To me it is becoming increasingly likely that money printing will be the path taken to repay sovereign debt. No one likes austerity as we have seen in the French and Greek elections. The leaders of the G8 also voted for growth rather than austerity in their meeting over the weekend. No one likes to take a loss or see their entitlements cut. It is more acceptable to print more money than to default or to cut spending. We prefer to get the same number of dollars even if they no longer have the same purchasing power. I guess it is psychologically easier to accept inflation rather than deflation. We like to hear that our houses have gone up in value but feel fearful if we hear that the value has dropped.

If the rest of the world is choosing to print money and devalue their currency, we should join the party. I am glad to see that the RBA is finally joining other central banks in cutting interest rates. When rates go to zero, perhaps the RBA can also print money to buy assets that nobody else wants in order to keep their prices up. However, all this rampant money printing will raise the fear of hyper-inflation which is possibly why the price of gold has done a U-turn last week. Maybe it is time to swap some bonds for gold in our portfolios?

So how can we find anything to be bullish about in all the above “bad news”?  French president Nicolas Sarkozy’s loss was no surprise and neither was the Greeks’ rejection of their current government, confirming that austerity is too painful for the man on the street and any leader who chooses to do this risks being ousted. We can now expect government borrowing and money printing to continue which would make inflation the more likely outcome in the future. The new budget simply means we need to change our investment strategies. With the higher tax free threshold and capping of super contributions, more investments will be made outside of super. Together with lower interest rates, this could provide a boost for property prices. JP Morgan’s $2 billion losses may not be as bad as it looks as they were actually on investments that were part of their hedging strategy. If their hedge lost money, hopefully this means their core investments are making money. Given that JP Morgan has $1.1 trillion of assets, a $2 billion loss on a hedge (insurance cover) may not be that significant.  As a result, I will still give Jamie Dimon the benefit of the doubt.

Although our stock market had a rough week, the ASX200 is holding up pretty well technically. In March, the index popped above the 200 day MA and by late March, the 50 day MA (moving average) crossed above the longer term 200 day MA forming a bullish cross. At Friday’s close, the index was still sitting above the 200 day MA. The index managed to break above the stubborn resistance (green line) at 4300 last month and it looks like it could be the new support level. All these are bullish signs.

If the above is not convincing enough, we just need to look at China’s stock market index. After falling for months, the Shanghai Composite index (see chart below) is showing signs of a reversal with an inverse head-and-shoulder pattern. This week, it even managed to briefly poke above the 200 day MA. These developments give me hope that China is not headed for a hard landing as feared.

For those who prefer to stay in less volatile investments, falling interest rates have been good for bond investors. The 1 year return for the UBS Composite Bond Index is close to 10%. Since I last wrote about how retail investors can get exposure to fixed income, I found out that a number of bond ETFs have been listed on the ASX (see table below) in the last couple of months. Bond ETFs are not very different from the unlisted bond funds except the fees are usually lower. For example, IAG, a fund that mirrors the UBS Composite Bond Index, is similar to the unlisted PIMCO Australian Bond fund that I hold, but the fees are about 0.5% cheaper.

For anyone interested in these products, check out the respective provider’s website for more details about each product.

Since August last year, I have been thinking about starting my own business in something that I am passionate about, and for me it has always been about building financial security. One of the first things I did was to write up a business plan and the template I used required me to declare my “BHAG” which stands for Big Hairy Audacious Goal. After thinking about it for many days, I wrote down “A Comfortable Retirement for Every Australian Baby Boomer” as my BHAG. As a baby boomer myself, I have many friends who are approaching retirement or have recently retired and the biggest worry they have is how to get consistent income from their investments to maintain their lifestyle once the salary stops coming in.

Over the next few weeks, I went through different ideas of what I could do and in early September, (when I wrote “Learn, Do, Teach”) I decided I would put together my own training and mentoring program to teach stock investors how to use options to generate income and manage risk, something I have been doing for my SMSF successfully for over three years.

I spent the next six weeks creating my training videos and launched the pilot program in mid-October. I had quite a few volunteers to pilot test my training videos and a couple of pilot mentoring students as well. I learned a lot from the pilot. I realised I was too focused on teaching “how to” execute the strategy and did not provide enough information to explain “what” the strategy was about and “why” it can generate consistent income in all market conditions. After the pilot, I wrote an e-book to explain the income strategy in simple English without too much options jargon to provide a “big picture” overview of what the income strategy was about. The e-book is the starting point for anyone who wants to learn about the income strategy.

I also realised I was too focused on “options” when I should be more focused on “income” as options are simply tools to generate additional income. Instead of “Options Training for Stock Investors” which covered using options for hedging and income generation, I decided to change the training to “Low Risk Income Strategies for Stock Investors” and simply focus on income generation using options in conjunction with other types of income such as dividends and interest to maximise the return on capital.

I also wanted to provide students with on-going support after the mentoring period.  The best way to do this is by starting a blog which will solely focus on trading these income strategies and creating a model portfolio using the trades that I am currently doing myself. I will update the model portfolio weekly to show the trades as they occur.  Although it does not take long to learn the mechanics of doing the strategy (and most people can do this within 3 months), it takes a little longer to master it. Like learning to drive a car, you probably need about ten lessons to learn enough to pass the driving test but it will take months of driving in different conditions to become a good driver. Likewise it will take months of experience to become really good at trading the strategy. The model portfolio will not only help to existing students but anyone who is considering learning the strategy to view the results of this strategy on an ongoing basis.

From the people I met during the pilot, I realised that while I know the strategy works, it may not work for everyone. Options are definitely more complex than stocks and one does need to invest some time on education. The education materials are readily available but many will not be prepared to spend the time to learn. Those who did the pre-requisite education got a lot from the training videos but those who did not had trouble following the videos and probably gave up as I never heard  back from them again. I have since created a pre-course assessment which learners must take before watching the training videos. The purpose of my training videos is to show someone who already understands the strategy conceptually how to implement it in real life. The videos also assume the audience have a basic understanding of options and are familiar with the common option terminology.

Well, for anyone reading this who is interested in learning some new skills to generate additional income from your stock portfolio, please visit http://LowRiskIncome.net soon and I will see you on the other side!

I tried to educate myself on fixed income but I have to admit the products are hard to understand so I really do not feel confident in choosing fixed income products myself. As the best products only seem to be available to wholesale investors anyway, the best option for retail investors is to invest via a fixed income fund. My first fixed income investment was a retail fixed income fund with I purchased with some of the funds in our SMSF. At the time all our super had been rolled into our SMSF. Like all managed funds, this fund charges management fees, and this fee is usually higher for retail funds than their wholesale equivalent. For example the management fee for the retail PIMCO EQT Australian Bond Fund is 0.72% p.a. whereas the management fee for the wholesale equivalent of this fund PIMCO EQT Wholesale Australian Bond Fund is only 0.50%. Again retail investors cannot get as good a deal as wholesale investors. Since we intend to outsource the management of our fixed income investments, the cheapest way to do it is via a wholesale investor like a corporate or industry super fund, rather than buying a retail fund in our SMSF. This is currently our preferred method of getting our exposure to fixed income. All new employer contributions are invested in fixed income through a corporate super fund.

As our allocation to fixed income grows in the corporate fund, I am reducing my fixed income investments in our SMSF to maintain our desired weighting in fixed income. Another question to ask is what is the appropriate allocation to fixed income? One simple rule of thumb is to use your age as a guide i.e. a 50 year old should have at least 50% and a 60 year old should have 60% in fixed income. As fixed income is considered a defensive asset, we should have more invested in this asset class as we get older. Consider the impact of a 50% market correction like the one we experienced in the recent GFC on a 25 year old, a 40 year old and a 60 year old who have all of their super invested in shares. The 25 year old would probably only have $20,000 in super and he would see his balance reduced to $10,000. As this is not a large amount to him and he has many years to retirement, the impact is not great for him. The 40 year old may have $100,000 in super and he would see this reduced to $50,000 but again the impact is not great as the amount involved is not too much and he has plenty of time to build up his super before retirement. The 60 year old may have a $300,000 balance and having it reduced to $150,000 will have a very large impact as he needs to draw on his super and cannot afford to wait years for the market to recover.

SMSFs are great for some investments but big super funds may be better for investments that benefit from specialized knowledge and economies of scale. I believe fixed income and insurance are some of the investment products that do and I am quite happy to get our exposure to these investments via a big super fund, while my SMSF is used to get exposure to products and strategies that are not readily available to big super funds. I am quite happy with our combo of “SMSF + corporate fund”. A financial planner I spoke to also uses a combo approach. He uses his SMSF to invest in Australian shares and uses a corporate fund to get his exposure to international shares and fixed income. As a SMSF trustee, the choice is yours. Most of us set up our SMSFs because we want control but it only makes sense to control the things we understand and to relinquish control on things we do not understand to others who do.

The age pension is an important source of retirement income that should not be overlooked as it is the safest form of annuity income. It is a lifetime annuity so you do not have to worry about outliving your annuity. As the government is the annuity provider, they are less likely to default on the payments compared with a private provider which is usually an insurance company. It is also typically indexed to inflation and so you don’t have to worry if your income can keep up with inflation. If you have read my previous posts, you will know I am big fan of annuities especially when you get older. You can get a lot of peace of mind from knowing that you will get a consistent income every year no matter what happens with the economy or financial markets.

Another big advantage of being a pension recipient is the pensioner concession card which entitles the holder to all sorts of discounts on essential items such as pharmaceuticals, transportation, and utility bills. Getting more income is not the only way to have a more comfortable lifestyle. Reducing your essential expenses will leave you with more money for the things you enjoy.

The key to planning for the age pension is understanding the Centrelink rules well. There is an asset test and the cut off for the pension assets test is much higher than what people think. At this time, a couple who own their own home can have $1.018 million in assets (not including their home) before they miss out, and non-home owners up to $1.153 million. For singles, the cut-offs are $686,000 and $821,000. If you have too much assessable assets, there are ways of reducing them. Your primary residence is not an assessable asset so one way is to use some of those assets to upgrade your primary residence. If I have this problem in the future, I would take the opportunity to renovate or move to a newer residence so I will be able to keep my expenses on home maintenance and repairs low in future years.

You can also give some of the assets away but you need to do it well before you reach pension age. There are limits on gifting that apply to the five years before you receive the Centrelink benefit. You can only give away $10,000 in any financial year up to a maximum of $30,000 over a consecutive five-year period. If you exceed these limits, the excess is treated as a ”deprived asset”, which means you are still assessed as owning it for five years. I would imagine my adult children will be quite happy if I offered to give them some money to help them pay off their mortgage and maybe they can in return chip in for my golf club membership or other lifestyle expenses with the savings they get from not paying interest to the banks.

There is also an income test that basically allows a couple to earn up to $2522 a fortnight before losing their pension, and singles up to $1647.60. This translates to $65,572 and $42,822 per year and seems like quite a generous amount considering the amount needed to live a comfortable life is only around $55,259 for a couple and $40,407 for a single according to the ASFA Retirement Standard. You can reduce your assessable income if you convert your assessable assets into an allocated pension because part of the income drawn from your allocated pension is considered capital so it does not count as assessable income.

If you want to have a worry free retirement, then the age pension should be part of your retirement plan.  My aunt is a retired nurse who has very little assets but is a recipient of two government pensions. She seems to have less financial worries than my parents who have a lot more assets than her. Like many retirees, my parents are afraid of losing their capital so they are mainly invested in safe investments which do not provide sufficient income to meet their expenses, whereas my aunt’s pension income is more than enough to cover her expenses. If you want to learn more read Planning for a Pension and check out the Centrelink website.

Christina McDonald

Where the debt sits in the debt hierarchy (see chart below) is also quite important in determining risk as “senior” debt holders will get paid before “junior” debt holders. Most hybrids are junior or subordinated debt so they are riskier than term deposits or covered bonds. Term deposits with banks are also guaranteed by the government which eliminates the credit risk of the issuer. Hybrids have been very popular and recent issues have been oversubscribed. Although they pay a slightly higher yield compared to term deposits, I wonder if investors understand the risk that they carry and if they are adequately compensated for the added risk.

The biggest risk with fixed income is actually inflation risk. All central banks want inflation and actually target to create inflation of 2-3% every year. While there is definitely less risk of capital loss with fixed income, there is also less potential for capital gain so they may not be able to keep up with inflation. Risk assets like stocks and property are more likely to keep up with inflation which is why I believe we should have some allocation to risk assets in our investment portfolio. The amount we allocate depends on our tolerance for volatility. Ideally we would love to be able to stay in the safety of fixed income until the next bull market comes along but unfortunately no one will ring a bell when the bottom is reached so we can all safely jump back into the stock market. The Australian share market has already had a major correction in 2008 and many stocks are still trading at well below their all-time highs in 2007. A universal measure of stock value is ratio of Price to Earnings. With the ASX/S&P200 at the current level of around 4300, the P/E is 13x which is historically cheap. When the index was at 6700, the P/E was 18x so the risk of investing in shares now is actually lower than in 2007.

As there is risk in all investments, one way to manage risk is diversification i.e. make sure you have both defensive assets such as cash and fixed income as well as risk assets such as shares and property. Another way to manage risk is to always buy at a discount to current market price. When we buy a new investment, we really do not know if it will go up or down in value after we buy it. If we can buy it at 5-10% cheaper than fair market value, then we have a margin of safety. It is possible to buy almost any investment at a discount. With property, you can always make an offer at below the asking price. Our property investment mentor always manages to get bargains. He would look at 100 similar properties to get a good feel of the market price. When he spots a good bargain because the sellers have not done their homework as well as he has, he quickly makes his offer to buy. We can do the same with stocks. We can put stocks that we like on our watch list and when they reach a good price by our own valuation, we make an offer to buy at the price we would like to pay by selling put options at that price. For example, if BHP is trading at $35 and you think that is a good price, you can sell a put option at a strike price of $34. This is my favourite stock acquisition strategy as it gives me a safety buffer when I buy stocks. We can even buy fixed income products at a discount. If you are interested in hybrids, instead of rushing to buy at the initial offer price, look at the secondary market. There are some that are trading at below their par value so you could be buying them at a discount.

My own views on risk are constantly being challenged. In the last few weeks, I have been challenged by two people – the first person thought I took too much risk and the second person thought I did not take enough risk. We all have different tolerance for risk. What is important is that we understand and are comfortable with the risks in the investments we make.

Since 2008, the share market may have entered a period that is more similar to 1941 to 1974. The strategies that worked so well in the 33 years prior may not work anymore. According to Marcus, the risk-reward ratio of investing in equities has shifted and making money will take more effort. Making money when it’s more risky requires more discipline and skill so you need good trading skills; in particular risk management skills if you want to continue to be participate in this type of market. If doing this is too hard, then it is best to step out. Not losing money is good now and survival should be the No. 1 priority.

In our SMSF investment strategy, we specify a target annual return and ours is 5% above inflation. However, this does not mean that meeting that target return every year is my No. 1 priority. My top priority is Safety or Survival, just like Marcus. I recognise that investing is like fishing – I cannot predict how many fish I can catch in a year. I can only make sure I have good fishing equipment and skills but it also does not mean I should go out to fish everyday even when it looks like a big storm is brewing. It is better to miss out on catching a few extra fish rather than risk losing your fishing equipment. Seasoned investors like Alan Kohler who publishes the Eureka Report understand this. At the end of 2011, he announced that he was reducing his allocation to equities in his personal portfolio to 30% when he saw the risk of another major credit disaster in Europe. The disaster was averted by some last minute intervention by the Europe Central Bank and the markets rallied in December 2011. Some of his readers voiced their disappointment in missing the rally because followed him and stayed out of the market. I believe Alan did the right thing and he will have better results than most of his readers in the long run.

I hope all new SMSF trustees who plan to invest in the stock market will take a few moments to read Marcus’s excellent article and heed his simple advice – Make survival your No. 1 priority.

Once again the global market indices in 2011 have shown that a strong economy does not automatically mean a strong stock market performance.  As you can see from the chart below, the stock markets in strong economies like China and Australia underperformed when compared to the US and even Europe despite the widely acknowledged economic problems there.

It looks like the availability of liquidity has a much bigger impact on stock performance than company earnings. 2012 is an election year in the US and we are pretty sure that the politicians will do whatever it takes to look good before the elections in November 2012. We will increase our long positions in quality undervalued US stocks in 2012.

Although we are a little more bullish on “risk assets” in 2012, we are aware that the long term “big picture” is still the same. The debt problems in the US, Japan and other European countries are still growing and will have to be addressed eventually and hence the risk of a big credit event remains. The ongoing debt crisis reminds me of a video I watched on the Buffalo Creek disaster. For years a mining company built dams to contain their toxic mining waste above the Buffalo Creek valley. When one dam filled up, they just built another one. Life in Buffalo Creek was just fine until one day a crack in Dam #3 caused the waste to overflow and overwhelm Dam #2 and Dam #1 as well. Seventeen towns in the Buffalo Creek valley were completed destroyed within hours. Right up to the end, the mining company assured the people of Buffalo Creek that the dams were fine and there was no danger to them. As a small retail private investor, I feel like a resident in one of the small towns in Buffalo Creek living under dams that contain the massive amounts of toxic debt. We have no control over government policy responses to the debt problems, but after 2008, we cannot say we are unaware of how fragile our global financial system is. We really cannot predict if we will have inflation or deflation in the years ahead so the best we can do is to maintain a 50-50 allocation to risk and defensive assets. While our SMSF may increase our investments in risk assets, we will still maintain our hedges and all new contributions will go into fixed income investments which we are doing through a corporate super fund rather than through our SMSF.

Looking back, last year was a transition year for me. Just as my youngest child who started secondary school was becoming more independent, I thought I would finally have more time to pursue my own interests. I tried starting a new career in financial planning but that did not quite work out. In hindsight, I am glad that door is closed as I really don’t think I could be happy working as a financial planner with sales targets. With aging parents who are becoming more dependent and needing more care and support, I also appreciate the flexibility of not being tied down to a job. When my mum had a medical emergency in March, none of my siblings with jobs could take the time off work to help look after her. In the past 12 months, I made 3 trips and spent over 3 months with them. Supporting my parents interrupted some of my own plans but I gained a lot of new insights on planning for retirement which I believe will help us plan better for our own retirement.

In the second half of last year I decided to build my own business around the things I am passionate about which are investing and building financial security. During my own journey to becoming a self-directed investor, I spent a lot of money on expensive courses which I felt over promised and under delivered. A lot of these courses were imported from the US and were not tailored to fit the local market. I wanted to provide cost effective training courses to teach practical investment skills which can work in the Australian market. Last year I developed a training course to teach the low risk income strategies that we have been using for our SMSF since 2008. The results from the pilot program have been very encouraging and this year I will be focusing on improving the course and providing more support for students. One of the things that I will be doing to support students is to start another blog which will solely focus on trading these strategies. Personally, I believe these strategies will do very well in the next few years but I realise that not everyone is equally interested and excited about these options based income strategies as I am! This “SMSF Investment Strategies” blog will focus on general SMSF strategies to support new SMSF trustees and those looking to start their own SMSF whereas the new “Low Risk Income” blog will go into a lot more detail on our income strategies to support those who are interested in generating additional income from their stock portfolios.

Kingsley and I will be reviewing our SMSF’s investment strategy over this weekend. It has been quite a while since our last review which was in September 2010. We normally do a review once a year but last year just flew by with little real economic change! I will share our thoughts in my next post. When did you last review your investment strategy? Does your investment strategy need an update for 2012?

Christina McDonald

The first thing you notice is that not all sectors are equally volatile. The defensive sectors (shaded in green) are hardly affected by the volatility. Some stocks in these sectors pay a good amount of fully franked dividends as well. Buying a defensive sector stock like Telstra seems like a no brainer. At the price of $3.28 per share it still has a dividend yield of 8.5% or 12% if you include franking credits, which is twice what we can get from cash.  For those of us who know options, this yield can be further improved by selling covered calls.

Another observation I have made from the above table is that big falls tend to be followed by sharp rallies in the volatile sectors (shaded in blue). Another strategy that I am currently pursuing is selling out of the money (OTM) put options on fundamentally good stocks in volatile sectors after a major correction. I will walk through an example of such a trade using BHP, which I think most would agree is a fundamentally good stock in the volatile materials sector. By looking at the chart of BHP (shown below), we can see that there is strong support for BHP at $34 i.e. BHP tends to rally whenever it falls to $34.

When the price of BHP comes close to this support level, I would look at selling put options at that strike price. At today’s price of $35.76, I can collect a premium of $1.12 for selling a BHP put option at the strike price of $34 which expires on 23 February 2012 as shown below.

 Source: E*TRADE

The most likely outcome in February 2012 is that BHP will be trading above $34 by that time and my put options will expire worthless and I get to keep the $1.12 premium.   This is a 3% return in 3 months or an annualised return of 12% which is a similar return to what I can get from Telstra dividends. Unlike doing covered calls, I do not need to own stocks to sell puts. The puts are secured by cash which I can keep in a high interest bearing account while waiting for my puts to expire. Based on the current Usaver interest rate, the bank interest can add another 6% return to this strategy. Selling puts does have risks and the risk is that I will have to buy BHP stocks at $34 if the buyers of my put options choose to exercise their right to sell their shares at that price. I need to make sure I have the cash to buy the BHP shares if that happens. For me buying BHP shares at a cost of $32.88 ($34 for the shares less the $1.12 option premium collected) is a risk I am prepared to take.

Selling OTM puts is my preferred options strategy for stocks that do not pay much dividends. There is not much point in holding these stocks in bearish / sideways markets when there is little chance of capital appreciation. I wholeheartedly agree with Aaron Gurwitz, the chief investment officer of Barclays Wealth that selling covered calls on stocks you own and selling puts on stocks you don’t mind owning are good strategies for this “directionless volatile” market.

As this may be my last post for the year, I would like to wish all my readers a Merry Christmas and a Happy 2012!

Christina McDonald