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How to Prepare an Investment Strategy for your SMSF

By Kingsley and Christina McDonald

SMSF Investment Master Plan How to Prepare An Investment Strategy For Your SMSF

2010 Kingsley and Christina McDonald

First Published in March 2010

What You Can Do With This e-Book. You are welcome to share this e-book with anyone, reprint portions of it on your blog or website, and basically do anything except sell it for profit. If you do reprint or reuse any content from this e-book or make any reference to content from this e-book, we would appreciate an attribution link to http://www.smsfinvestmentstrategy.com.au

Disclaimer The information contained in this e-book is not intended to be taken or relied upon as specific investment or financial advice. The authors shall not be liable in respect of any claim arising out of any reliance on the information in this e-book. At the time of writing all information including prices and interest rates is as far as the authors can ascertain, correct. Readers should always obtain independent or professional advice before acting on any information in this e-book.
________________________________ SMSF Investment Master Plan v1.0

2010 Kingsley & Christina McDonald

http://www.smsfinvestmentstrategy.com.au

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SMSF Investment Master Plan How to Prepare An Investment Strategy For Your SMSF

CONTENTS
WHY WE CREATED THIS E-BOOK INTRODUCTION OUR INVESTMENT EXPERIENCE PERFORMANCE OF SLI SUPERANNUATION FUND
Performance for 2008 Financial Year Performance for 2009 Financial Year Summary of Fund Performance

4 4 5 6
6 7 8

BEFORE CONTINUING PART 1 CONSIDERATIONS IN PREPARING AN INVESTMENT STRATEGY INTRODUCTION WHY DO YOU NEED AN INVESTMENT STRATEGY? WHAT SHOULD YOU HAVE IN YOUR INVESTMENT STRATEGY?
Investment Objectives Investment Methods Traditional Investment Methods SLI Supers Investment Methods

8 9 10 10 11
12 14 14 18

WHEN DO YOU PREPARE YOUR INVESTMENT STRATEGY? HOW DO YOU PREPARE AN INVESTMENT STRATEGY?
Step 1: Determine Your Investment Objectives Step 2: Determine the Asset Classes in Which You Wish To Invest Step 3: Determine Your Investment Methods i.e. Active Vs Passive Step 4: Determine Your Risk Management Strategy Step 5: Determine Your Allocations to the Different Asset Classes Step 6: Document and Sign Off Your Investment Strategy

21 22
22 22 23 23 25 26

PART 2 INVESTMENT STRATEGY FOR SLI SUPER FUND FOR 2010 INTRODUCTION OUTLOOK FOR 2010
Inflation or Deflation US Dollar China Sovereign Debt Crises

27 28 28
29 31 33 33

OUR INVESTMENT STRATEGY AND ASSET ALLOCATION FOR 2010 APPENDIX A INVESTMENT STRATEGY CHECKLIST APPENDIX B EXAMPLE INVESTMENT STRATEGY

34 36 38

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http://www.smsfinvestmentstrategy.com.au

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SMSF Investment Master Plan How to Prepare An Investment Strategy For Your SMSF

WHY WE CREATED THIS E-BOOK Introduction


Firstly, congratulations! Given that you have downloaded this e-book, you are now amongst the growing ranks of people (772,000 plus to date) who have decided to take more control of their financial future by starting their own Self Managed Super Fund (SMSF). We started our own SMSF fund (SLI Superannuation Fund) in March 2007 as we wanted to take more control of managing our investments. In case you are wondering, SLI stands for Strategic Life Investments. We believe our SMSF is a strategic life investment that will be our primary vehicle for funding our living expenses after retirement. Starting Out Although we knew that we wanted to have more control over our investments, we had no idea what was required to set up a SMSF. We sought advice from various SMSF professionals. Financial planners told us it was complicated to manage and we needed a large amount of money in our superannuation (which we did not have). Accountants told us it was simple to manage and we did not need much money to get started. We were told many things that confused us. In the end, after eliminating all the noise, it was just a matter of having our accountant set up the foundations for us; a trust deed, ABN and tax registration, accounting and audit facilities. Compliance The Fear Factor Issues around being non-compliant were prevalent from all angles, and it was definitely our biggest fear. You must not take money out to buy a car for yourself, you must do everything at arms length, you must consider sole purpose, you must this, you must not that, you must comply or risk getting into big trouble with the ATO! We were so paranoid about compliance that we did not dare deviate from a traditional investment strategy which is to buy and hold a diversified portfolio of blue chip stocks and cash. We had just started yet we already felt hamstrung! We became even more worried when market conditions changed and we strongly believed that the traditional investment strategy was not going to work. We quickly investigated compliance, spoke to the ATO and educated ourselves further, following which, we realised that we did not need to feel hamstrung, as compliance was no where near as restrictive as we were led to believe. The SMSF is really nothing more than a separate legal entity which has its own governance (the investment strategy) that must be followed within the guidelines of the ATO. The reality is the ATO gives you reasonable flexibility; you just need to ensure that you document what you plan to do (the investment strategy). Investment Advice - To Pay or Not To Pay After all the paperwork to establish our SMSF was completed we were left on our own to do the most important task; manage and grow our investments. We looked for guidance on how

2010 Kingsley & Christina McDonald

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SMSF Investment Master Plan How to Prepare An Investment Strategy For Your SMSF to prepare our investment strategy but the investment professionals we talked to either wanted to charge us to do this or wanted to manage our investments for us. As we discovered, the reality is that it is not that difficult to prepare an investment strategy. Initially, as we were so concerned about being compliant, we began with a simple investment strategy based on traditional investment approach and slowly expanded it as we became more confident about what was or was not allowed. We have no issue in paying for investment advice when there is clear value, and to date, we have found there is a mini industry that is more than willing to charge you for information that we believe should be available to people freely. We have written down the steps in preparing an investment strategy in this e-book which includes defining your investment objectives, selecting your investment methods and determining your allocations based on your risk tolerance. To help you document your investment strategy, we have also provided you with a copy of ours which you can use as a template for documenting the investment strategy for your own SMSF. If you are unsure or concerned about any compliance issues, do not hesitate to validate these concerns with a good accountant or the ATO whom we have found to be nothing more than helpful and responsive. Think of the ATO as your compliance partner. Likewise, for complicated investment strategies, transition into retirement etc, you should seek counsel from financial professionals who understand the intricate details around these. We have written this e-book to share some of our thoughts and findings and to help you develop your own investment strategy with the right priority, which takes into account the trustees investment objectives and available resources such as skills, experience, time and interests as the primary focus. At a high level this e-book will help to provide you with: a) the steps to write an investment strategy b) investment strategies for all market conditions c) sample investment strategy We hope new trustees will find the information helpful in preparing your initial investment strategy for your SMSF. If this does nothing more than to give you some extra food for thought when preparing your own investment strategy, then we will be very happy.

Our Investment Experience


We, Kingsley and Christina McDonald, are the trustees of the SLI Superannuation Fund. Kingsley has been a property and stock investor for many years; he has a keen interest in property as an investment and continues to focus on this. Given that we have a number of property investments outside of super, we made a conscious decision not to include this asset class within our SMSF. Kingsleys main strategy for stocks was buy and hold. Kingsley has learnt about options trading and futures trading but has not extended this experience on a significant scale.

2010 Kingsley & Christina McDonald

http://www.smsfinvestmentstrategy.com.au

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SMSF Investment Master Plan How to Prepare An Investment Strategy For Your SMSF Christina has been trading options for 6 years with her primary focus being on the US market. Prior to this Christina had never owned a single stock. In 2005, Christina took a year off work to focus on building her option trading skills; as a result, Christina never returned to her job and has been successfully trading options full time for our family investment company since 2006. She specialises in monthly income strategies using nondirectional option strategies such as butterflies, iron condors and calendars which allow her to take advantage of a market irrespective of the direction in which it is travelling. These strategies are beyond the scope of this document and our discussions of SMSFs. Since the birth of our SLI Superannuation Fund, Christina has been primarily responsible for managing the investments for the fund while Kingsley continues to work full-time to add additional contributions to the fund.

Performance of SLI Superannuation Fund


Before continuing to read this e-book, we are sure you would like to know how well our fund has performed using the investment strategies that we talk about in this e-book.

Performance for 2008 Financial Year


It took us nearly 6 months to roll over all our different super funds that we had into our SMSF, so we really only started our investment activities in September 2007. At that time the economy and stock market was booming so naturally we wanted to put our money to work in the stock market. We allocated 90% of our funds into Australian blue chip stocks. We followed the investing principles from Dale Gillhams book How to Beat Managed Funds by 20% and built a portfolio of six Australian blue chip stocks across diversified sectors with an equal amount of capital allocated to each stock. However, given that the stock market already had a three year bull run, we wanted to manage our risk against a market correction and we were prepared to exit the market quickly if there were signs that the bull run was over. With some economic concerns in the US stemming from the subprime crisis and when the S&P 500 failed to make a new high in December 2007, forming what is called a head and shoulder pattern (which is a bearish sign in technical analysis), we decided to exit the market.

Chart 1: Weekly Chart of S&P 500

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SMSF Investment Master Plan How to Prepare An Investment Strategy For Your SMSF We closed all our stock positions in December 2007 and stayed in the safety of cash as the stock market crashed. Thanks to our quick action we did not lose any money on our stock portfolio and with the help of good bank interest rates, we were able to generate a return of +3.87% for FY2008 even though our fund was 100% in cash after December 2007. Although it was below our target return, which was 5% above inflation, it was pretty good compared to the average return of -8.1% of over 600 professionally managed super funds (source Australian Prudential Regulation Authority (APRA)s Annual Superannuation Bulletin June 2009)

Performance for 2009 Financial Year


When the government started to aggressively cut interest rates in the second half of 2008, we knew that we could no longer stay in cash if we wanted to meet our target annual rate of return. We moved slowly back to equities and tried diversifying into other asset classes such as precious metals and international shares. We soon found out that diversification did not really work as a method for spreading risks as all our asset classes moved downwards in tandem. However, we applied our knowledge of options and started using options to hedge our stocks and to generate extra income. Despite making a number of mistakes, we still managed a return of +12.23% for FY2009 which was 23.93% better than the average return of -11.7% across the large super funds regulated by APRA (see Table 1 below for break down of returns by fund type).

Table 1: Ten Year Returns of Large (APRA regulated) Super Funds

A small part of the good performance was due to us moving some of the funds into USD when the AUD was strong. Our main purpose for doing this was not so much for currency speculation, rather is was to enable us to buy assets that were not available on the ASX such as Exchange Traded Funds (ETFs) for gold, silver and international shares. Even though those assets did not do as well as had been anticipated, the strengthening of the US dollar did compensate and that helped to offset some of the losses when we converted the values of those assets back to AUD. However, the bulk of our earnings came from applying option strategies such as selling cash-secured put options, and covered calls over our Australian stock portfolio.

2010 Kingsley & Christina McDonald

http://www.smsfinvestmentstrategy.com.au

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SMSF Investment Master Plan How to Prepare An Investment Strategy For Your SMSF

Summary of Fund Performance


At a quick glance we are already ahead of where we would have been had we kept our superannuation in the large super funds. Even though our SMSF has only been going for a little over 2 years, we have just been through the worst financial crisis in our lifetime. Fund Our Fund (SLI SMSF) Average return of Large Super Funds Out Performed Larger Funds By 2007 / 08 3.87% -8.10% 11.97% 2008 / 09 12.23% -11.70% 23.93%

Table 2: Our SMSF Performance Record

The investment strategies employed by our fund are not complex, and we do not believe that they need to be. With some knowledge through education, and proactively managing your investments it is possible to outperform the average large super fund.

Before Continuing
Before going any further, we wanted to have a quick word about the imbedded links in this e-book. We have included links to many resources throughout this e-book and clicking on the blue underlined text will take you to the related resource (eg. SMSF Investment Strategy, in this case when you click on the blue underlined text it will take you to our web site). In Part 1, we will cover some of the principles we used in creating our Investment Strategy, and in Part 2, we share our outlook for 2010 and our Investment Strategy for 2010. There are a number of appendices, one of which contains a copy of our investment strategy. We love the fact that we now have direct control of our finances and we enjoy investing. We hope that this e-book helps you with your move into your own SMSF and taking control of your finances. We would welcome any feedback about this e-book or thoughts about other topics that you would like us to cover in the future. We wish you all the very best.

Kingsley and Christina McDonald

2010 Kingsley & Christina McDonald

http://www.smsfinvestmentstrategy.com.au

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SMSF Investment Master Plan How to Prepare An Investment Strategy For Your SMSF

PART 1 CONSIDERATIONS IN PREPARING AN INVESTMENT STRATEGY

2010 Kingsley & Christina McDonald

http://www.smsfinvestmentstrategy.com.au

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SMSF Investment Master Plan How to Prepare An Investment Strategy For Your SMSF

Introduction
In this section, we will be discussing general considerations in preparing your investment strategy. We believe that each SMSFs investment strategy should be tailored to fit the needs and preferences of the members. It should take into account the investment skills and experience of the trustees, and how much time the trustees have to manage their investments. We have structured this section to answer the following questions: 1. Why do you need an investment strategy? 2. What should you have in your investment strategy? 3. When do you prepare your investment strategy? 4. How do you prepare an investment strategy?

Why Do You Need An Investment Strategy?


For many people, the primary reason for preparing an investment strategy is for compliance, based on the requirement from the Australian Tax Office (ATO). As most new SMSF trustees have little idea what is required to comply with this, some accountants we know have come up with services to help new trustees (for a fee of course) to prepare their investment strategy. Most investment strategies we have seen are very generic with a few broad statements on asset allocation, probably so that you will not need to update this investment strategy frequently, even when you change your investments. Typically the asset allocation breakdown would be something similar to: Cash Australian shares International shares 10 - 20% 20 - 80% 0 - 30%

However, although it is mandatory for compliance, we believe that the investment strategy is significantly more than a compliance document. Primarily, it is our Master Plan for how we plan to invest our funds (see Appendix B Example Investment Strategy). Kingsley is a project manager by profession and one of the most important documents that a project manager must prepare before starting a project is the project plan which details how a project is to be managed and executed. A popular saying in project management is failure to plan is equivalent to planning to fail. Our investment strategy is our plan which guides our investment decisions and execution for our fund. The strategy is a living document and it should be specific and tailored to meet your needs and you should not be afraid to change it if your assumptions or market conditions change. We have updated our investment strategy twice in the last 2 years. When we started SLI Super Fund in March 2007, there was a bullish stock market and a booming economy, so naturally we wanted to allocate more of our funds to shares but when the subprime crisis started and the bull market showed signs of topping, we decided to move to the safety of cash thus we changed our investment strategy again to capture what we planned to do, i.e. to stay 100% in cash. When the interest rates started to fall, we decided to get back into equities but wanted to use options to hedge our stock portfolio and generate extra income so we changed our investment strategy to allow us to do that. It is not difficult to change an investment strategy for a SMSF all you need to do

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SMSF Investment Master Plan How to Prepare An Investment Strategy For Your SMSF is to call a meeting of all the trustees and agree to the changes, document your decision, sign the document and keep a copy in your tax file for your auditor. Whether you have a SMSF or not, we believe that having an investment strategy and reviewing it regularly is a habit that is prudent to adopt. Even if you have your superannuation assets with one of the public super funds (we still have a small amount in one of these funds as the penalties to roll the money out were too high), you still have the ability to change your investment allocation within your fund should you believe the market is going to change. You should also monitor your funds performance and change funds if yours is underperforming. APRA regulates these super funds and the performance of each super fund can be found in the Annual Superannuation Bulletin which is published on their website every year around February/March. Most of us spend a lot of our time making money but very little time managing the money we make. We made a conscious decision to spend more time managing the money we already have as this is something we will have to do when we are retired. As a result, we started developing our fund management skills now instead of waiting until we retire. If we make mistakes now, it will not affect our lifestyle as we still have the active income coming in from our jobs. However, this will not be the case if we depended on income from our investments to live on as retirees do. In the last two years if Christina had been working full-time, she would probably have made maybe an extra $50,000 (after tax and expenses) but we would have lost about $25,000 in our managed super funds due to the decline in the market. Instead of working to earn active income, she spent her time managing our super funds and made a $25,000 return on our funds. Although the net increase in our wealth was about the same, the experience we gained in managing our funds through the global financial crisis is far more valuable. Unlike most of our friends who are feeling fearful about their financial future after watching their retirement funds decline through this crisis, we feel confident about our financial future as we were able to successfully managed our way through probably the worst financial crisis we will experience, and if we managed that then we should be able to handle future crises with even greater confidence and in the knowledge that we will be able to minimise any impact to our retirement fund.

What Should You Have In Your Investment Strategy?


The ATO has set out some guidelines for preparing an Investment Strategy. It states that: Your investment strategy needs to reflect the purpose and circumstances of your fund and consider the following: investing in a way to maximise member returns taking into account the risk associated with the investment diversification and the benefits of investing across a number of asset classes (for example, shares, property and fixed deposit) in a long-term investment strategy the ability of your fund to pay benefits as members retire and pay other costs incurred by your fund the needs of members (for example, age, income level, employment pattern and retirement needs).

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SMSF Investment Master Plan How to Prepare An Investment Strategy For Your SMSF The investment strategy should set out your investment objectives and detail the investment methods youll adopt to achieve these objectives. You need to make sure all investment decisions are made according to the investment strategy of your fund.

Investment Objectives
Our main objective was to be able to have enough funds on which to live comfortably when we retire, however, we did not know how much we would actually need to do that nor how long our funds would last us. Noel Whittakers book Living Well in Retirement helped provide the guidance for us to answer this, and we would highly recommend this book for anyone who has the same questions. Retirement planning books like this one and the Retirement Planning calculator on the FIDO website can help you validate if you will have enough funds at the age that you plan to retire and if your retirement savings will be sufficient to meet your needs after you retire. The results can be very surprising! Hopefully it will simply confirm that you are well on track to meet your retirement objectives. If not, at least you are now aware of the problem and you can put together a corrective action plan, which may include increasing your super contributions, working longer before retiring or improving your investing skills to help you increase the returns on your investments. Table 3 shows how long it would take to consume $100,000 at a real rate of return (i.e. after adjustment for inflation) of 3% Vs 5% based on fixed annual draw downs. As is evident, you can quickly see that your money will last longer with a higher real rate of return. Annual Drawings $6,000 $7,000 $8,000 $10,000 $11,000 Years (at 3%) 24 19 16 12 11 Years (at 5%) Indefinite 25 20 15 12

Table 3: Duration To Consume $100,000 for a Set Annual Draw Down at a given Real Rate of Return

This is very important when determining how much money you will need to have available to invest as a minimum before you can retire. If you have worked out that you need roughly $40,000 per year to live on and you expect to live for around 25 years after you retire, then you need to have the following amounts in your retirement fund before you can retire: If you expect to generate a real rate of return of 3% then you would require approximately $720,000 at the time of retirement (from Table 4) If you expect to generate a real rate of return of 5% then you would require approximately $576,000 at the time of retirement (from Table 5)

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SMSF Investment Master Plan How to Prepare An Investment Strategy For Your SMSF
Expected Years In Retirement 10 years 15 years 20 years 25 years 30 years 10 92 126 154 180 200 $ '000 Required To Live On Per Year 20 30 40 184 276 368 252 378 504 308 462 616 360 400 540 600 720 800 50 460 630 770 900 1,000

Table 4: $ 000 Required to Live on Per Year Given Life Expectancy After Retirement Based on a Real Rate of Return of 3.0%

Expected Years In Retirement 10 years 15 years 20 years 25 years 30 years

10 84 110 128 144 156

$ '000 Required To Live On Per Year 20 30 40 168 252 336 220 256 288 312 330 384 432 468 440 512 576 624

50 420 550 640 720 780

Table 5: $ 000 Required to Live on Per Year Given Life Expectancy After Retirement Based on a Real Rate of Return of 5.0%

Initially we thought Noel Whittaker was being too conservative using 3 - 5% real rate of returns in his projections. After all, did we not see double digit returns in our super fund balances from 2004 to 2006? It turns out that Noel was quite right to use 3 - 5% when you look at the ten year performance of super funds. The most common investment category for superannuation funds is the balanced fund with 60-76% in shares and the rest in cash and fixed interest investments. According to Superatings, despite four years of double digit returns as shown in Figure 1 below, the rolling 10 year returns (up to 31 December 2009) of the median balanced fund is only 5.5% per annum with an inflation rate of 3.2% over the same period. This works out to a real rate of return of only 2.3%, which is even less than Noels conservative estimate of 3%!

Figure 1: Median Returns for "Balanced Funds" 2000 - 2009

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SMSF Investment Master Plan How to Prepare An Investment Strategy For Your SMSF Using Noels book as a guide, we set the target annual return for SLI Super Fund to a real rate of return of 5% when we first started the fund. We thought it would be easy to achieve this but with the global financial crisis, it turned out to be a lot harder than we first thought. In a stable market, we believe this an easily achievable target. However, the effects of the GFC are still in play, making this target more challenging.

Investment Methods
Traditional Investment Methods
The traditional investment method used by most super funds is simply to allocate their funds across a few different asset classes as the conventional assumption is that: All assets will increase in value over time and Diversification, i.e. spreading the funds over a few asset classes, will minimise risk.

Common asset classes used by super funds for investment are cash, fixed interest, property and shares (Australian and international). Asset classes can be further broken down into two categories: Defensive assets - Cash and fixed interest investments are considered defensive assets which are safer but tend to have lower returns. Growth or risk assets - Property and shares are considered growth or risk assets which are riskier but have the potential of generating higher returns.

Depending on your age and appetite for risk, you would allocate an appropriate proportion of your fund to defensive and risk assets. Most public super funds offer pre-mixed investment options such as: Growth (70% risk and 30% defensive) Balanced (60% risk and 40% defensive) and Conservative (40% risk and 60% defensive).

A key consideration for setting your asset allocation is your tolerance for risk. As you get closer to retirement, your tolerance for risk will probably be less than when you were younger. If you are retired or very close to retirement, you will probably prefer not to see large draw downs in your retirement account. In order not to have such volatility in your account balance, you will have to reduce your allocation to risk assets. That means you may have to sacrifice higher returns due to a lower exposure to risk assets. In general, lower risk also means lower returns so you need to check that you have a realistic target return in your investment objectives based on your tolerance for risk. Other considerations could be related to your age, and any other special personal circumstances. For example you may want more income and liquidity from your investments if you are using your super fund to provide you with income for your living expenses. Once you have decided on your asset allocation, you would simply buy and hold investments in those asset classes. Buy and hold is a passive investment method which would suit people who have little time to manage their super funds. With your own SMSF, you can fine tune your allocations even

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SMSF Investment Master Plan How to Prepare An Investment Strategy For Your SMSF further. For example, for Australian shares, you can choose which sectors you want more exposure to and which sectors you may want to avoid. For international shares you can choose which countries you may want more exposure to. Using Exchange Traded Funds (ETFs), you can choose to have exposure to Emerging Markets or a specific country like China. You can also gain exposure to alternative asset classes such as gold and other commodities using ETFs as well. All it takes to implement this method of investing is to review the performance of each asset class and rebalance your portfolio at least once a year. When we started our SMSF in 2007, we thought we should follow the traditional investment method and modelled our fund on a growth portfolio with an allocation of 70 - 90% to equities. However, with Christinas background as an options trader, she always had a problem with the buy and hold concept for the following reasons: 1. The only way you can make money is if your assets go up in value. In trading, the first thing we were taught was that the market can move in three possible directions: up, down or sideways and we should have strategies to make money in all three market directions. How do we make money to meet our target returns if our stocks do not go up in value as we hope? We cannot always assume that assets such as stocks and property will always go up in value over time. Below is a chart of the values of these assets in Japan over the past 25 years provided by Richard Koo, the chief economist at Nomura Research Institute in Japan, in an interview with welling@weeden. The values of property and shares have shrunk by USD 45 trillion in this 25 year period. When asset prices started to fall instead of rise in Japan, everyone said it will not happen in their own country, however, since 2007 we can now see similar trends happening in the US and Europe. Christina did a lot of research on this and has posted some of her findings in a series of blog posts on Inflation or Deflation. When there is deflation, asset prices will fall instead of going up. We used to wonder why Japanese investors would buy Japanese government bonds which provided a yield of only 1.3%. If you look at Figure 2 below you will see that the government bonds still far outperformed property or shares which had negative returns.

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SMSF Investment Master Plan How to Prepare An Investment Strategy For Your SMSF

Figure 2: Cumulative Capital Loses on Shares and Land since 1990

2.

There is no clear exit strategy if things go wrong. If our stock prices fall instead of going up as we hope, what should we do? Do we continue to hold and hope that the price will eventually recover and continue to go up again? In trading, we always had two planned exits for each trade a primary exit if the trade goes as planned and a secondary exit if the trade does not go as planned. Christina was very uncomfortable about not having an exit plan if our stocks did not go up in value as we hope. Kingsleys role model for investing was Warren Buffet who is definitely a buy and hold investor, and as a result we had many discussions about what we should do if our stocks fell in value. We finally agreed that we would follow the method described by Dale Gilham in his book How to beat managed funds by 20% and his method for limiting losses. Although we knew that put options could also limit our losses, we did not include options in our first investment strategy in 2007 as we were not sure if they would cause compliance issues with the Australian Tax Office. Buy and hold investors typically say that time in the market is better than timing the market. Even though the market has had negative returns for the past one or two years, there was also positive double digit returns the three years before that, and so you still would have had a positive return if you take the average over a period of five to ten years. Although we think history is important, it is also necessary to look forward as to what you think will happen to the global economy in the next few years. Two years into the financial crisis, we would imagine everyone agrees that the main cause of the crisis was over leverage due to cheap and easy credit. According to the economists who correctly predicted the economic downturn, the expectation is for a long period of deleveraging and with that slow growth. Growth predictions from the International Monetary Fund (IMF) are equally subdued, especially for developed countries like the US, Europe and Japan who have the biggest economies in the world. Although the downturn has shown signs of easing,

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SMSF Investment Master Plan How to Prepare An Investment Strategy For Your SMSF we may not see growth in asset prices such as those from 2003 to 2007 for a long time to come. The more consideration we gave to our strategy, the more we identified what we saw as being other problems with traditional investment methods: 3. Diversification across asset classes does not always lower risk. While we agree that diversification across defensive and risk asset classes can help to lower your risk, diversification across risk assets has not helped us very much. When the stock market started to fall in 2008, we thought it would be a good idea to diversify into gold and silver to reduce our risk. Gold is supposed to be a safe haven so we thought it would be good to own some of these assets in times of uncertainty. We bought some ETFs for gold and silver in June 2008 and watched them fall together with stocks and property in the next few months. Gold and silver prices have been so volatile and they behave more like commodity stocks rather than safe haven investments. Another risk in diversification into new asset classes is your level (or lack) of skill in selecting and managing the right investments within that asset class. If you are a seasoned stock investor, you will know successful stock investing is more than just buying a basket of stocks. You need to have some understanding of the company fundamentals and valuation and you may use technical analysis to pick a good time to buy/sell the stock. Likewise a seasoned property investor would know which suburbs to buy into, how to negotiate a good deal, etc. Most of these skills are developed over time and you are most likely to make the most mistakes with your first few investments in that asset class. When you invest in a new asset class you may not understand all the associated risks. We learned our lesson when we invested in Managed Forestry Schemes. We were attracted by the tax benefits and we thought it was a simple business model (how hard can it be to grow trees?) and there seemed to be a ready market for timber products. We also liked the idea of owning a green investment which was in some way reducing the carbon emissions and making our planet a better place. We were shocked when Timbercorp and Great Southern went into voluntary administration and our managed timber investments are now worthless. I think everyone agrees that it will be very challenging to get good returns from the share market in the next few years. Some of the investments experts have suggested trying out new asset classes such as Corporate Bonds and Hybrid Securities as a way to increase yields. If you are thinking about invest in these or any asset class that you are not familiar with, we would highly recommend investing very small amounts into these until you fully understand them and all the associated risks and how these risks can be managed.

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SMSF Investment Master Plan How to Prepare An Investment Strategy For Your SMSF 4. It may not be able to provide you the returns you seek. If the values of all the risk asset classes are stagnant or falling, and the returns of defensive assets like cash are very low, how can you generate the returns you seek? That was the question we asked ourselves in late 2008. In December 2007, we changed our asset allocation and move all our investments into cash as we believed that a big stock market correction was coming and with interest rates of around 8% per annum, we were happy to park our funds in cash. When the Reserve Bank started to cut interest rates in August 2008, we could no longer afford to stay in cash if we wanted to meet our target return and as a result we decided to try other investment methods that could help us achieve our investment objectives.

SLI Supers Investment Methods


Our investment methods have evolved considerably over the past three years. We started with the traditional method; however, we quickly changed this to address the weaknesses mentioned above. Some of the things that we have done are: 1. Incorporate investment methods that enable us to make money in all market directions, not just up. We know markets can move in three directions up, down or sideways. If you buy and hold stocks, you can only make money if the market goes up. When there is a protracted bear market, it is very difficult to make money from owning shares as seen in the example of Japan (see Figure 2: Cumulative Capital Loses on Shares and Land since 1990). Using traditional investment methods, if you see a market correction coming, the best you can do to avoid losses is to sell your stock and you are unable to take advantage of a falling market to make money. In December 2007, we were very uncomfortable about staying in the stock market after the subprime crisis started. We also realised that we have had a very strong bull market for over three years and a major correction would not be unexpected. In addition to looking at some of the market fundamentals, we saw a strong bearish pattern on the price charts when doing our technical analysis. As a result we decided to sell all of our stocks and allocated 100% of the fund to cash. Although we were correct in our prediction of the stock market correction we had not set ourselves up to profit from it. One way to make money in a falling market is by short-selling stocks, however, the ATO has stipulated that a super fund can not expose itself to unlimited risk. Take the example where you short a stock that is currently worth $5 per share, the maximum profit you can make is $5 i.e. the stock value drops to zero. However, if the stock goes up to $25, you will lose $20. Theoretically, the stock price can go up to an infinite value so your risk is theoretically unlimited.

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SMSF Investment Master Plan How to Prepare An Investment Strategy For Your SMSF However, there are other ways of taking advantage of a falling market using instruments such as options, CFDs, futures or short funds. Our personal preference is to use options as it is easy to limit and manage the risk. Stock options have been trading on organized exchanges in the US since 1973 and in Australia since 1976. The size of the option market in Australia is small and it seems that not many stock investors understand options. In general, we find that stock investors are still fearful of options and believe that they are high risk. Some accountants even tell their clients they cannot use options in their SMSF, probably because they do not understand options themselves. The reality is that there is no restriction on using options as a form of investment, as long as the SMSF does not borrow (see page 5 of Income Tax Treatment of Exchange Traded Options, written by Patrick Broughan and Alison Noble from Deloitte Touche Tohmatsu Ltd which is available on the ASX website). There is tremendous flexibility in using options, and there are many option-based strategies that allow you to profit when the market falls or moves sideways. It is beyond the scope of this document to discuss this, however, if you wish to learn more about options please look at the Learn Options on a Budget resource page on our blog which will point you to many places to get free or value for money education on options. 2. Have a clear exit strategy if things do not go the way you plan. When we invest, we all hope to make money. We buy a stock because we believe it will go up in value. What if you are wrong and the stock starts to fall? Some investors such as Dale Gilhams (author of How to beat managed funds by 20%) use stop losses to limit their maximum loss. As an example, if you buy a stock at $50 per share and you set a stop loss to $40, this means you will sell the share if it falls to $40 and that will limit your loss to 20%. If you lose 50% of your investment, you will need to make 100% to recoup your original capital. In a good year, stock markets go up by 20 - 30%. 2009 was an exceptionally good year when the stock market went up as much as 60%. Even with such a strong market rally, most buy and hold investors are still having a net loss on their stock positions. This is why it is very important to keep your losses small. We like to use put options to limit our losses especially with any new investment. A put option allows you to sell your stock at a pre-determined strike price. For example, if we buy a stock at $50 per share and a put option at a strike price of $45, we are guaranteed that we can sell our stock for $45 per share, even if the stock price falls to zero. For more information on this strategy please have a look at How to buy safely and profit from your mistakes. 3. Instead of blindly diversifying, focus on our core competencies. We all have our favourite asset classes that we are comfortable with, Kingsleys is property and Christina prefers stocks and options. A close friend of ours is a very successful property investor; however, he is completely

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SMSF Investment Master Plan How to Prepare An Investment Strategy For Your SMSF hopeless with shares. The more you invest in one asset class, the better you understand it and therefore the better you get at managing it. When Christina first started trading options in the US market, she used to have sleepless nights worrying about her positions. She tried out various trading strategies and finally found some that gave her the returns she was happy with at a level of risk that she could tolerate, thus allowing her to sleep well. Now putting on those trades has become routine and even when she has to take a loss, it does not worry her as she is fully aware and has accepted the risk and reward before ever placing a trade. She also enjoys watching the financial markets and also spends a lot of her time reading financial news and books. As this is an area that interests her, it makes sense for us to invest our super funds mainly in the markets that she watches, being the US and Australian markets. Additionally, with Christinas knowledge of options, it has made sense for us to apply that to our super fund investments. However, if you have no interest at all in the stock market, then perhaps you should not put a lot of your funds in these investments. Not long ago, we attended a property seminar and one of the speakers worked for a popular property investment publication. He was clearly very knowledgeable about property and he could even show that some of his property recommendations in 2007 had doubled in value in two years. Yet at the end of his presentation, he mentioned that he had to delay his own retirement because his super fund had been halved by the global financial crisis. We wondered why he did not start his own SMSF and put his super funds into the types of property investments that he was recommending other people to buy. If he had invested his super funds in those properties, he would have doubled his fund during the global financial crisis. The bottom line is invest in what you know. 4. Actively manage investments to increase returns. Based on the data from the Australian Tax Office (ATO), direct shares is one of the favourite asset classes for SMSFs. If you are already a share investor, you can improve your returns by actively managing your share portfolio. Some experts recommend buying small cap instead of blue chips, or buying stock with good dividend yields. Our method is to use options to generate additional income on our stock holdings. Selling covered calls and cash secured puts are some of the option strategies that we use to increase our returns on our stock portfolio. If like us, you are looking for an 8-10% gross return p.a. then you should definitely investigate the Learn Options on a Budget page on our website for more details. In summary, there are alternatives to the traditional investment method of using asset allocation together with the buy and hold strategy. Given that we now understand that we are able to utilise options in our super fund, our investment strategy for 2010 has been extended to include using options to: protect stock positions when market falls buy stocks at a discount

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SMSF Investment Master Plan How to Prepare An Investment Strategy For Your SMSF generate additional income in a flat market make money in a falling market

Although the conventional belief that assets always go up in value over time has mostly held true for the Australian housing and stock market, we cannot assume that this will continue into the future especially when we look at what is happening in other developed countries. The Japanese market has been declining since 1989 and the Nikkei index is now at the same level as what it was 25 years ago. The US has been through two major corrections and the S&P500 index is current at the same level as where it was 10 years ago. Looking at Australia, we are currently at the same level we were in 2005. Based on the severity of the global financial crisis, it may be a very long time before we can regain the highs of 2007. We do not believe that we can afford to take a passive investment approach by buying and holding and expecting our investments to grow over time (or even wait for that time to occur). Even if you prefer a passive investment method, at least do a review once a year and re-balance your allocations based on your market outlook.

When Do You Prepare Your Investment Strategy?


Ideally, you should prepare your investment strategy before you even start your SMSF. However, the reality is that most people do this only when they find out that it is a requirement by the ATO. Hopefully most SMSF trustees do have an idea of their investment objectives and the types of assets they would like to invest in before they start their SMSF even if it is not formally documented as an investment strategy. If you have no idea what to invest in or have no investment experience, you probably should not start a SMSF (even if your accountant says that you can save on the management fees charged by the professionally managed funds). From a compliance perspective, you should have an investment strategy in place that is agreed by all the members of the SMSF before you start investing as your investments need to align with your investment strategy. Just as a fund manager can only invest according to the investment strategies outlined in their product disclosure statement (PDS), likewise, a SMSF trustee can only invest according to the funds investment strategy. If your investment strategy says that you plan to invest in cash and equities, then you cannot use the fund to buy art or property as you will definitely have a compliance issues. Even though a SMSF has very few members, all members must still agree to the investment strategy and it must be able to meet the objectives of all members of the fund. It is important that you prepare an investment strategy that is agreed in writing by all the fund members. We only have two members in our SMSF i.e. Kingsley and Christina. Although Christina is the one who actively manages the investments, Kingsley must be comfortable with the investment strategies to be adopted as a significant portion of the fund is made up from his contributions. We had a lot of discussions about the type of investment strategies to use when we first started SLI Super Fund. Kingsley is more of a value investor like Warren Buffet and likes to buy and hold forever whereas Christina thinks more like a trader and likes to have clear exit strategies if investments do no perform as expect. After much discussion, we arrived at a compromised investment strategy. This is very important for the designated fund

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SMSF Investment Master Plan How to Prepare An Investment Strategy For Your SMSF manager especially if the investments do not work out as planned and the fund loses money. No one complained about their super fund managers when their investments were doing well in the bull market but there were a lot of complaints about the same fund managers when they lost money in the same investments. Keep that in mind if you are going to be the designated fund manager for your SMSF. After you have prepared your first investment strategy, you should review it: at least once a year whenever there is a change that affects your assumptions you made when formulating your investment strategy. When we started investing our funds in September 2007, the stock market was still rising so we wanted to put most of our funds into quality stocks. When the market stopped rising a few months later, we changed our investment strategy very promptly.

How Do You Prepare An Investment Strategy?


There are six key steps in preparing an Investment Strategy: 1. Determine your investment objectives 2. Determine the asset classes in which you wish to invest 3. Determine your investment methods i.e. passive or active 4. Determine your risk management strategy 5. Determine your allocations to the different asset classes 6. Document and sign off the investment strategy To assist you in your thinking as you walk through each of the steps below we suggest that you print out Appendix A Investment Strategy Checklist and read this in conjunction with the process below. This should help you to think about the things you will want to consider as you develop your investment strategy.

Step 1: Determine Your Investment Objectives


This has been covered in the section What Should You Have In Your Investment Strategy?

Step 2: Determine the Asset Classes in Which You Wish To Invest


When determining the asset classes, you should think about the skills, experience and interest you have in investing in those asset classes. When considering asset classes in your super fund, ensure you look at your overall financial position and also take into account what you own outside of superannuation to get a complete picture of the types of investments you have. At the time of writing this, SMSFs are allowed to borrow to buy property and this has led to many people wanting to buy property using their super fund. We consciously chose not to invest in property via our SMSF as we already had a number of property investments external to the fund. We also felt it was easier and more tax effective for us to invest in property outside of super as there is no need to set up additional structures

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SMSF Investment Master Plan How to Prepare An Investment Strategy For Your SMSF such as Bare Trusts, there is a bigger choice of mortgage lenders, borrowing rates are lower and all related expenses are tax deductible at Kingsleys marginal tax rate which is higher than the 15% tax rate for super. As the main objective of our super is to provide us with retirement income in the future, we wanted our investments to be liquid and we wanted the flexibility to be able to convert small portions of the assets to cash easily. Shares and other listed securities are good in this respect as you can easily sell a few shares if you need cash but you cannot sell a few bricks from your investment property. We also had the necessary skills, experience and interest to invest in shares.

Step 3: Determine Your Investment Methods i.e. Active Vs Passive


The choice of investment methods could depend on how much time you have to manage your investments. Passive (buy and hold) is the least time consuming and works well in a bull market as asset prices keep going up but may not be able to generate the return you want in a flat or bear market. Active methods will require more of your time as you have to watch market and execute the necessary strategies to take advantage of the perceived market direction. As we already had some knowledge and experience with options, we decided to actively manage our investments and use exchange traded options to protect our assets and enhance returns in a flat or falling market. We started in August 2008 with very simple, conservative strategies which were less risky than buying and holding stocks, such as selling put options to buy stock at a discount and selling calls to boost income over and above any dividends. This has worked well for us and we have shared these simple strategies on our blog, http://smsfinvestmentstrategy.com.au. We are aware that time may be a constraint for some trustees and after some self education; these strategies do not require much time to implement. We know people who use their SMSF to trade futures and CFDs. We have looked at some of these active investment strategies for our fund, however at this stage we have decided not to extend into other investment instruments in our fund as we want to be focused and we can manage risk with the instruments we do know and have.

Step 4: Determine Your Risk Management Strategy


In general we do not believe anyone should take great risk with their retirement funds. For passive investors, risk is managed by setting an appropriate allocation to risk assets based on your risk tolerance. The traditional belief is that if you have more time on your side, you can afford to take more risk so younger people with more years to retirement can afford to allocate more funds to risk assets. If you choose to be an active investor, you may choose to use methods such as stop losses, trailing stops, or put options to actively manage your risk. Christina has a reasonably low tolerance for risk and prefers to manage risk and if necessary see small positive returns every year rather than seeing large swings in our account balance. As a result we stay with the safest investments that we can find that can meet our investment objectives while allowing us to manage the risk. If we can get a risk free 8% return in the form of a term deposit, we will be happy to park most of our funds in cash because our target return is a real rate of return of 5% and we need to allow another 3% for inflation. However, we seldom get such great returns on cash and under-investing in risk

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SMSF Investment Master Plan How to Prepare An Investment Strategy For Your SMSF assets has its own risks as we need to be able to generate a stable but fair return on our investment. In times of uncertainty, the first thing we do is to reduce our allocation to risk assets such as shares and maintain mainly defensive stocks e.g. consumer staples and healthcare stocks, and stocks that pay high dividends in our stock portfolio. To further boost returns from these shares, we sell options over these shares (covered calls). We will not go into detail about how we do this here but if you are interested you can read more in this blog post Why I am (still) buying Telstra as an example of how we execute this strategy. To further reduce risk, we may buy put options to hedge our stock portfolio when we think there may be a big market correction ahead as detailed in the blog post AORD head and shoulders an example of when to hedge. If we do decide to take a position in a more speculative investment which has potentially higher returns, we always allocate capital and set what we call secondary exits (i.e. what to do if the investment does not turn out as planned) in such a way so that we do not lose more than 2% of our entire portfolio in one investment. A simple example of this is to allocate say 10% of your total funds to that investment and set a stop loss if that investment loses 20% of its value. That way your maximum loss will only be 2%. We normally prefer to use put options rather than stop losses to manage maximum loss as this has other benefits for us. Due to our rather cautious approach in managing our fund, we expect our returns in the 2010 financial year may appear small compared to funds which simply bought stocks in 2009. A telemarketer from a financial advisory company rang Christina the other day and asked Did you make a 60% return in 2009? He claimed that their clients had. She felt like asking him How much did your clients lose in 2008? but decided it was not worth her time arguing with him. The media is full of reports such as this one Super results for superannuation funds that boasted that the median balanced super fund made close to 13% returns in 2009. However, the same funds also made a -19.7% return in 2008. When we plotted their returns with an initial starting capital of $100,000 against a hypothetical fund (lets call it The Tortoise Fund) that only made a modest 5% in the past two years, the results show that despite a great result in 2009, the median balanced fund still has a net loss of -9.3% after two years, whereas The Tortoise Fund has a net gain of 10.3%. The median balanced fund now needs to achieve a return of 27.7% to catch up with where the Tortoise Fund will be at the end of 2010 (as shown in Figure 3 below). In fact, the median balanced fund would need to make 10.3% to break even with its initial capital investment.

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SMSF Investment Master Plan How to Prepare An Investment Strategy For Your SMSF
140,000

120,000 110,250 105,000 100,000 100,000 100,000 5.0% 80,300 80,000 -19.7% 60,000 5.0% 90,659 12.9%

115,763 5.0%

115,763 27.7%

40,000

20,000

0 2007 2008 2009 2010

Figure 3: Impact of Negative Returns on an Investment

After six years of trading, Christina has learned that the only way to make money consistently is by having good risk management. We are prepared to sacrifice higher returns in exchange for lower risk. Good risk management also helps us sleep better at night. Warren Buffet sums it up beautifully in his famous quote for making money: Rule number one: never lose money. Rule number two: never forget rule #1

Step 5: Determine Your Allocations to the Different Asset Classes


Once you have defined your investment objectives, decided on the asset classes in which you will participate, determined your investment methods and your risk management strategy, you need to decide how much to allocate to each asset class. Rather than making a fixed allocation based on age / risk tolerance, we determine our allocations each year based on our outlook for the year ahead. We normally start with the big picture and try to make our assessment as to where the global economy is headed and how it may affect the Australian economy. We also look at what the Australian government initiatives are and make an assessment on how this will affect the economy and stock markets. Following this, we determine our investment theme for the year and where we think we should allocate our funds for the best returns. For example, if you think the global economy is headed for a recovery led by the Chinas investments in fixed assets, you may want to increase your allocation to equities and in particularly to resource stocks. On the other hand if you are worried about inflation because of the large amounts of money that governments have been printing through their quantitative easing programs, you may consider allocating some funds to buying gold. If the Australian government has announced big incentives for building new homes, you may want to increase your investments in construction related companies.

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Step 6: Document and Sign Off Your Investment Strategy


Once agreed, the investment strategy should be properly documented and signed off by all members of the fund. Our investment strategy is a living document which is reviewed and updated as required at least once a year or whenever there is a major change that could affect our original assumptions. We like to review ours at the start of the financial year after we have had a chance to assess the performance of our investments and strategies in the previous financial year. We try to learn from our mistakes and adjust our investment strategy accordingly. We also discuss our outlook for the next year and how we think it would impact our investment strategy and document our thoughts and any suggestions for changes in the minutes of the meeting. We completed our last annual review of our investment strategy in July 2009 and have revised it to match our outlook for the next financial year. We posted our Investment Strategy for FY 2010, on the Resources page of our website and it has been downloaded by over 600 people since we posted it and therefore we are also including it in this e-book in Appendix B Example Investment Strategy. The investment strategy document is quite brief and we will go into more detail about some of our thinking behind the content of this document in Part 2. Feel free to use it as a template for preparing your own investment strategy. After the investment strategy has been created/updated, all members must sign it and copies of it should be given to your accountant and auditor to ensure compliance with ATO requirements.

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PART 2 INVESTMENT STRATEGY FOR SLI SUPER FUND FOR 2010

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Introduction
In the investment strategy for SLI Super Fund, we allow for a dynamic asset allocation of our funds into the different asset classes and we set our allocations based on our outlook each year. In this section we have provided details of our views covering our: outlook for 2010 for the markets that we are involved in which are the US and Australian stock markets, and asset allocations and types of investments for 2010

Depending on the investment strategy for your SMSF, this may or may not be relevant to you. Please ensure you have read this disclaimer before proceeding.

Outlook For 2010


We perform our market analysis using a top down approach, that is, we look at global trends and try to analyse how these may affect Australia and our portfolio. Two countries we pay special attention to are the United States and China. Firstly, as the worlds largest economy, we watch the US developments as anything that happens there tends to have a ripple effect globally. When there is an earthquake in the US, the rest of the world gets hit with a tsunami, as was the case of the collapse of Lehman Brothers in September 2008. Secondly, we watch China closely as it is also a huge economy and they are the biggest buyer of Australias exports. Hence what happens in China will have a significant impact on Australias economy. A bottom up analysis approach, focusing on such things as the Australian government policies, interest rates and employment data, is probably appropriate for property investments due to their more direct impact on housing prices. We feel a top down analysis approach is more appropriate for stocks as most of the largest companies on the Australian Stock Exchange are global companies or have significant overseas exposure and global events tend to impact our stock market. Although economic conditions are clearly quite different in Australia compared to the US, our broad stock market indices (Australian All Ordinaries (^AORD) Vs the US S&P500 (^GSPC)) have moved in tandem as show in the chart below.

Chart 2: Comparison of Australian Vs US Broad Market Indices

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Inflation or Deflation
One trend that was clearly noticeable in 2009 was the trend of asset deflation in developed countries such as the US and Europe, particularly in property prices. Despite massive government interventions to prop prices up by lowering interest rates to near zero and providing first home buyer incentives, property prices continued to fall. This is rather unusual as people tend to increase borrowings when interest rates are low as the cost of servicing debt is lower. Instead lending in the US has continued to fall and credit has been contracting instead of expanding as shown Chart 3 below:

Chart 3: Commercial and Industrial Loans at all Commercial Banks

It was expected that low interest rates would discourage savings and encourage spending as the incentive for keeping money in the bank is reduced. However, the opposite happened and US savings went up and consumer spending went down. We were very curious as to why this was happening and this prompted us to do further research on this phenomenon (Christina wrote about this in a series of blog posts starting with Inflation or Deflation in September 2009). Our own conclusion was that we are likely to face deflation in years ahead due to demographics and the impact this has on the economy. Figure 4 below from the book The Depression Ahead by Harry Dent, shows the spending patterns of people in different age groups.

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Figure 4: Change in Spending at each Age & Stage of Life

You can see that spending increases from age 20 to your late forties, and declines after you hit 50. All of us who have families should be able to relate to this. When we focus on spending pertaining to accommodation alone, we start out renting a room for ourselves in our late teens or early 20s, buy a starter home in our 30s, and upgrade to a bigger home in our 40s as the kids get older and our earning capacity increases. After our kids have grown up, we will probably downsize to a smaller home and eventually rent a room in a nursing home. When you apply the average spend in each age group over the population in each country, you can derive what is called the Spending Wave. The biggest age group in the US and most developed countries are the baby boomers who were born between 1946 and 1964. The youngest boomer is now aged 46. In the last two decades, the baby boomers have been in the age groups that have increased their spending but now most are past their peak spending years and are falling onto the other side where spending typically decreases. If you think about it, lower interest rates are only incentives to borrow if you are young and you expect your income to increase in the future and do not worry about holding debt. People facing retirement are far less likely to borrow, even if interest rates are low. This is why the lowering of the interest rates did not create the desired expansion of credit as it had done in the past. People over 50 are more likely to continue to spend less and save more. You can also extrapolate investment patterns based on demographics, as people retire, they will generally move to less risky investments with higher yield. In 2009, equities based mutual funds in the US experienced an outflow of funds whereas bond funds grew. This is one of the reasons why we do not see another bull run in stock markets anytime soon, instead we see that defensive and high yielding assets such as quality bonds are more likely to do well. Australia has similar demographics to most Western countries, however, Australia has been making up for the shortfall of younger people by increasing immigration, especially of young skilled migrants, and this has helped to keep Australias property prices high. However, unlike people who are born in Australia, immigrants have roots elsewhere as well and are likely to leave if they cannot make a better life for themselves here. We wont count on immigration to keep Australias spending wave up if unemployment becomes a problem or if anti-immigrant sentiments increase.

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US Dollar
The US dollar is the worlds reserve currency and is the most widely used currency in global trade. Based on the fiat currency system, the US Reserve Bank is able to print as many dollars as they like as the currency does not have to be fixed in value in terms of any objective standard, which in the past was backed by gold which was held in reserve. During the banking crisis in 2008, the US Reserve Bank printed an extra trillion dollars (as shown in Chart 4). This massive surge in the supply of currency made many investors very nervous about the possibility of high inflation and the future value of the US dollar as it is widely believed that inflation is caused by more and more dollars chasing the same amount of goods. Many of these investors have rushed to buy gold as a hedge against hyper inflation and the devaluation of the US dollar.

Chart 4: Currency Supply of US Dollars

Although the currency supply chart looks worrying, in reality the trillion dollars is not circulating through the economy. Instead it is sitting as excess bank reserves (as shown in the Chart 5) and therefore the real money supply has not increased. In fact the broader money supply, when you include credit (see Chart 3), has actually contracted, explaining why there has been no inflation even with the printing of an extra trillion US dollars.

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Chart 5: US Dollars Held As Bank Reserves

Even though money can be freely printed by Reserve Banks, banks must be willing to lend this money out and people must be willing to borrow for it to affect the economy. When we understood that the real money supply is not really controlled by the Reserve Banks, we became less worried about hyper inflation or the US dollar becoming worthless. In fact, we became more bullish on the US dollar in 2009 for a number of reasons. Firstly, with interest rates at zero, the only possible direction for interest rates was to go up. When interest rates go up, the value of the dollar tends to go up as there are many speculators doing what is called the carry trade, which is to make money by borrowing in a low interest currency such as the US dollar or Japanese yen to invest in higher yielding currencies like the Australian dollar. When US interest rates eventually go up, it will cause an unwinding of these carry trades as these speculators scramble to sell the high yield currency and buy US dollars to repay their loans. Secondly, since the global financial crisis started in the US, the media has been focusing on the problems in the US such as high unemployment, the ballooning US government debt and budget deficits. However, Europe and the UK actually have far bigger problems than the US but they were not as heavily covered by the media until Dubai almost defaulted on their debt in November 2009 and now with Greece facing the same problem in 2010. The sovereign debt problems in Greece and other countries in the Euro zone, including Portugal, Italy, Ireland and Spain, are causing investors to lose faith in the Euro. A fall in the Euro will also be bullish for the US dollar. We maintain quite a high percentage of our super funds in USD denominated assets and some people may see that as a high exposure to currency risk. Unless you plan to live in Australia forever and only plan to buy things that are produced in Australia, we feel it is riskier to have all your wealth in one currency and it is good to have some currency diversification. If commodity prices fall again as they did in 2008, the Australian dollar will most likely fall as well and all our imports and overseas trips will cost more. Most of our net worth is in Australian property outside of superannuation and therefore our overall portfolio exposure to currency risk is still quite small.

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SMSF Investment Master Plan How to Prepare An Investment Strategy For Your SMSF

China
It is quite clear that China has played a big part in helping Australia avoid a recession. Most people in Australia, including our Reserve Bank are very confident that Chinas demand for Australian resources will continue and this will virtually guarantee Australia a booming economy for at least another 20 years. However, the Chinese government is not very transparent in their reporting and it is important to be mindful of this when trying to understand what is really going on in China. On the surface, everything looks almost too good to be true, with a Gross Domestic Product (GDP) growth of ten percent in 2009 while most other economies were struggling to generate positive GDP growth. When you dig a little deeper, you will find that most of the growth is coming from fixed asset investment by the government, which is not a sustainable type of growth. Even though one billion Chinese people will need significant infrastructure, construction in the past few years has been relentless and there is growing evidence that there is an overcapacity problem in China. If that is the case, demand for our resources may fall sooner than we think and the outlook for Australia will not be so bright. We are keeping a close eye on China and have written a series of blog posts on our research findings on China. While the rest of the world is confident about Chinas growth and is looking towards China to lead the recovery from the global financial crisis, the Chinese do not seem so confident. When you look at the chart of the Shanghai composite index, it looks as though the market peaked in August 2009 when the Chinese governments first ordered the banks to tighten credit, and it has gone sideways since (see Chart 6).

Chart 6: Shanghai Composite Index

Sovereign Debt Crises


No discussion surrounding the outlook for 2010 would be complete without talking about the unfolding sovereign debt crises. We started with Dubai in November 2009 and of course Greeces sovereign debt problem has been making the international financial headlines daily since January 2010. Although the debts of these two nations are quite small, many respected economists worry that this will have a contagion effect similar to that of the subprime crisis. Even though the subprime debt by itself is not a large amount, defaults in subprime debt caused a loss of investor confidence in all mortgage backed securities and as a result this has had a huge flow on effect. There are many other larger countries that are

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SMSF Investment Master Plan How to Prepare An Investment Strategy For Your SMSF deeply in debt including Portugal, Italy, Ireland and Spain in Europe, the UK, the US and Japan. If the confidence of lenders is shaken by debt defaults, they are going to be even more careful who they lend to and the credit problems that we experienced in 2008 may resurface again. The book This time is different by Carmen Reinhart and Kenneth Rogoff provides a very comprehensive analysis of the financial crises. The authors show us what happened in over 250 historical crises in 66 countries. An unsustainable rise in asset prices and credit precede banking crises and banking crises tend to be followed by sovereign debt crises and it could take up to ten years to get back to pre-crisis level. We believe the financial crisis that started in October 2007 is still playing out and it will be quite a few years before we see the end of its effects.

Our Investment Strategy and Asset Allocation for 2010


Based on the above analysis, we do not believe the 2009 stock market rally is sustainable. The rally has been based on the availability of cheap money and the hope that the generous government stimulus would create a V shaped recovery. The reality is that governments had to borrow heavily to provide for the bailouts and stimulus packages in 2008-09 and they are now saddled with huge debts which they are having trouble servicing. Now in 2010, governments are talking about exiting the stimulus measures even though the economic recovery is still weak. We believe that the global financial crisis is far from over. We may have been able to get past the first round, which was a banking crisis, but we are headed into the second round, being a sovereign debt crisis. Governments with high debt are going to be forced to cut spending and to take austerity measures as we have seen in Greece and Ireland, and this has a real possibility of leading to deflation and/or depression. The last time the world experienced a global depression was in the 1930s. Chart 7 shows the Dow Jones Industrials for that period. The market peaked in 1929 and then crashed, which was followed by a 50% bear rally. The left hand side of the chart looks very similar to what we have seen since October 2007. If history were to repeat itself, we can expect the stock market to fall for the next two years or more.

Chart 7: Dow Jones Industrials Performance During the 1930's Great Depression

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SMSF Investment Master Plan How to Prepare An Investment Strategy For Your SMSF We have been slowly cashing out of our stock market investments since October 2009 and increased our cash holdings in anticipation of further market correction in 2010. Investors in Australia have been very lucky as it is still possible to obtain yields of 6% or more for our cash deposits. That is almost the same yield as a Greek bond but without the risk! Our asset allocation at the end of January 2010 shows that we are mostly in cash and defensive assets as shown below: Asset Classes Cash Bonds Shares Short Funds Total Investments 36% 64% Balance USD AUD Asset Allocation 60% 8% 22% 10% 100%

Table 6: SLI SMSF Asset Allocation as at Feb 2010

Technical forecasting using methods like Elliott Waves also predict a major correction in the stock market in 2010. The only shares we now own are in defensive sectors (e.g. utilities, health care and consumer staples) which have held up well in the last market downturn and we continue to sell options over our share portfolio to generate additional income. As we are also bullish on the US dollar, we have also increased our holdings of USD denominated assets. Some of the USD funds are invested in short Exchange Traded Funds (ETF) which are only available on the US market and this investment will profit if the market falls. It is important to make the distinction that investing in a short fund is not the same as shorting stocks. There is unlimited risk in shorting stocks and this is against the ATOs rules, and thus not allowed. The worst outcome from an investment in a short ETF is that its value falls to zero, therefore the risk is the same as buying a stock or mutual fund. However, we still manage our risk and have set a loss limit of 20% for these investments which means a maximum loss of 2% of our total funds if we are wrong and the 2009 rally continues to power on into 2010. With our current asset allocation, we are sleeping very well at night. We would probably not be able to sleep as well if we were 70% allocated to equities, especially if there is more market action like the sharp 10% correction that we saw in January 2010 to come. Although we still are bearish and believe that we are headed for deflation and possibly a depression globally, many shrewd investors think otherwise. Well known hedge fund managers like George Soros and John Paulson are loading up on gold as they are predicting high inflation and devaluation of the US dollar. You should do your own research to come to your own conclusions. Getting this right is quite crucial for your financial future because assets like property, shares and gold will do well with inflation but cash and quality bonds will be the best investment options with deflation. We will continue to monitor the markets and economies as the future unfolds in front of us. If our analysis and/or assumptions prove to be incorrect, we are ready to quickly reassess the situation and if necessary take corrective action. Remember that you can follow our thoughts about investing and the economy on our blog site http://www.smsfinvestmentstrategy.com.au/.

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SMSF Investment Master Plan How to Prepare An Investment Strategy For Your SMSF

APPENDIX A INVESTMENT STRATEGY CHECKLIST


The following are aligned to the steps in the How Do You Prepare An Investment Strategy? section in Part 1 of this e-book. The questions below are the types of questions you should be asking yourself when preparing your investment strategy.

Step 1

Determine Your Investment Objectives How much do I need to retire? If you are not sure, use the retirement planning calculator on the FIDO website. Noel Whittakers book Living Well into Retirement provides an excellent break down of the information you may want to consider and enable you to answer this in greater detail. What real rate of return will I require?

Step 2

Determine The Asset Classes In Which You Will Invest What experience do I have in investing? What types of investment am I interested in? Am I prepared to learn new skills?

Step 3

Determine Your Investment Methods i.e. Passive Vs Active How much time to I have to monitor my investments? How closely do I follow developments in the financial markets? Do I believe in timing the market rather than time in the market? Do I use stock charts and technical analysis? Do I look at company fundamentals? Do I listen to the recommendation provided by investment managers and analysts reports?

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SMSF Investment Master Plan How to Prepare An Investment Strategy For Your SMSF

Step 4

Determine Your Risk Management Strategy Based on the result of Step 3, look at either the Passive or Active questions below Passive Do I know my risk profile? If not, complete a risk profile questionnaire. A good example of one can be found on the RBS Morgans website. Active What sort of risk management techniques will I use, e.g. stop loss, put options, etc? How and when would I employ such techniques? What is my maximum loss for each investment as a percentage of my total capital? What is my maximum loss on each individual position?

Step 5

Determine Your Asset Allocation Based on the result of Step 3, look at either the Passive or Active questions below Passive Allocate based on your risk tolerance e.g. Active You would consider dynamic asset allocation based on your own assessment of the outlook for the asset class in which you plan to invest. Based on your assessment for an asset class you would increase or decrease your allocation to it for that year (or until your next assessment). Conservative 80% defensive, Moderate Balanced 60% defensive, 40% defensive, 20% growth 40% growth 60% growth

Step 6

Document And Sign Off Your Investment Document your agreement and sign the strategy. An example of our Investment Strategy for our SMSF is available in Appendix B Example Investment Strategy.

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SMSF Investment Master Plan How to Prepare An Investment Strategy For Your SMSF

APPENDIX B EXAMPLE INVESTMENT STRATEGY


SLI SUPERANNUATION FUND INVESTMENT STRATEGY
Effective Date - 04 JULY 2009 1. Investment Objectives To provide for the retirement of its members who are age 45 and 49 and have no planned retirement date within the next 10 years. and 2. To maintain the real value of the investments at 5% above the inflation rate after allowing for costs and taxes.

Guiding Principles The fund will not invest in any illegal activities or immoral companies or services. A position will never be taken where the fund is at risk of being unable to fulfil its obligations of that position. The fund will operate within the guidelines defined by the Australian Tax Office. The investment strategies will be reviewed at least once per year or when our market outlook changes.

3.

Asset Allocation The following are the asset classes that the fund will invest in, and ranges have been outlined for each asset class to allow the fund to move assets from one class to another as necessary:
Asset Class Cash Fixed Interest Shares and Options (Listed, Unlisted, International & Australian) Managed Funds (Exchange Traded Funds, Mutual Funds) Alternative Assets (Hard and soft commodities) Maximum % of Funds Invested 100 50 90 50 50 Typical Holding % 30 0 40 20 10

The fund will not invest in property as the members already have significant exposure to property investments outside of the fund. Exposure to alternative assets may be effected via investment in exchange traded commodities. Cash will be held in sufficient amount to meet tax and administration expenses and to allow for investment opportunities.

4.

Investment methods the fund will use to generate returns

Asset prices do not always go up so a buy and hold strategy will not be able to generate the desired returns in a down or flat market. Hence, the

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SMSF Investment Master Plan How to Prepare An Investment Strategy For Your SMSF

fund will actively manage its assets and use Exchange Traded Options to increase returns. Investment methods used must take advantage of a market travelling in any of its possible directions (up [bull], down [bear] and sideways [neutral]) Investment methods to be used include: o Bull Market o Buy and hold assets for capital growth Sell put options to enter a long asset position at a discount Buy short funds that profit in a falling market Buy put options to take advantage of a falling market Sell put options to either enter a long stock position at a desired price (if option gets assigned) or generate additional income (if option expires worthless) Sell call options on assets (i.e. covered calls) to generate additional income Sell option credit spreads (bear calls or bull puts) to generate income

Bear Market

Neutral Market

5.

Investment methods the fund will use to manage risk The fund will diversify investments across different asset classes shown in the asset allocation table in Point 3. Typical holdings reflect a growth oriented portfolio but the fund may be rebalanced as required to reflect our market outlook. All exchange-traded investments will employ at least one of the following risk management strategies: o Assets with Options Buy put options to protect the underlying asset when asset/sector/market show a potential change in direction (e.g. company earnings report/ bad news in a particular sector/bad economic news) Buy put options in an index that most closely relate to asset Set a stop loss and sell asset if it falls below this value

Assets without Options

DATED

4 July 2009 ______________________________________ Kingsley McDonald

____________________________________ Christina Bong

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SMSF Investment Master Plan How to Prepare An Investment Strategy For Your SMSF Minutes of a meeting of the Trustees of the SLI Superannuation Fund

Meeting: Attendees: Date & Time: Agenda 1. 2. 3. 4. 5. 1.

SLI Superannuation Fund Investment Strategy Annual Review Christina Bong (CB), Kingsley McDonald (KM) 4 July 2009 @ 10:15 AM

Assessment of market conditions Directional Opinion Agreement of Strategy Other Items Close Assessment of Market Conditions The Global Financial Crisis kicked off with the decline of the US stock market November 2007 and spread throughout the other world markets as a result of the cross boundary trade and borrowing agreements that exist. The collapse of the sub-prime mortgage market, where institution over leveraged themselves to make as much money as they could saw a crippling of the financial sector. As a result a massive flow on effect swept the world with the destabilisation of the US financial markets. This destabilisation, which saw massive bailouts by the US government to avoid financial instability across the country, lead to the massive US debt funded by the selling of bonds (predominantly to China). As the US economy struggled, consumers tightened their spending, putting local businesses at risk, impacting employment as well a significantly reducing imports which was helping to drive the China economy. As the Chinese economy slowed, declining requests from China for Australian ore exports, which had helped to drive the Australian economy significantly through the bull period from Mar 2003 Jan 2008, began to take its toll. In an attempt to avoid a melt down of the Australian economy similar to that of the USA, the Australian Labour government attempted to maintain economic cash flow by providing a stimulus package and offering money to taxpayers as a hope that these funds cycled back into the economy via spending on goods and services. Although this worked (short term), this pushed the government into deficit. With further decline in spending across Australia and rising unemployment in Australia hitting 5.8% in Jun 2009 (source ABS), the near future outcome for the economy is still bound with uncertainty. Looking forward for the next year and beyond, taxes will need to rise to repay to deficit (and already the threshold for contributions to super have been impacted by being reduced by 50%), and consumers will continue to pay down their debts. Cautious spending will see less retail dollars and companies making less money. With lower profits, dividends will be slashed and share prices cannot be expected to have any significant growth. The question of sustainability within companies with reduced cash flow will continue to put pressure on financial consolidation with companies leading to and expected further increase in the unemployment figures. We expect to see this stabilise over the next six (6)

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SMSF Investment Master Plan How to Prepare An Investment Strategy For Your SMSF
months as the economy reaches a state of equilibrium. Beyond this, mild growth would be expected as people are always cautious after they have been beaten down economically. 2. Directional Opinion Although our investment instruments allow us to take advantage of a market moving in any direction, up, down and sideways, we have assessed where we believe the market will be moving as these will provide guidance the strategies employed by the fund to achieve its targeted investment return. Bull We are not expecting a bull market in the next 1 2 years without significant change in consumer confidence. However, bear rallies may occur from time to time and we must be positioned to take advantage of these rallies. Neutral We expect the market to oscillate sideways in a range for a period of time (similar to 1999 to 2002), as investors test the market and will take profit when they believe the share price is greater that the value of the company given the cash flow and profits it is able to generate. Bear The other possibility is that there are still unknown factors which may impacts significant corporate companies which could see a potential of a further leg down in the market. The next support level is at 2850 and a break of this support level could create a sense of panic in the market (note, as at 1 Jul 2009 the AORD is at 3947.80).

The chart below shows the All Ordinaries movement over the past 25 years and the channels that it has followed.

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SMSF Investment Master Plan How to Prepare An Investment Strategy For Your SMSF
3. Strategy Agreement 1. Given our analysis of the market, our outlook is flat to deflationary i.e. we expect asset prices to stay low and possibly go down further. It was agreed that no changes to the asset class allocation is required as it already allows us to hold the fund 100% in cash if there are no suitable opportunities to profit in the market. 2. It was noted that under the expected market conditions, we will need to manage the fund more actively to generate the returns stated in our investment objectives. In a neutral market: The use of defined risk credit spreads to take advantage of a market in a trading range should be included into the pool of investment methods. Where possible, we plan to increase the returns on these assets by selling options on long asset positions, to generate additional income.

3. With the quantitative easing measures taken by governments, there is also a risk of inflation. To manage the funds risk to inflation; the fund will maintain some investments in alternative assets which typically do well in an inflationary environment. These include hard commodities such as gold and silver and soft commodities such as oil and agricultural products. 4. Although people see wide diversification as a way to manage risk, we do not agree with this as there are risks in investing in new asset classes that we are not familiar with. We prefer to focus on key asset classes that we understand accompanied by necessary risk management activities. 5. Summary of changes and asset class breakdown: Cash Typical holding to move from 10% to 30% Fixed Interest - remain unchanged Shares Typical holding to move from 50% to 40% Managed Funds (ETF and Mutual Funds) remain unchanged Alternative Assets Typical holding to move from 20% to 10% 6. It was agreed that the strategy should be rewritten to discuss the strategies for the fund and the risk management techniques. 4. 5. Other Items None Meeting Closed 11:00 am

____________________________________ Christina Bong Dated: 4 July 2009

______________________________________ Kingsley McDonald

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