flu. By Monday I was dying good and proper, as only a man with a cold can.

Health is the most precious thing in this life. A cliche I know — if you want to stitch it into one of those wall hangings old people used to hang above their beds, perhaps with a picture of a dozing dormouse, be my guest. It’s true.

I would give all my wealth for the guarantee of never being ill again (perhaps reluctantly compromising on some termination clause, such as a piano dropping on my head or a date with the proverbial bus).

If you don’t feel the same, you probably haven’t been ill recently. The speed with which your world closes in is always shocking. And the clarity and sparkle of the world as you return to health seems like special effects.

Inevitably, I thought of my father.

Long-suffering readers may remember he had a heart attack this time last year, went into a coma, then recovered slowly to plateau at about the physical strength of a 90-year old man (he’s late 60s), with a mental age that could vary from all the wisdom of those years down to the logic of a 4-year old.

The last couple of months have been about decline. He suffers strange things, such as his hands curling up like claws — he can only use two fingers on each, and that thanks to a daily massage from my mum. Various doctors are stumped.

We also think he had a mini stroke last week. He’s more confused than ever.

On a brighter note, we got the result of a scan that says he hasn’t got tumors in his lungs. New lumps are in his bones, which is apparently better. On the other hand, he’s too weak for the open heart surgery that prompted the scans. And his doctor doesn’t think the risk and hardship is worth it, given his likely lifespan.

The thought that my dad won’t walk back out into the metaphorical sunshine like I have in the past 24 hours is terrible. But that’s the deal with old age, I guess. There’s no point taking it personally.

I try to avoid writing about my father too much but I genuinely could write that money is not the point every week. On this, a financial blog.

That’s not why you come here though, and in truth it’s not what I spend the week thinking about either. Life goes on.

But if money — which gives us more options, freedoms, health care, food, novels — is not the point, then cheap designer tat, having a better holiday than your friends, and driving a brand new car certainly isn’t, either.

And so on we go, Monevators!

From this week’s personal finance blogs

• Asset allocation and time horizon – Oblivious Investor

• A graph showing how US consumer debt has boomed – The Digerati Life

• Frugal Friday: Cutting electricity bills – Five Pence Piece

• Why don’t most financial planners plan finances? – Million Dollar Journey

• Why the hell do guys have to pay for everything? – Fabulously Broke

• I just fired myself (Who’s next?) – WP writing at Frugal Dad

• How working overseas boosts your career – Brip Blap

• Sell your gold without getting ripped off – Money Watch UK

Other interesting financial and money articles

• Investing in frontier markets – FT

• John Lee’s love affair with property shares – FT

• Buffett triples profits thanks to derivative gains – Bloomberg

• US unemployment really 17.5% – New York Times

• Do morals or money rule investments? – Independent

• British pair share record £91 million lottery jackpot – Telegraph

• Ethical travel firm drops CO2 offsetting – Independent

Save the cost of a weekend paper by subscribing to get this free update.

Further reading:

1. Weekend reading: Formula 1 in crisis
2. Weekend reading for investors: 11/04/09
3. Weekend reading for investors: 14/3/09

A friend of mine sometimes speculates about the size of the ‘Monevator Hoard’, as he almost calls it.

Over the years he’s noted I like to save a lot, and also my interest in the stock market. Putting two and two together, he gets millions.

I avoid talking about money and my portfolio in everyday life. Partly it’s because I’m a very private person, blogging notwithstanding.

It’s also because I live in London, one of the most moneyed cities in the world, where there’s thousands of wealthy folk who make any normal person’s savings look like loose change. (£500,000 bonus, anyone?)

But my friend does the same sort of work as me, and is roughly the same age – he wouldn’t expect me to have £5 million and my own man at Coutts.

I’m certain from what he’s implied though that he’d think the cash value of my investments very large, were I to tell him. He’d likely see me (maybe he already does see me) as a wealthy miser who should spend his mundanely-gotten gains on wine, women, and song – or at least the next round.

That assessment of our relative wealth would differ markedly from mine.

Firstly, my friend doesn’t appreciate how I want to use my portfolio to replace my income from work. Only if I achieve this will I consider myself financially free. This is a personal goal, and I’m nowhere near achieving it, but it does mean the Chardonnay quaffing chorus girls are on hold.

More pertinently, my friend has a nice house in the Home Counties that he bought in the 1980s for about the price of a mid-range sports car today.

It’s now worth at least five sports cars. In contrast, I rent.

My friend suffers from the common delusion that his house is not a financial asset, and therefore its value does not represent ‘real money’, only ‘paper money’.

One day I’ll do a whole post on how wrong this is; suffice to say he could sell his house tomorrow (tax free), rent, and have a large lump sum to invest for himself.

It got me thinking about what other assets people have that they might not appreciate, but which could factor into their personal net worth?

Hard assets

Property

If you have a property that is bigger than the outstanding mortgage, the difference is an asset. Period, as our US cousins say. Yes you’d have to rent if you sold. So what? That doesn’t negate the house’s value. I find it almost impossible to articulate how ludicrous I find any other position.

Pension

A different friend of mine (I’m a popular guy!) has less than three month’s emergency savings, but he has been putting money into a public sector pension scheme for 15 years. He’d think I’m much wealthier than him, but I have no formal pension. He has a valuable financial asset, albeit an unattractively restrictive one.

Endowment or life insurance policies

I don’t have any of these, but older people often do. Endowment policies are frequently derided due to their poor performance, but whatever they’re worth it’s more than something – and that’s an asset. Ask your provider what the surrender value is and use that as the worst case value. Life insurance (whether part of an endowment policy or separate) is a bit of a mixed blessing. It’s more helpful if someone else has it in your name! If you have no dependents, spend your money on sweets instead.

Genuinely valuable stuff

Most of what most people buy is approximately worthless in the medium term. Some things are worth owning though, such as works of art, classic jewellery, and antique furniture. If you’ve a collection of stamps or old teddy bears, you’ll already have an idea of what it’s worth. Your collection is an asset, even if you have no plans to sell.

Your clutter

What about your gadgets? Your new kitchen? What about cars (unless vintage), clothes, watches, paperbacks, furniture (unless antique or iconic) and so on? At best they’re rapidly depreciating assets, and at worst they’re consumables. They’re also hugely illiquid – selling something on eBay is a time sink. Add a value to your balance sheet if you like, but at a realistic re-sale price, and a 20% markdown. Avoid buying costly tat where possible – either eat your dinner off a table that will hold its value, or buy a cheap one at IKEA.

Soft or intangible assets

An expected inheritance

Difficult, this one, even leaving aside the morality of getting or hoping for a large inheritance. I think it’s an asset in the same way that an oil explorer is allowed to book oil it believes it owns and expects to pump but that is still in the ground. If I was 90% likely to inherit a large sum of money, it would definitely alter what I do with my money now. It’s true the inheritance might be smaller or later than expected, but we always have to work to probabilities.

A solvent husband

As blogger Fabulously Broke pointed out yesterday, it seems fantastical that a woman who got divorced 25 years ago and signed a paper waiving all rights could go back to her former husband to win a $1,600 a month. But it just happened. (One day I may need to modify this to include ‘/wife’. Not yet, however – it’s still overwhelmingly men who payout).

A happy marriage

If you and your betrothed do stay together, the marriage may make you richer – if you’re a man. Married men earn 20% more than single men in similar professions. Interestingly, married women earn 4% less than their single sisters, even accounting for kids. Bisexuals do best – but that’s a bit of an extreme lifestyle change, even for me.

Adult offspring

Children can enrich your life in many ways, but since slavery was abolished their cash value has been curtailed – economically-speaking, they’re cost centres. As adults, they’re worth having though, albeit a bit of a lottery. You’ll never get more than fraction of your investment back but your sunk cost will deliver some (inconsistent) returns – occasional labour and transport, instruction in the ways of the modern world, updates on how your generation ruined the planet, and maybe even grandchildren.

Health

This is literally priceless. I’ve had flu for the past week or so (hence the lack of updates) and it derailed my work regime and cost me in earnings. But that’s as nothing compared to a serious physical impairment, irrespective of whether it requires expensive treatment. If you’re healthy and free of debt, you can’t call yourself poor in my book.

What have I forgotten? Let me know in the comments below.

Image by FR Antunes

Further reading:

1. Assets: The building blocks of a portfolio

Over on the far right of the bell curve are women with perfect curves and uniquely beautiful faces.

This was the founding premise of Perfect 10, a magazine focused on the most attractive females around.

Perfect 10s are rare. According to the standards of glamour photography – entirely aesthetic and youth-obsessed – almost no women are Perfect 10s.

• Age alone rules out nearly anyone over 25 or under 18.
• Of the 10% of women left, most would be considered overweight.
• We’re down then to a pool of perhaps 2% of the female population before we’ve even considered their winning smiles, breasts, or acne.
• The magazine actually found many of its beauties in Eastern Europe.

I’d even question whether the Perfect 10 dream is all that?

This isn’t the place to judge the morality of objectifying female beauty (for the record, I think it is objectify-able, but I’m completely clear about the consequences that women have to live with).

Rather, I’d suggest that even if most Perfect 10 readers could snag themselves one of these rare creatures, they’d find living with her a trial.

From experience (cough cough) I can confirm that dating a very beautiful young woman regularly entails a weird combination of fending off endless advances, while dealing with her often chronic insecurity.

There’s more to life – and to women – than that.

More Perfect 10 fantasies

Perfect 10 readers could argue that the magazine is a complete daydream.

I suspect most believe there’s actually some scenario (perhaps involving a trapped lift or the kiss of life) that would snag them any woman.

But let’s presume it’s pure escapism.

Aside from making them unsatisfied with the majority of the female species, the immediate consequences of a Perfect 10 obsession might be pretty limited.

But there are other ways to obsess on the far right of the bell curve.

Here are some other fantasies that flounder on mathematical reality:

• Writing a best-selling novel
• Setting up a world-conquering business
• Playing for Manchester United or the New York Yankees
• Become bigger than The Beatles
• Stumbling across the next Warren Buffett

You can easily spend your teens and 20s pursuing such improbable goals.

But as my father used to quote, “Don’t let the enemy of the good be the best”.

It’s great for society – vital – that some people won’t settle for anything less than their dreams. Maybe it’s even best to follow your heart where it takes you, if you truly must.

But for most of us, it’s statistically clear the dream will end in failure.

What about Warren Buffett?

If I told you to dump your girlfriend or wife because she’s not Perfect 10 material, you’d laugh in my face.

Yet instead of following the market via an index tracker, most investors do the equivalent when investing.

Instead of accepting realistic returns from a tracker, we pick stocks or buy funds because we dream we’ll either be the next Warren Buffett or else we’ll find his successor.

Stock picking

This is largely a fantasy. Statistics have repeatedly shown most stock pickers don’t beat the market over a period of years, whether they’re amateurs or professionals.

Finding the next Buffett

Even less likely. Most funds fail to beat the market.

Also remember Warren was basically running a friends and family hedge fund when he set out. Your chances of turning $1,000 into nearly $3 million over 43 years by backing the next Warren Buffett are approximately zero.

Over shorter time periods, the chances of picking a manager who beats the market are still less than 5%, even before costs, as this 2008 letter to the FT (found via The Munro Fund) demonstrates:

Sir, In his piece “Trackers are crackers” (Money, December 13/14) Jason Britton asserts that while it would have been very hard to pick one of the nine (out of 177) actively managed funds that have outperformed the FTSE All-Share since March 2000, one would have had a “much better chance” of selecting one of the 89 (out of 177) that outperformed from March 2000 to March 2003; one of the 78 (out of 236) that outperformed from March 2003 to July 2007; and one of the 71 (out of 317) that have outperformed from July 2007 to November 2008.

So the overall chance of me achieving a return consistently above the FTSE All-Share during the whole period by picking “successful” active fund managers from this pool?

A shade over 3.5 per cent – not quite the “much better” I was hoping for.

Colin Barrett,
Harrogate

Using charts and graphs

As I mentioned the other day in my article about bear market rally chartists, academics have again failed to find one single technical signal that consistently leads to profitable results in developed markets.

Choose Credible 7 investing

If you’re a morally dubious male, you might marry a Credible 7, then try to seduce 10s on the side.

Or maybe you’ll stay single and ‘unsullied’ by a less-than-perfect partner, and instead get older looking to pick up beauties who will only get older, too.

Neither approach seems particularly sustainable to me, but this isn’t the writing for that..

Rather, I’d like to stress that when investing we have better choices.

• We can back trackers, diversify across an ETF portfolio, and achieve better results than most people by simply aiming for average market returns. (Regular, adequate saving and average returns from stocks are the secrets to later prosperity, not stock picking.)

• Alternatively, we can put say 75% of our money into trackers, and allocate a side portfolio into individual shares or funds. We’ll probably end up poorer than going all tracker, but we keep alive the fantasy of finding that Perfect 10 result without totally derailing our financial futures.

The second option is something like my own strategy.

I usually avoid funds, which are nearly always crippled by costs, but I can’t resist dreaming I might beat the market with my stock picks, any more than I can avoid sneaking a peek at some lissome beauty in the street.

Most of my long-term money though is in tracker funds and ETFs, where I know what I’m getting. For most people, ‘all’ would be the most appropriate allocation.

The world of chasing endless beauty queens in the absence of all other kinds of women or relationships isn’t for me.

And nor can I recommend Perfect 10 investing.

Postscript: Perfect 10 magazine is no longer on the shelves – though it lives on in the Perfect 10 website. I guess the reality of paper publishing in the Internet era caught up. Will reality catch up with Perfect 10 investors? Don’t hold your breath. I notice the website mentions a dating service touting potential dinner with a Perfect 10 model. Men are wired to believe they’re above average.

No related posts.

Most investors — even those who pick shares and should know better — would do well to get their stock market exposure via cheap index trackers.

Invest via an exchange-traded fund (ETF) and you’ll also benefit from lower annual charges and the freedom to liquidate your holding in an instant.

Buy a few ETFs to cover several asset classes and you can create a diversified portfolio in less than 15 minutes!

With dealing costs of less than £100 and no stamp duty to pay on ETFs, creating your portfolio will cost you a tiny fraction of what a private wealth manager or full service broker would charge, and the chances are you’ll do just as well over time — likely better, considering ETFs’ low costs.

If you rebalance your holdings annually – cheap and easy with ETFs — you’ll manage your state-of-the-art portfolio in less time than it takes to eat your Christmas turkey.

Sounds simple?

It is. The only big decision is what ETFs to hold.

Understand there is no perfect portfolio. Complex asset allocation strategies aren’t proven to be more effective than rough-and-ready ones.

Instead, numerous writers have offered so-called ‘lazy portfolios’, which deliver most of the rewards for minimal time, effort, and/or cost.

In this post I’ll outline nine such ‘lazy’ ETF portfolios for UK investors.

I’m even lazier though, and I’m basing this article on one the Oblivious Investor blog first ran that used US ETFs. The author, Mike Piper, has kindly allowed me to riff off his piece (I think he’s relieved to see me not raving about banks again!)

If you’re a North American investor you should definitely check out Mike’s article for the US originals.

Some notes on creating these UK portfolios

• I’ve used Barclays iShares ETFs to keep things simple; they’re the most well-known ETFs in the UK, and you can research them all at one site.

• I‘ve generally used a FTSE 100 ETF in place of a UK All-Share ETF because the latter is not available from iShares. You might use a UK All-Share index fund (as opposed to an ETF); the results will be very similar, since the FTSE 100 dominates the All-Share. (Over the long-term the FTSE 100 might do slightly better or worse).

• Where no suitable ETF is available, I’ve used investment trusts.

This final point definitely increases risk, due to how investment trusts can trade at a discount, and how they can diverge from market returns. My other options were to go for Euro- or Dollar-denominated ETFs, introducing more currency risk, to suggest managed funds and higher fees, or to change the portfolios.

I like investment trusts, especially those I’ve picked, but I accept their use isn’t ideal here. (Don’t blame me: Write to iShares!)

1. Allan Roth’s Second Grader Portfolio

• 60% FTSE 100 (ISF)
• 30% FTSE Developed World ex-UK (IWXU)
• 5% iBoxx £ Corporate Bond ex-Financials (ISXF)
• 5% FTSE UK All Stocks Gilt (IGLT)

With 90% in stocks, this is a portfolio for younger investors. Roth likes ETFs because they’re simple and cheap. He thinks adults over-complicate things.

The US version uses just one bond ETF that tracks the whole market. The only iShares equivalent is Euro-denominated, so I’ve split the holding across two Sterling ETFs to do the full job.

(If you’re a purist, split the corporate bond holding again between ISXF and SLXX to get the financials in the latter).

2. David Swensen’s Ivy League Portfolio

• 15% FTSE 100 (ISF)
• 15% FTSE 250 (MIDD)
• 5%: MSCI Emerging Market Equity (IEEM)
• 15%: FTSE Developed World ex-UK (IWXU)
• 20%: FTSE EPRA/NAREIT UK Property (IUKP)
• 15%: FTSE UK All Stocks Gilt (IGLT)
• 15%: £ Index-Linked Gilts (INXG)

I’ve previously posted an Ivy League ETF portfolio in detail.

This time I’ve split the 30% weighting to domestic shares between the FTSE 100 and the UK mid-caps. You could do the same for Roth portfolio above if you like.

Note the absence of corporate bonds; Swensen doesn’t like them.

3. Rick Ferri’s Core Four Portfolio

• 36% FTSE 100 (ISF)
• 18% FTSE Developed World ex-UK (IWXU)
• 6% FTSE EPRA/NAREIT UK Property (IUKP)
• 20% iBoxx £ Corporate Bond ex-Financials (ISXF)
• 20% FTSE UK All Stocks Gilt (IGLT)

Ferri says you only need a few asset classes before you get diminishing returns. I’ve had to add a fifth Beatle to his core four to cover the UK bond market.

4. Bill Schultheis’ Coffeehouse Portfolio

• 10% FTSE 100 (ISF)
• 10% The Edinburgh Investment Trust (EDIN)
• 10% BlackRock Smaller Companies Trust (BRSC)
• 10% Aberforth Smaller Companies Trust (ASL)
• 10% FTSE Developed World ex-UK (IWXU)
• 10% FTSE EPRA/NAREIT UK Property (IUKP)
• 20% iBoxx £ Corporate Bond ex-Financials (ISXF)
• 20% FTSE UK All Stocks Gilt (IGLT)

I love the clean 10% breaks in this portfolio.

Schultheis’ believes it’s more fun to loaf about drinking coffee than worry about the markets. For most people he’s probably right.

Note the use of investment trusts here.

I’ve chosen the Edinburgh Investment Trust to substitute for a Value-based ETF; iShares has a Euro-based value one, but no Sterling one. I own EDIN; it’s run by renowned manager Neil Woodford and pays around 6% a year. It does have a tiny bit of debt though. I’m confident it fills the gap.

The two small cap trusts are riskier. The BlackRock trust is a general small cap picker, the Aberforth Trust has a distinct value-ish tilt.

These trusts will increase the volatility of your portfolio, and the potential for market out- or under-performance.

Finally, there’s the usual drill of splitting bonds across the two UK ETFs.

5. Larry Swedroe’s Big Rocks Portfolio

• 9% FTSE 100 (ISF)
• 9% The Edinburgh Investment Trust (EDIN)
• 9% BlackRock Smaller Companies Trust (BRSC)
• 9% Aberforth Smaller Companies Trust (ASL)
• 6% FTSE EPRA/NAREIT UK Property (IUKP)
• 3% FTSE Developed World ex-UK (IWXU)
• 6% iShares DJ Asia/Pacific Select Dividend (IAPD)
• 3% iShares DJ Euro STOXX Value (IDJV)
• 3% Rights and Issues Income Trust (RIII)
• 3% MSCI Emerging Market Equity (IEEM)
• 40% iShares FTSE Gilts UK 0-5 (IGLS)

This portfolio seemed fussy in the US version; the UK one is a dog’s dinner.

You should know that I’ve taken extra liberties, due to the lack of ex-UK global dividend or small cap value options.

I think my choices get across what Swedroe is looking for in terms of adding some international diversity and focusing on dividends and smaller companies, but it’s not a great match-up with the all-ETF equivalent.

6. Harry Browne’s Permanent Portfolio

• 25% FTSE 100 (ISF)
• 25% FTSE UK All Stocks Gilt (IGLT)
• 25% ETFS Physical Gold (PHGP)
• 25% Cash (High interest savings accounts)

Browne’s Permanent Portfolio is getting a lot of attention these days, doubtless due to the huge rise in the price of gold; I don’t remember hearing about it between 1985 and 2000, when gold was in a bear market!

My cynicism aside, there’s no denying this is a simple and diversified portfolio, with gold adding something extra if you fear for paper currencies (in which case you should probably hold gold in your cellar).

I’ve used a non-iShares ETF; PHGP is backed by bullion, rather than just contracts.

7. William Bernstein’s No Brainer Portfolio

• 25% FTSE 100 (ISF)
• 25% BlackRock Smaller Companies Trust (BRSC)
• 25% FTSE Developed World ex-UK (IWXU)
• 12.5% iBoxx £ Corporate Bond ex-Financials (ISXF)
• 12.5% FTSE UK All Stocks Gilt (IGLT)

Another one for risk-taking investors in their 20s, 30s and young-at-heart 40s, though I’d probably ditch the corporate bond holding and go for 25% government bonds myself.

8. Harry Markowitz’s ‘In Real Life’ Portfolio

• 50% iShares MSCI World (IWRD)
• 25% iBoxx £ Corporate Bond ex-Financials (ISXF)
• 25% FTSE UK All Stocks Gilt (IGLT)

For fun, Mike included this portfolio in honour of the Nobel prize winning father of Modern Portfolio Theory in his original lazy roundup.

When once asked how he invested, Markowitz said: “I should have computed the historical co-variances of the asset classes and drawn an efficient frontier…Instead, I split my contributions 50/50 between bonds and equities.”

Further proof, if you need it, that complex allocation is for the classroom, not the real world.

9. Bonus: Ben Graham’s ‘Mr Market’ beating portfolio

• 25-75% FTSE 100 (ISF)
• 25-75% FTSE UK All Stocks Gilt (IGLT)

Note: The allocations can only add up to 100%! (E.g. 30% ISF and 70% IGLT).

As the ultimate Oblivious Investor, Mike couldn’t include a Benjamin Graham portfolio, since the latter believed it might be profitable to vary your equity/bond holdings depending on the market’s bull or bear moodswings.

Graham didn’t say it was easy, mind.

The danger is you increase equity exposure at exactly the wrong time – when investing feels safe and the market has risen for years. In Graham’s world, that’s the time to move towards bonds.

Because he knew it was difficult, Graham urged readers never to go below 25% for either asset class. In practice, simply rebalancing  between the two once a year would be hard to beat.

Note that Graham passed away before ETFs were invented, but this portfolio gets across the spirit of his fabulous book The Intelligent Investor.

Further reading:

1. How to create an Ivy League endowment fund using UK ETFs
2. Weekend reading for investors 4/4/09
3. Historical returns from corporate bonds

My regular Saturday comment followed by this week’s blog and financial site links.

I admit there are worrying signs in the market. I don’t mean how the main indexes seem to have stalled — it’s always very hard to tell signals from noise, and anyway Australian academics just proved that technical analysis doesn’t work:

Technical analysis is not consistently profitable in the 49 countries that comprise the Morgan Stanley Capital Index once data snooping bias is accounted for.

There is some evidence that technical trading rules perform better in emerging markets than developed markets, which is consistent with the finding of previous studies that these markets are less efficient, but this result is not strong.

While we cannot rule out the possibility that technical analysis compliments other market timing techniques or that trading rules we do not test are profitable, we do show that over 5,000 trading rules do not add value beyond what may be expected by chance when used in isolation.

No, what’s slightly concerned me are reports that traders are making out like bandits on the City desks, oblivious to risk.

On the one hand, this explains why bankers are making a fortune.

On the other, I don’t think bankers are demonstrably cleverer than more cautious souls, what with them bringing the world to its knees 12 months ago.

Bull markets are always manic, but I wonder if the 22-year olds on these trading desks are getting carried away again?

Gutting the bears

One group of 20-somethings who don’t worry me are the analysts whose stock market graphs don’t go back beyond 2007.

(Actually, most are well into their 40s and 50s — I’m just making excuses!)

This week saw a rush of articles warning the so-called ‘bear market rally’ is almost over because of a vague similarity between graphs of other major historical declines and their subsequent false rallies.

The gist is we’re going to have a second leg down that will retest the March lows.

For instance, here’s a chart from zippy insider blog, The Big Picture:

(Click to enlarge).

And here’s one of my favourite commentators, John Authers in the Financial Times, also commentating on the same pattern:

What should we make of the landmark? [...] Rebounds after big bear markets tend to be about 70 per cent. This one is closing in on that. But the speed with which this rebound has made good the losses is historically unusual – perhaps because this rebound is being deliberately aided by governments.

Also the historic pattern is for the rebound rally to give way to a new bear market.

There’s plenty more in the less respectable corners of the Internet, too.

Now, given those academics proved 5,000 technical signals don’t work, what, to paraphrase John Authers’ question, should we make of news that one squiggly line from 2009 looks a little bit like another from the 1930s?

I say: Absolutely nothing!

The market will go down a bit at some point, because it can’t go up forever.

But if it does so at the same percentage point as with the bear market of the 1930s, it’ll surely be a coincidence.

There’s not a Bear Market Rally God with a Google Alert to SMS him when the Dow hits 11,000.

Furthermore, these graph watchers all believe the slump began in 2007.

I’d argue it makes more sense to think of it starting in 2000. It was then that equities were super expensive. In 2007, most of them looked pricey but not at 1999/1929 levels.

In short, we’ve already been through a ten-year bear market. If you want to see a second slump, look for it in 2007-2008, not in 2010.

Here’s a FTSE 100 graph from 1999 to 2009 that I nabbed off a bulletin board this week (sorry, no source, but standard with some red lines added):

Looks pretty double-dippy to me.

Will the market fall some day? As ever, yes. I may even liquidate a few more holdings to play it safe if the bullishness keeps growing.

But will the markets retrace a path mapped out 30 or 70 years ago because human beings like to see patterns in the data — even the wrong data?

What do you think?

From this week’s personal finance blogs

• Three reasons why you’re a genius for not buying gold — Wealth Pilgrim

• On the other hand: 10 secret places to hide gold — Money Energy

• How to use a stock screener — The Digerati Life

• Why we fail to make good financial decisions — Consumerism Commentary

• How to make yourself an expert — Brip Blap

• 92 quotes about debt — Man Vs Debt (and blogging genius)

• 12 quirky ways to avoid flu — Everyday Finance

Other interesting financial and money articles

• UK housing market stabilising — Bond Vigilantes

• I argue banks shouldn’t be making vast profits from trading. George Soros agrees such profits are a ‘gift from the state’ — Financial Times

• Property liars should put their house in order — Financial Times

• Private investors turn tail on equities — Financial Times

• M&S pledges to avert palm oil eco-disaster — The Independent

• Mark Dampier finally discovers tech funds — The Independent

• Be bullish about UK house prices — The Telegraph

• VCTs offer double digit yields — The Motley Fool

• And finally, Da Vinci’s Mona Lisa smile decoded — New Scientist

Save the cost of a weekend paper by subscribing to get this free update.

Further reading:

1. Weekend reading: Buffett stumped
2. Weekend reading: Beware of bonds edition
3. Benjamin Graham on bear markets

“Never in the field of financial endeavor has so much been owed by so few to so many.”
– Mervyn King, Governor of the bank of England

I have said before I’m too lazy busy to feel able to update you about every trade I make in the active portion of my share portfolio.

But I don’t mind saying that I’ve now sold all my Lloyds shares.

While I didn’t catch the highs — and have already explained how my heady trading profits were pretty illusory — the quick gains I did bank were too tempting in light of the ongoing risks of holding Lloyds.

Lloyds shares still look cheap – and sitting through the many risks is what investors will likely be rewarded for – but with even the Bank of England governor Mervyn King last night stating banks must be broken up, the uncertainty just keeps mounting.

I’d already sold because Lloyds is rumoured to be pulling out of the Asset Protection Scheme that would insulate it from 90% of £260 billion of bad debts.

Analysts believe operating outside the scheme could be more profitable for Lloyds — at the cost of a rights issue — but as I’m still bearish on UK residential property, I can’t be bothered with the extra risk.

The danger of the EU commission forcing a clumsy break up of the merged Lloyds and HBOS ‘superbank’ was also worrying me. The whole reason I’d bought Lloyds was for the economies of scale that merger would bring.

King’s call

But while it’s not been personally good for my bank shares, I fully agree with Mervyn King’s sentiments.

In his speech last night, King said that:

“The belief that appropriate regulation can ensure that speculative activities do not result in failures is a delusion.”

And he is absolutely right.

Failure is part of capitalism, not to mention human nature. It is particularly a feature of banking, where ‘once a century’ blow-ups seem to come along every couple of decades.

We should therefore concentrate on making the economic system robust enough to cope with the fallout from failure (and to avoid encouraging it) rather than thinking we can legislate against it.

That doesn’t mean we should do nothing about the structure of banking – far from it.

But we shouldn’t daydream that a financial meltdown can “never happen again”, whatever measures are imposed.

Why banks blow-up

Take, for instance, the idea that you can make banking safer by obliging the banks to hold more capital depending on the risks they’re taking.

Sounds great in theory, but in practice the rocket scientists they employ will always find ways to ‘hide’ the risk in order to reduce the need for it to be backed by capital, as this is what makes banking more profitable.

I don’t mean they will do so fraudulently.

I mean lots of smart people in lots of banks will find ‘innovative’ ways to make bets with ever less equity at stake.

Ideas such as providing more debt that converts to equity as a buffer should disaster strike are all well and good (and a warning to those many private investors punting on Lloyds and RBS preference shares) but no measure can stop risk diffusing away from the regulator’s eyes.

Even splitting up the banks to hive off ‘casino’ elements such as proprietary trading from everyday High Street banking won’t solve the problem.

For starters, investment bank failure is a systemic risk, too – it was Lehman Brothers’ collapse that brought the world to its knees, after all.

More importantly, the fall of Lehman’s showed the bigger problem by threatening the solvency of insurer AIG, which had vast quantities of assets and obligations that nobody would have expected it to own when the regulations were drawn up.

This growth in ‘shadow banking’ is inevitable whatever regulations you have in place, for the simple reason that eventually people will become complacent, chase higher returns, and flock to pump up the size of whatever market agents can provide it, be they investment banks, hedge funds, or even a fraudster like Bernie Madoff.

You just can’t regulate against the madness of a bull market.

Profiting at our expense

Mervyn King is therefore right to suggest we should reduce the size of the biggest banks in anticipation of future disasters to come.

Yet all the financial crisis has done so far is concentrated power in even fewer hands, and added state guarantees to the mix.

What about self-restraint on the bankers’ part, I hear some optimist cry?

That’s a good one. We’ve already seen how laughable calls for ‘better behaviour’ from investment banks are in the light of the ludicrous profits and bonuses Goldman declared last week.

Goldman makes such outsized profits partly because it’s clever, but mainly because at the highest level investment banking is not prone to competition in the way that most businesses understand it.

This is especially true given that when the risk blows up, the investment bank gets bailed out.

Yes, Goldman has repaid the TARP bailout money the US government loaned it.

But that’s irrelevant. I’d happily spreadbet the FTSE for £10 million if I thought the Government would cover my temporary losses in the down years.

Vast profits, excess risk, and ridiculous bonuses all need to be stamped out, mainly by scaling down the size of banks and altering the market to enable more competition, as well as ensuring operators have more of their skin in the game.

There’s even a case for investment banking to be forced back to its original un-quoted roots, where the partners risk everything and take all the rewards.

Banking as a utility

Retail banks vulnerable to bank runs will always require the implicit guarantee of the State, whatever regulations are in place.

But financial companies shouldn’t be able to make huge profits from those guarantees – low risk and low returns should be the order of the day for any such quasi-public utility.

I still own HSBC and Standard Chartered because I think banking is a vital component of the financial system, and it makes sense to buy and hold while there’s so much uncertainty around depressing the outlook.

And in my view, those two banks are already close to where we’ll likely end up after any restructuring of the bank sector is done with (and I don’t say that it will go far enough). I also like their big focus on Asia, which is awash with savings.

But the farce of a banking collapse and state bailouts turning into multi-billion pound bonuses in the blink of an eye needs to be addressed as a matter of moral urgency.

I don’t think it’s too extreme to suggest that faith in capitalism is at stake.

The trickier question for legislators is not how to reform banking, but how to provide a safety net for the economy that doesn’t accidentally underwrite even greater risk-taking in future.

King has opened the debate, but it’s up to politicians to seize the gauntlet.

Further reading:

1. Weekend reading: Banks are back edition

A few people emailed to ask how I calculated the yield on the RBS Royal Bond.

Hey presto! This post will tell you everything you need to know about calculating bond yields, whether for government or corporate bonds.

First I’ll remind you of the basic kinds of rates or yields, then we’ll look at how to calculate them.

The main types of bond yield

There are three main yields applicable to dated bonds:

Coupon rate

This is the interest rate the bond initially pays on issue. It’s invariably given in the name of the bond.

For instance Treasury 5% would have a coupon of 5%. i.e. If you bought it when it was first issued — before the price began to fluctuate in the market — you’d get 5% interest annually for the life of the bond (ignoring costs). The coupon rate is also known as the interest rate.

Running yield

Bond prices fluctuate in value as they are bought and sold in the secondary market. As their price changes, so does the running yield that the (fixed) coupon delivers on the (variable) price paid.

The running yield is also called the flat yield or the interest yield.

Redemption yield

Bonds with a fixed lifespan pay back their nominal face/par value when they mature. If you buy a bond at less than par and hold to maturity you’ll make a capital gain. If you pay more than par, you’ll make a capital loss.

The redemption yield adjusts the running yield to take this gain or loss into account. It’s the most important yield calculation in most circumstances.

It is also called the yield to maturity (YTM).

How to calculate the running yield

The running yield is very easy to work out.

Let’s say Treasury 5% has five years to maturity and is currently selling for £120. It has a nominal value of £100.

We can see from its name that it pays a coupon of 5% of £100, so £5 per year.

If you buy this bond in the secondary market for £120, the running yield calculation is as follows:

Running yield = Gross (pre-tax) coupon x 100
                   ---------------------------
                        Price in market

= £5 x 100  = 4.17%
   ------
    £120

How to calculate the redemption yield

The running yield may be easy to work out, but it’s not very useful.

Usually you’ll prefer to know the redemption yield, unless for some reason capital gains or losses aren’t important to you, or the bond has a very long life ahead of it, in which case the running yield is close enough.

Undated bonds by definition have no redemption value, and so you only need to calculate the running yield for them.

The redemption yield is harder to work out than the running yield, due to compound interest. It’s best done using a special calculator.

Let’s consider the variables via our previous example:

• We know Treasury 5% is going to be redeemed for £100 in five years.

• We’ve paid £120 for it, so we know we’ll lose £20 when it’s redeemed.

The redemption yield spreads such capital gains or losses over the bond’s lifespan, to give an annual return estimate for anyone buying today.

For very short-dated bonds, we can use a handy proxy called the simple yield.

Say we buy a bond for £95 with one year left to run and a 5% coupon.

Over one year we will get £5 as income, and £5 when the bond matures, for £10 in total.

The return over 12 months is thus £10/£95 = 10.52%

Stretching this even to a few years reduces the accuracy, however.

For instance, returning to our Treasury 5%:

• We know the capital loss will be £20

• That is a loss of £4 every year over five years

The annual loss is £4/£120 x 100 = 3.33% a year

The redemption yield is therefore roughly: 4.17% - 3.33% = 0.84%

Working out the redemption yield using a calculator

My approximation of the redemption yield won’t be miles off, but the longer the bond has left to run, the more inaccurate it gets.

We really need to calculate the Internal Rate of Return, which takes into account when the coupon is paid and assumes it is reinvested into the same bond to benefit from compound interest.

This requires complex maths that you can read over on MoneyChimp if you’re a masochist.

Alternatively you can use that site’s online bond yield calculator.

Putting the numbers for Treasury 5% into the MoneyChimp calculator, we see the redemption yield is actually 0.892%, so slightly higher than our approximation.

Even easier than using an online calculator is to simply look at the redemption yield column in the bond tables you get online or in the newspapers. It gives you a fair idea of the return you’ll get from buying a bond, and its attractiveness relative to other bonds.

The general rule on yields is as follows:

Yield to call

One other kind of yield worth mentioning is the Yield to Call.

This is the yield you’d get if you bought and held a callable bond until to the date when the issuer can decide to redeem it (via a call option), ahead of the definite redemption date.

It pretty much amounts to the same calculation as the redemption yield, except you put the bond’s call date and call price into the calculator.

Further reading:

1. What are corporate bonds?
2. What causes corporate bond prices to fluctuate?
3. Is the RBS Royal Bond a good buy?

My weekly commentary followed by this week’s links to blogs and financial articles.

I only wrote two posts for Monevator this week, instead of my usual three.

I’m currently working long hours, you see, and that’s devoured most of my free time.

But never mind, because according to the specious logic of self-justifying bankers, I must be entitled to a six-figure bonus check as a result of my labours.

After all, “We work hard!” is one of the cries that the denizens of the financial goldfish bowl use to justify their inflated incomes.

As if nobody else works hard.

They’ve been justifying themselves a lot this week, after Goldman Sachs announced stunning results:

Workers at Goldman Sachs have racked up an average $527,192 (£324,607) in salary and bonuses so far this year after the American investment bank made a $3.1 billion profit in the third quarter.

Average pay for staff at the group, which employs around 5,500 staff in London, is 46 per cent higher compared to last year.

Come on, you must remember Goldman Sachs? They’re the princely free marketeers who were bailed out by the US government last year, like humble autoworkers or farmers.

I am so sick of the hypocrisy that bankers and other financial service providers spout. Unfortunately I know some read Monevator, and I know from experience that they’re completely incapable of looking objectively at their grossly inflated incomes, so they won’t take this post well.

It’s bizarre — most of them are pretty smart, and the can debate the legs off a cow. They can be thoughtful and generous too, just like anybody else can.

But when it comes to pay they start from the conclusion “I deserve a £300,000 bonus” and then work backwards, reeling off disconnected statements that on the surface might justify their position but are logically irrelevant.

We work long hours! — So do factory shift workers and illegal immigrants. They don’t earn six figures a year.

Our jobs are insecure! — Yep, that’s why most staff from Lehman Brothers are now working at Barclays or Nomura or similar. Besides, out here in the real world we lose jobs, too. Just ask anyone in the unemployment queues.

It’s very, very hard! — Lots of jobs are hard. Vets train for seven years before they’re allowed to stitch a cat, which is about seven years longer than bankers study banking. Even London taxi drivers study ‘The Knowledge’ for a year. Researching cures for cancer is hard — I must have missed the stories about lab workers earning £1 million a year.

It’s really competitive! — This is certainly true. But then lots of jobs are competitive. Being a lap-dancer is competitive. Being a music journalist is competitive. Far more people want to play classical music professionally than there are jobs for violinists or viola players. Their average salary is about £30,000 a year, and they supplement it with teaching.

It’s a free market! – True, when we’re not bailing it out for everyone’s sake. Or when a company wants to raise money or mount a takeover, and can only choose from three or four names — and it can hardly shop around publicly. Like law, it’s a racket.

You pay your hairdresser a tip! – So therefore bankers should be paid £300,000 bonuses? This idiotic comparison was made by the Miss Moneypenny columnist who writes for the Financial Times. She’s usually savvy and a good read, but even she threw up these kinds of inanities in her desperate argument to justify obscene City salaries. Is the reverse true? She earns a bonus — so should she clip my ear lob hair and rub wax into my scalp, then sweep the floor?

It’s stressful! — Even French workers with their 30-hour weeks and excellent social safety nets find work stressful. In fact, some are killing themselves.

It does something useful! – I am not one of those people who argues the City does nothing for its money. I fully accept that the crude image of a 22-year old gambling away a pension in one window while he’s on the phone to a lap dancer booking the evening’s entertainment is misplaced. All the phones are recorded nowadays, so he’d have to use his personal mobile.

More seriously, of course we need efficient financial services, deep and sophisticated credit markets, people who can wrap up the obligations of a country, company or individual and turn them into financial packages with defined risk that enable them to be traded, insured against, or whatever.

But we don’t need pay them on average £300,000 a year.

Why does it happen? The answer is obvious to anyone who’s had a job.

If you work in a crisp factory, you get free crisps. If you’re an estate agent, you see the best houses first. Nobody who works in a sweet shop ever went without sweets. Staff at Gap and H&M get big discounts.

And if you work alongside money, and you’re moving billions about, and 1% is neither here nor there in the good times — there’s your £300,000.

They make lots of money because they handle lots of money, and they take a commission, whether individually or as a company.

At best they provide innovative and socially useful functions akin to engineering or air traffic control, and they should earn say £100,000 a year for the role.

(This is more like the money most earned in the 1960s and 1970s, when it was a slow job for simple posh chaps from the right schools. Contrary to banker propaganda, the world kept turning and the communists were kept at bay.)

In the middle, they are engaged in zero sum games — fund management, say — so in aggregate are just enormous friction. Use an index tracker or pick your own stocks to do your bit to help fight this flea that’s smothering the dog.

At worst? They put people into crummy pension schemes and charge 5% upfront fees and deliver mediocre returns. They create complicated products designed to extract value from customers, not to deliver value. They speak humbly about their $800,000 salary as being a lot from where they came from, like John Mack of Morgan Stanley did on TV this week, because they think that candid talk will play well to the masses — but they neglect to mention the $69 million he was awarded between 2005 and 2009 alone.

Oh yes, and they cause little hiccups like the credit crisis.

From this week’s personal finance blogs

• The five stages of financial enlightenment — Free Money Finance

• Black Swan Investing — Oblivious Investor

• What is your definition of self-worth? — Wealth Pilgrim

• Why Dow 10,000 may not last — The Digerati Life

• Five steps to six figures in seven years — Get Rich Slowly

• Communist, capitalist or socialist joint finances — Plonkee Money

• Watch UK TV online for free — Money Watch

Other interesting financial and money articles

• Smart people getting into banking caused the crisis — New York Times

• Self-employed face self-cert loan ban — Financial Times

• Do you fear inflation or deflation? — Financial Times

• British are in denial about pain ahead: ex-FSA head — The Telegraph

• Anthony Bolton tips emerging markets — Financial Times

• An appetite for global food stocks — The Independent

• It is cheaper to buy than rent in much of the UK — Love Money

Save the cost of a weekend paper by subscribing to get this free update.

Further reading:

1. Weekend reading: Scare bear markets
2. Weekend reading: Recession cessation edition
3. Weekend reading: Gone fishing edition

A lot of people confuse tax avoidance and tax evasion. It can be a dangerous mistake to make!

As the former British Chancellor of the Exchequer Denis Healey said:

“The difference between tax avoidance and tax evasion is the thickness of a prison wall”.

What can’t be stressed enough is that the two terms – and the actions each entails – are definitely not the same thing.

• Tax avoidance involves using whatever legal means you choose to reduce your current or future tax liabilities.

• Tax evasion means doing illegal things to avoid paying taxes. It’s the Al Capone path to financial freedom.

Unfortunately for any criminals who Googled ‘tax evasion’, I’m not about to give you a masterclass in laundering cash or doctoring a passport.

I’ve never evaded taxes, I don’t condone it, and I couldn’t tell you how it’s done.

Tax avoidance is another matter. With taxes likely to rise in the West to pay down public debt regardless of what party in power, it makes sense for investors to do what we can to reduce our tax burden without overly compromising other aspects of our lives.

Note that according to the bastion of all knowledge good and true – *cough* Wikipedia *cough* — the term ‘tax avoidance’ is currently in some dispute in the UK, with ‘tax mitigation’ being suggested as a better term for legal tax reduction:

The United Kingdom and jurisdictions following the UK approach (such as New Zealand) have recently adopted the evasion/avoidance terminology as used in the United States: evasion is a criminal attempt to avoid paying tax owed while avoidance is an attempt to use the law to reduce taxes owed.

There is, however, a further distinction drawn between tax avoidance and tax mitigation. Tax avoidance is a course of action designed to conflict with or defeat the evident intention of Parliament.

Tax mitigation is conduct which reduces tax liabilities without “tax avoidance” (not contrary to the intention of Parliament), for instance, by gifts to charity or investments in certain assets which qualify for tax relief. This is important for tax provisions which apply in cases of “avoidance”: they are held not to apply in cases of mitigation.

I suspect this is largely a courtroom debate, caused by the Revenue looking to close down schemes of dubious legality created by planners for wealthy individuals.

But I’m no legal expert nor a tax planner – just an everyday bloke who enjoys investing. So to be absolutely clear, what I’m talking about is reducing the taxes you pay, mainly on investments, by using legal and above board means.

I’ll outline a few such measures in part two. (Subscribe to ensure you see it!)

Be prepared to do some research about the tax regime in your country, though, and potentially to take professional advice.

Tax laws can be complicated, and you don’t want to end up on the wrong side of that prison wall.

Further reading:

1. Tax and costs will eat up returns
2. How UK dividends are taxed