A Great Position To Be In

Had you known this couple like I did, you would have seen that they'd never had a new car. In fact their car is what could be described as a bomb. You know the type; rust in all the wrong places, a constant pinging noise as they drive and an exhaust that could wake up the whole neighbourhood. Not getting a new car and avoiding luxuries is probably a good part of why they could have paid off their home loan so quickly. In fact I know it is.

After talking to this couple about their financial situation I was somewhat compelled to give my opinion on their car purchase. Our discussions led to the fact that they had little savings. The $40,000 tucked away, once spent, would take them down just to $2,000 left over as each extra dollar they have earned went to paying down the home loan right away.

My advice is to put away the majority of the $40,000 for a rainy day fund, you know, in case anything happens where you need money quickly. As I pointed out, disaster can strike in many ways and insurance won't always cover it. If you don't have money at short notice, things can get pretty ugly. Plus, after the money is tucked away they can start saving again for a new car right away, and once again it will not take too long.

Of course if they bought the new car and disaster struck, they could sell their car or even take a mortgage on their house but again this would be moving backwards in my opinion. My advice was to buy a $10,000 second hand car and use $30,000 on good quality blue chip shares. At least in my scenario they could get rid of the lemon car and if they needed money they could sell only a portion of their shares for the money they needed.

To my surprise Mr Johnstone was quickly sold on the idea, even though this meant he would have to give up his new car for the time being. Mrs Johnstone was a little bit scared as she was concerned with the risk of the shares going down and subsequently losing her money.

I felt compelled at this stage to point out that if she bought a new car it was not only likely to lose money, but 100% guaranteed. If they owned the new $40,000 car for ten years they could expect to lose 75% of the value and only be able to sell it for $10,000. It is a guaranteed loser.

So I wrote some figures down for them to take a look at. I asked them to pretend they where in this situation but it was ten year prior (eg October 2001).

At this point they purchased a $10,000 car and invested the remaining $30,000 in Telstra shares. By my research, Telstra was selling at $5.10 in October 2001. So they could have bought 5,882 shares with their $30,000. Fast forward to October 2011 and the shares are trading at $3.08. This means they would have lost $11,884 but on dividends over the years they would have been paid $17,646. Plus if they sold the car for $1,000 in 2011 they would have a total amount left of $36,762. This is a total loss of $3,238, or 8%. As you can see, to be a Telstra shareholder over the last ten years has a been a pretty rough ride. But the Johnstones would have only paid $3,238 for the use of a car for this whole time. This is a total loss of 88 cents a day.

If they had invested $30,000 in Westpac shares in October 2001 when they were selling at $14.18, they could have purchased 2,115 shares. Fast forward to October 2011 and the shares are trading at $25.82. They have gone up to $54,626; not bad. If you include the dividends they had paid out plus selling the second hand car, you would have a total of $78,595. That's a total gain of $38,595, or $10.57 a day.

Had they purchased a $40,000 car ten years ago, today in October 2011 they could have sold it at around $10,000 which would be a total loss of $30,000, or $8.21 a day.

Looking back on life is easy. Nobody knows the future going forward. What blue chip share will be the next Telstra, what will be the next Westpac? What I can predict without a shadow of a doubt is that a new car will lose 75% of its value in ten years. Mrs Johnstone is worried about losing her money in shares, but not worried about losing the bulk of her $40,000 guaranteed. When we look at it along these lines, are good quality shares really that risky?