A good plan violently executed now is better than a perfect plan executed next week

George S. Patton

Just over two years ago I set out on an exploratory voyage to try and build a passive income of around $58 000 by July 2021. With good initial progress, I reset the compass a year ago to seek to meet this initial financial independence objective by the end of 2018.

As I covered in detail in my recent year in review post, that accelerated timetable has not been met. The past few weeks have been spent reviewing my plans, assumptions and proposed approaches into the future to build both on what I have learnt and new information.

The half-year portfolio income update below forms part of this new information. To begin however, this post explains findings from my review, details my updated portfolio goals and assumptions, and discusses how I will approach my FI journey from here.

Shifting tides and new ports of call

To start with the ultimate goals, I have decided to refine my two complementary objectives, and re-base the target portfolio level of each.

Updated Objective #1 – The revised first objective is to reach a portfolio of $1 598 000 by 31 December 2020. This would produce a real annual income of about $67 000 (in 2018 dollars).

This is an increase of around $120 000 on my previous objective. This moves to a benchmark that I consider to be a better reflection of the original objective.

This new passive income benchmark equals the median annual earnings of an Australian full time worker. This is drawn from Australian Bureau of Statistics earnings data, which is updated at least annually, and which therefore can be consistently tracked through time. This replaces the previous goal of $58 000, a number which had not been inflation indexed since 2016, and which was taken from a variety of ad hoc sources.

Updated Objective #2 – The second objective is to reach a portfolio of $1 980 000 by 31 July 2023. This would produce a real annual income of about $83 000 (in 2018 dollars).

This is a small decrease on my previous Objective #2, a result of changes to some return and asset allocation assumptions discussed more fully in sections below.

The passive income target for this objective remains the approximate equivalent of average Australian full-time ordinary earnings, and a little above my average annual credit card liability. This second longer-term goal is designed to reflect a more ‘business as usual’ lifestyle, rather than more of a ‘leanFIRE’ concept – at least in my current phase of life – of $63 000 pa. As I have observed, it is closer to the level of expenditure at which I think I would truly become indifferent to working or not.

To set the target timeframe for both objectives, I have used very approximate and conservative estimates, based on previous average total portfolio increases over the past five years. This method largely ignores extra contributions arising from above average portfolio distributions, or any return impacts, given the relatively short time until both targets. Achievement of each target will inevitably be impacted by market fluctuations over the next few years, so constructing exact yearly forecasts of the impacts of average returns does not appear particularly worthwhile.

The portfolio targets levels are estimated by dividing the passive income target by a real return of 4.19%, equivalent to a nominal return of 7.19%. The real return assumption is based on the portfolio allocation discussed further below.

Measuring the journey

With the destination set, the next issue is how to measure the journey. So far I have just measured progress in simple percentage terms against the two objectives.

I plan to continue this, but to expand it in two significant ways.

First, recognising that I have some significant superannuation that currently sits outside of the investment portfolio, I will now seek to assess progress on two metrics:

• the current measure based on reliance on the investment portfolio alone; and
• a new ‘All Assets’ measure with superannuation assets taken into account.

The reason for this approach is that it increasingly seems artificial to entirely ignore a substantial potential contributor to a FI target, even if it comes with accessibility restrictions and some legislative risk.

Due to these risk and restriction factors, I continue to target financial independence through my private investment portfolio alone, with superannuation providing an additional margin of safety and buffer. Recognising this, I plan to simply report a total ‘All Assets’ measure, rather than detail or write about my superannuation arrangements (spoiler, they are almost exclusively in a low cost index fund).

Second, I plan to report against an expanded set of benchmarks, beyond just my formal investment objectives. Currently I plan to report against two additional measures. My average annual credit card expenditure (a ‘credit card FI’ benchmark) is one, and the second is an aggregated rough estimate of total current annual expenditure. This latter measure is quite approximate and results from adding some known fixed expenses to my total credit card expenditure. I recognise that it is by no measure a frugal existence, and how fortunate I am to be able to live in this way.

For simplicity I will report these progress percentages as below in future monthly updates, using the portfolio position on 1 January this year as inputs in this example.

Measure	Portfolio	All Assets
Objective #1 – $1 598 000 (or $67 000 pa)	82.5%	115.5%
Objective #2 – $1 980 000 (or $83 000 pa)	66.6%	93.3%
Credit card purchases – $73 000 pa	76.8%	107.5%
Total expenses – $96 000pa	57.6%	80.6%

What can be seen from this is that on a couple of measures, using an ‘All Assets’ basis that includes superannuation, I have already reached some of these basic FI benchmarks. On other purely portfolio measures I am still well-progressed, in sight of Objective #1 and about two-thirds of the way to Objective #2, for instance.

Plotting the course

Having set the objectives, the most critical part is planning how to achieve it. This is the purpose of an annual investment policy which I have been reviewing over past weeks.

From a review of articles and research on Australian safe withdrawal rates and asset allocation I have elected to move to a portfolio target of 75% allocation to equities with the following other target allocations.

Specific asset allocation targets

• 75 per cent equity based investments, comprising:
  • 30 per cent international shares
  • 45 per cent Australian shares
• 15 per cent bonds and fixed interest holdings
  • 7.5 per cent Australian bonds and fixed interest
  • 7.5 per cent international bonds and fixed interest
• 10 per cent gold and commodity securities and Bitcoin
  • 7.5 per cent physical gold holdings and securities
  • 2.5 per cent Bitcoin

Reasons for allocation targets and assumed asset returns

Equity returns, safe withdrawal rates and international diversification

Equities provide the fundamental engine of returns in the portfolio, with the best chance of outperforming other asset classes, and maximising after inflation returns.

The overall asset allocation approach has been driven primarily by reference to a study How Safe are Safe Withdrawal Rates in Retirement: An Australian Perspective (pdf). This is public study which calculates safe withdrawal rates for a range of possible asset allocation mixes over a range of timescales, between 10 and 40 years, using historical Australian data.

At a 75% equity allocation, a withdrawal rate of 4% has had a 88% success rate, and over 30 years a withdrawal rate of 4.0% provides a 95% success rate. In addition to this, I have examined Early Retirement Now’s brilliant US-focused safe withdrawal series. Recently, AussieHIFIRE and Ordinary Dollar have produced excellent shorter and simpler analyses of Australia returns, which have largely reinforced the findings from the study mentioned above, with slightly more recent data.

This represents a 10% increase in my equity allocation. Separately, to help estimate the portfolio target, I have also reached long-term real equity return estimates. These are 5.65% for Australian equities, the mid-point of measured long-run historical returns over risk-free assets over the past century. For global equities the real return estimate is 4.5%, a historical figure sourced from the 2018 Global Investment Returns Study.

The split between Australian and international equities is designed to maximise total returns and minimise portfolio volatility, while taking advantage of the tax advantaged nature of Australian franked dividends. The equities sub-targets above seek to achieve a target 60/40 split between Australian and foreign equities, which this recent published academic survey determines to be optimal for most Australian investors (see Optimal Domestic Equity Allocations for Australian Investors and the Role of Franking Credits published in the Journal of Wealth Management and also discussed previously here). A key finding of the study is that Australian equity exposures at higher rates significantly increase portfolio volatility, and maximum potential losses.

Bonds and fixed interest

Bonds and fixed interest play a role in diversification, reducing overall portfolio volatility. The assumed return of 2.0% for these assets is in line with long term global averages measured since 1900, sourced from the Dimson, Marsh and Staunton book Triumph of the Optimists – 101 Years of Global Investment Returns. 

Property, gold and Bitcoin

I have no formal property allocation, excepting my small exploratory investments through BrickX. In the current market environment my assessment is Australian property is likely to enjoy low yields and returns for a considerable period, and not offer much diversification benefit over Australian equities or other asset classes.

The role of gold and Bitcoin are primarily as non-correlated financial instruments for diversification, and as an insurance against extreme capital market events. No real return is assumed for either asset, and I plan to only rebalance by purchasing low cost gold index ETFs if the overall alternatives asset class falls well below its 10% allocation.

Taking into account the above asset allocation and return assumptions, the overall portfolio return is estimated on a weighted average basis at 4.19%. This is equal to a nominal return of 7.19% based on an assumption of inflation being at the top half of the Reserve Bank’s target band over the medium-term.

This is a little above the safe withdrawal assumptions detailed above, but within a sufficient margin of error for current planning, considering that the above studies are all entirely based on patterns of realised historical returns, which will not necessarily be determinative of future returns.

Sailing out of port

Going though the process of testing assumptions and goals has been useful, even where the refinements have been modest. I am now more comfortable that my return assumptions are realistically modest, and that my goals accurately anchor my journey to points of greater psychological significance, rather than past rough approximations.

Remembering why a choice was made, and being forced to develop or find evidence for assumptions made is a critical part in my building greater confidence over time to tackle the remaining journey.

Portfolio Income Update – Half Year to December 31, 2018

A large income is the best recipe for happiness I ever heard of.

Jane Austen Mansfield Park

Twice a year I prepare a summary of the total income from my portfolio. This is my fifth passive income update since starting this blog. As part of the transparency and accountability of this journey, I regularly report this income.

As discussed above, my goals are to build up a passive income of around $67 000 by 31 December 2020 (Objective #1) and $83 000 by July 2023 (Objective #2).

Passive income summary

• Vanguard Lifestrategy High Growth – $8 044
• Vanguard Lifestrategy Growth – $444
• Vanguard Lifestrategy Balanced – $539
• Vanguard Diversified Bonds – $86
• Vanguard ETF Australian Shares ETF (VAS) – $1 812
• Betashares Australia 200 ETF (A200) – $2 194
• Telstra shares – $146
• Insurance Australia Group shares – $455
• NIB shares – $188
• Ratesetter (P2P lending) – $1 528
• Raiz app (Aggressive portfolio) – $122
• Spaceship Voyager app (Index portfolio) – $0
• BrickX (P2P rental real estate) – $43

Total passive income half year to December 31, 2018: $15 602

Presented in a pie chart form, the following is a breakdown of the percentage contribution of each investment to the total half-year income.

A time series of past passive income delivered from the portfolio is below.

Comments

The half-year passive income from the portfolio was $15 602, the equivalent of $2 600 per month, falling significantly below my base expectations.

The fall from the previous half-year result in July 2018 was the largest ever experienced for the portfolio. It seems the ‘reversion to the mean’ I have previously mooted has arrived, sending the December half-year income back to around 2016 levels.

This is likely the result of the a few different factors, such as:

1. the overall poorer performance of nearly all asset markets in late 2018
2. lower realised capital gains from the Vanguard retail funds, after previous strong equity returns in the past two years
3. lower cash returns from a slow fall in the balance of the Ratesetter account, and a re-allocation of these funds to new equity ETFs with lower total distributions

The pattern of consistently lower distributions in the December half-year period continues. The results do exclude the value of franking credits, and so there is some understatement of total after-tax returns. My preference, however, is to seek to track cash actually delivered into my bank account as a tangible and easy to calculate metric.

The results do seem to suggest a focus on the overall portfolio objective, rather than narrowly interpreting this single half-year measure as a true indicator of the long-term income potential of the portfolio. Alternatively, it illustrates the value in viewing portfolio returns in smoother annual terms, such as on a whole of financial year basis. Interestingly, overall annual distributions have not fallen once over the past seven years. As a positive, as well, it is apparent that in calendar year 2018 just past, portfolio income was $61 600, not too distant from my revised Objective #1 target of $63 000 pa.

For forward planning purposes, I have settled on the average of the past five full years of distributions as a reasonable conservative estimate of future distributions. This implies an estimate of $45 000 per annum, which I use as one input into estimates of my required emergency fund and insurances.

Forecasting distributions from Vanguard managed funds has proved quite challenging. Based on past averages, I had expected higher distributions from the Vanguard High Growth fund. Using naive averages of overall portfolio distribution rates and averages had led to total portfolio income estimates for the half year of between $20 000-$25 000.

What has proved much more accurate in the case of the Vanguard funds is using past ‘cents per unit’ distribution data for the five previous December half years, which up to a few weeks ago I had never explored. Another method was to observe the overall change in value from 31 December to 1 January fund values, though this obviously has some market noise in it. These methods came within about 20-30% of the final lower distributions from Vanguard.

Some of these large variations I expect to be slightly reduced in the future by the increasing role of ETFs in my portfolio. These should have a more stable distribution profile that will be based on underlying firm earnings rather than the pre-mixed funds that are realising capital gains in an effort to seek to track a particular asset allocation. In this regard, it is pleasing to see that together the Vanguard VAS and A200 ETFs accounted for just over 25% of all portfolio income.

Over the hot summer days in prospect I will be eagerly waiting for the Vanguard fund and ETF distributions and then settling how to reinvest them. My current target asset allocation suggests purchases of more Australian equity ETFs such as A200, to reach my new target allocation for equities, and between Australian and international shares.

Overall, while the half-yearly income has not been what I expected, I still feel very fortunate to have had, on any measure, my portfolio providing additional income of $2600 per month over the last six months, meeting just under half of my typical monthly credit card expenses.

Just two or three years ago, these types of results were ambitious new highs. With each new investment in 2019, I will be looking forward to growing the total distributions income further in the future.