Be what you were before;

Or weigh the great occasion, and be more.

Homer, Iliad, Bk.1.155

This recorded journey towards financial independence started six years ago, with an initial objective of building a passive income of $58,000 per annum by July 2021.

Since that time, goals have evolved and changed, with the most recent target actually being temporarily achieved through March 2021 to May 2022.

Each year in early January I spend time reviewing my investment goals and how I plan to reach them.

This longer post talks about reflections arising as part of this annual review, updates my portfolio goal and assumptions, and discusses how I will approach my financial independence journey through 2023 and beyond.

The aim, as always, is to have a clear written record of the objectives, approaches and reasoning underlying the plan, to serve as a reference point through the year to come. The process also enables the updating of plans and assumptions for changes in circumstances, thinking, as well as available data and evidence.

A reversal of course on the voyage to financial independence

For the past seven months, the total portfolio has been below the overall portfolio objective.

The previous reaching of the target was therefore a fleeting state of affairs, a function of temporarily surging Bitcoin prices.

Excluding Bitcoin, the portfolio only ever reached around 86 per cent of its target of $2,620,000. At the close of last year the equity portfolio sat at about 88 per cent of its intended final target amount of around $2,100,000.

The target for the year just past was based around a benchmark of the portfolio producing a real annual income of $91,600 in 2022 dollars. The level was chosen because it reflected an amount equal to Australian adult full-time ordinary earnings, and was close to my (then) estimated spending of around $84,000 per annum.

The target has been primarily a short-hand way to measure progress towards the goal of financial independence. It was never designed to act as a crude countdown clock or trigger to immediate early retirement once that dollar value was exceeded.

The target, for example, was notionally exceeded in the first five months of last year, but this did not result in retirement – and for the better as markets turned out, and in terms of reducing sequence risks.

A key benefit of the process of setting a specific target has been to help define what type of post-financial independence is actually envisaged and sought.

This is an important and fundamentally personal decision. In some circumstances, it represents a irreversible or ‘once in time’ decision about the approximate standard of living to be locked in and experienced across multiple decades – including those in which flexibility to adjust income or expenses may be circumscribed in completely unforeseen ways.

In this respect, the target goal of adult ordinary full-time earnings represents an objective external measure of a continuing capacity to fully access and participate in the broad range of goods, services and daily experiences of those in the community.

That it continues to sits close to my actual spending also provides an assurance that post-early retirement life would not see a material diminishment in, or undue limitation of, lifestyle.

Back to the ships: updating the target portfolio goal

The target portfolio goal was slightly revised early last year to account for shifts in annual ordinary earnings, following a more significant move towards a ‘safe withdrawal’ rate approach in 2021.

This latter move reset the portfolio goal to a level sufficient to generate the target income in real 2021 dollars at a defined safe withdrawal rate of 3.5 per cent. That shift resulted in an upwards adjustment of the final target by $400,000, to $2,620,000.

Consistent with maintaining the real inflation-adjusted value of the target, I have updated my existing goal and formed an updated Portfolio Objective.

The new objective is to seek to achieve and maintain a portfolio of at least $2,750,000 through 2023. This should be capable of producing an annual income from total returns of about $94,800 (in May 2023 dollars).

This updated target is an increase of $130,000 on my previous portfolio objective.

The key reasons for this change are to account for movements in benchmark earnings, and bringing the target income into 2023 dollars in a period of relatively high inflation. Simply moving the previous target into nominal 2023 dollars and updating average ordinary earnings for real changes accounts for most of the increase of the target.

The passive income target for the objective is updated using May 2022 Australian Bureau of Statistics data, and an expected increase in the median salary of 3.0 per cent across the financial year 2022-23. That is, it seeks to reflect the approximate equivalent of average Australian full-time ordinary earnings in mid-2023. It remains above my current estimated average annual spending between 2013-2022 of around $85,000.

This income goal is designed to reflect a ‘business as usual’ lifestyle, rather than a ‘leanFIRE’ approach. This is personal choice.

As described above, as I considered my goals for financial independence, this level is closer to the level of expenditure at which I think I will be truly indifferent to working or not in terms of lifestyle.

Recapping the movement to a safe withdrawal rate approach

Two years ago I changed my approach to setting the portfolio goal by explicitly incorporating a safe withdrawal rate into its calculation.

Prior to that I estimated the portfolio goal by dividing the passive income target by a projected average real portfolio return.

The real return assumption used in this past calculation was based on the total return arising from the portfolio allocation. These return assumptions are discussed further below in the second half of this entry which reviews allocation plans and portfolio design.

Such an approach was a useful rough approximation of a safe withdrawal rate, and past annual reviews recognised it as an imperfect but serviceable proxy measure for use on the journey of accumulation.

The weakness of this approach, however, was that it failed to properly account for sequence of returns risk. This is the potential for early negative returns affecting the portfolio in the first years of income drawdown to lead to unsustainably high portfolio withdrawals, depleting the portfolio irreversibly.

This change was made to move beyond approximations and to target explicitly a portfolio goal that better took into account a reasonable estimate of a sustainable safe withdrawal rate.

A target safe withdrawal rate of 3.45 per cent will be used. This figure underpins the updated portfolio goal (i.e. $94,800/0.0345 = $2,750,000, with some rounding).

Reasoning for the selected safe withdrawal rate

Any safe withdrawal rate is at its core a highly individual decision.

In past years I have used a safe withdrawal rate of 3.5 per cent. This year I have decided to review this, and adjust it slightly downwards to 3.45 per cent.

This choice is informed by risk tolerances, personal factors, available academic and other studies and views about the value of historical data in forward-looking decisions of high and enduring personal consequence.

The primary basis for previous decisions on safe withdrawal rates has been the finding that based on historical Australian equity returns data over the period 1900-2011, a safe withdrawal rate of 4.0 per cent has had an 88 per cent success rate over a 40 year time horizon. This success rate lifted to 97 per cent at a withdrawal rate of 3.0 per cent.

A further study by Professor Wade Pfau, an eminent academic commentator in this area, has indicated that the maximum safe withdrawal rate for Australia using 1900-1979 equity market data was 3.68 per cent.

Factors considered in setting an initial safe withdrawal rate

These Australian-based findings might suggest a safe withdrawal rate around 3.7-4.0 per cent. Several factors, however, have led to a more conservative rate being adopted.

These factors are:

• Survivorship bias – Due to a historically strong equity market performance Australia has had one of the highest safe withdrawal rates in the world. Effectively projecting continued higher than globally average equity market returns indefinitely into the future is not likely to reflect a realistic central estimate of probable outcomes. Many other highly developed countries with comparable advantages have experienced lower safe withdrawal rates. There are no particular reasons to suppose that the outperformance of Australia’s equity markets over the past century will reliably persist (see Pfau An International Perspective on Safe Withdrawal Rates from Retirement Savings: The Demise of the 4 Percent Rule? 2010).

• Portfolio management fees not taken into account – Academic and other estimates of safe withdrawal rates routinely assume away real world investment management fees. For the investment portfolio at present, these average around 0.2 per cent per annum. Paying 1 per cent in fund expenses has been estimated to lower a safe withdrawal rate by 0.5 per cent (see Pye, G. 2001. “Adjusting Withdrawal Rates for Taxes and Expenses.” Journal of Financial Planning, Vol. 14, No. 4, p. 126).

• Statistical portfolio ‘success’ can look and feel a lot like failure – Many statistical ‘successes’ with a higher safe withdrawal rate would actually be close run exercises. This is because success is frequently defined in such studies as having at least $1 in the retirement portfolio at the end of the drawdown. Suffice to say, this does not match many people’s intuitive desire for a margin of safety and security late in life’s journey. In short, as this analysis shows, ‘terminal values’ and the experienced path of the drawdown matters.

Last year two additional factors, supported by some market evidence, were noted that might have had the impact of lowering the safe withdrawal rate.

These were high equity market valuations and a low bond yield environment. Over the course of 2022, falling equity markets and historically rapid rises in bond yields have led to these factors being less persuasive considerations in informing the final rate, and have therefore not been given any weight in this review.

A 2021 study by Morningstar (h/t Aussie HIFIRE) examined some of the above listed factors, and projecting lower future returns estimated that a safe withdrawal rate for a 40 year period with an equity allocation of 80 per cent could be as low as 2.6 per cent (modelled based on a 90 per cent ‘success’ rate).

A similar Morningstar study recently released reviewed safe withdrawal rates in the context of higher bond yields and lower equity valuations across 2022. For a 40 year period (at a 90 per cent success rate), with the same equity allocation of 80 per cent, the safe withdrawal rate had risen to 3.1 per cent.

Reviewing international evidence of safe withdrawal rates: a forever lucky country?

The most significant new evidence on safe withdrawal rates for my considerations has been a new paper from Anarkulova et at in September 2022 titled The Safe Withdrawal Rate: Evidence from a Broad Sample of Developed Markets.

This examines the question of safe withdrawal rates using an expanded set of 38 developed country markets, and including hypothecated returns data from ‘difficult’ data periods typically excluded from such analysis.

The paper then analyses the resulting approximate 2,500 years of asset class return data from 1890 to 2015 to ‘test’ by simulations safe withdrawal rates across developed countries. The point of this analysis is to account for the kind of survivorship bias inherent in using only Australian or US data sets to determine safe withdrawal rates.

The results therefore represent a more realistic, ex ante or forward-looking, analysis of possible safe withdrawal rates, taking into account the fact that US or Australian returns in the future are quite likely to resemble broader averages from developed markets.

This removes the often implicit, and potentially dangerous, assumption from solely US or Australian-based withdrawal rate analysis that these markets will unquestionably continue to produce above average returns in the decades ahead. The new paper adds significantly to similar evidence in the previously mentioned Pfau analysis from 2010.

The headline finding of Anarkulova et al (2022) is that the 4 per cent ‘rule of thumb’ commonly applied and cited in retirement planning and many financial independence sources is not ‘safe’.

In fact, pursuing the standard ‘4 per cent rule’ applying this more comprehensive global data set results in a failure rate of around 17 per cent, or running out of portfolio income in nearly one in five cases. The work focuses its central case on a safe withdrawal rate of 2.26 per cent, for a traditional retirement horizon, with a 5 per cent chance of failure and with a standard 60/40 equity and debt portfolio, but also provides further iterations and scenarios.

Using some extrapolation from the 2022 Morningstar analysis, and some of these tailored scenarios that apply more closely to my circumstances and portfolio allocation, the data in Anarkulova would suggest a starting point for a safe withdrawal rate of around 3.3 per cent.

Estimating a final estimated safe withdrawal rate: accounting for additional factors

These factors and evidence discussed above all argue for an initial safe withdrawal figure lower than 4 per cent.

The 3.3 per cent rate suggested by the Anarkulova analysis represents a key initial starting point for a final estimate.

Yet there are other factors to consider in reaching a final point estimate.

First, as noted safe withdrawal analysis can often exclude the impact of portfolio management costs. To account for this in the final estimate I lower the Anarkulova estimate by 0.20 per cent, or 20 basis points, which is the approximate average expected portfolio costs over the long term.

The second factor to account for is the potential value of flexibility in withdrawal rates and approaches.

The flexibility to not draw on one year of distributions can make a significant difference in the performance and success rate of a reasonable safe withdrawal rate. Similarly, this (pdf) Canadian Vanguard study shows that a dynamic flexibility in spending can lift a safe withdrawal rate for a high equity allocation portfolio across 40 years from 3.5 per cent to 4.3 per cent.

The 2022 Morningstar research paper discusses the potential impacts of a range of flexibility strategies in actual withdrawals. These include rules such as reducing spending by 10 per cent temporarily after a negative annual portfolio return, or forgoing annual inflation adjustments in similar circumstances.

The findings are that these strategies can increase safe withdrawal rates (noting a limitation that this analysis is using only US returns data) by 0.2 per cent and 0.5 per cent respectively. Other more complex ‘guardrails’ strategies are presented as potentially offering up to a 1.8 per cent uplift to safe withdrawal rates.

From observations to coordinates: reaching a final point estimate

Taking the initial 3.3 per cent rate from the Anarkulova analysis, my current preferred approach is to then deduct 0.2 per cent to account for portfolio management fees, resulting in an adjusted rate of 3.1 per cent.

I have yet to finalise my precise preferred drawdown approach and strategy, but anticipate it will likely have elements of flexibility, as well as potentially a 12-month cash ‘bucket’ to avoid some unnecessary withdrawals of capital in any shorter duration adverse market events.

Taking the range of potential uplifts from the ‘10% reduction’ and ‘forgoing inflation’ strategies in the 2022 Morningstar report results in a range of 3.3 to 3.6 per cent. I then select the mid-point of this range, reflecting uncertainty over which of these specific strategies I may seek to adopt.

On balance, taking all these considerations into account, a target value of 3.45 per cent appears to be appropriate as a reasonable estimate, and to match the personal degree of assurance I am comfortable with in my personal circumstances.

This is very slightly lower than the previous 3.5 per cent figure adopted, but is supported by more detailed evidence, and a more explicit accounting for each factor considered.

The presence of a superannuation portfolio continues to provide an additional 24 per cent ‘buffer’ in dollar terms, potentially reducing the risk of poor ‘tail end’ outcomes that would arise from strict reliance only on the financial independence portfolio.

An indication of the impact of superannuation on the ‘margin of safety’ actually in place is that using January 2023 figures, the target income of $94,800 would represent a 3.2 per cent drawdown of the sum of all financial assets (portfolio assets excluding Bitcoin) and current superannuation holdings.

One factor not accounted for which this additional margin may assist with offsetting is the fact that most safe withdrawal rate estimates and resulting income estimates to do not explicitly account for tax liabilities incurred.

Role of the portfolio goal and pre-conditions of financial independence

This year the portfolio goal resumes its primary function as an aspiration to target, following the portfolio falling below the identified target last year, and the largely inflation-driven adjustment of the goal this year.

Yet as the portfolio value grows over time, the role of chance and standard equity market volatility in determining whether a specific numerical target is met also increases.

The potential magnitude of these fluctuations is illustrated by the historical record of closing monthly financial portfolio values since 2019 (e.g. excluding Bitcoin) in the chart below.

For example, the largest consecutive falls in the financial porfolio together delivered around $270,000 in losses, across February and March 2020. Similarly, market movements in October and November 2022 delivered combined increases of over $200,000 to the financial portfolio.

This means that the portfolio objective, while perhaps seeming distant at any given point, may actually only be a short period of strong market performance away.

As noted last year – correctly, as it turns out – it also means losses can easily push the portfolio well below the portfolio goal, in turn delaying the re-attaining of the target by a year or more.

Towards port: conditions for the final stages of the financial independence journey

The 2021 review introduced the point that this later phase of the journey could turn out to be less about whether a particular portfolio value is reached than previous phases.

Rather, it may focus more on whether a number of broader conditions informing a decision to change the nature of my work in the future are met.

These conditions are:

1. Portfolio target being met – in particular, is the portfolio target met or exceeded, such that applying a 3.45 per cent safe withdrawal rate can be expected to be sustainable over a forty year period? The logic for this target and withdrawal rate is detailed above.
2. Achieving the minimum equity target – has the minimum equity holding targeted been achieved (i.e. whether the equity component of the portfolio is at its target level) to ensure that the long-term core of the portfolio which is assumed to generate income and capital growth is able to serve its function? If the equity holdings are below this level, any decision to retire would be at appreciably higher risk.
3. Cash reserve in place – is a capital reserve in place that is equivalent to at least one year of normal expenditure, to minimise or avoid required portfolio withdrawals in future equity market drawdowns?

Currently, none of these three conditions are met. All three being met will be an important threshold for any future decision to change my existing full-time work status.

So for this year my approach will be to focus on meeting conditions #1 and #2.

By current estimates, meeting each of these conditions should be possible by the end of 2024. In the case of the equity portfolio target, this estimate is based on average monthly equity portfolio increases since 2017. The nature of equity returns is volatile, however, so this timing is suggestive only.

Putting the cash reserve in place is only partially complete, and should be achievable relatively quickly taking into account expected future distributions in the last phase of the journey.

Therefore a key secondary focus through 2023 will be achieving the minimum equity target, which is $2,200,000, prior to any changes in work status.

This equity target is estimated by multiplying the overall portfolio target with the target equity allocation (of 80 per cent).

Continuing additional measures on the journey to financial independence

I will continue to measure the value of the portfolio in simple percentage terms against the updated total portfolio goal needed to deliver the passive income target, for the reasons described above.

Similarly, after expanding the reporting of progress in recent years to recognise that I have some significant superannuation assets that sit outside of the financial independence portfolio, I will continue to assess progress using two key benchmarks:

• a ‘Portfolio’ benchmark – this is the primary measure based on the total value of assets in the financial independence focused investment portfolio alone; and

• an ‘All Assets’ benchmark – a secondary ‘All Assets’ measure which takes into account portfolio assets, but also the additional value of superannuation assets.

This latter ‘All Assets’ metric recognises the incompleteness of a too narrow portfolio-only view.

Such a partial view unrealistically ignores a substantial set of financial assets that are in this case large enough to have significant implications for the achievement of financial independence. This remains the case, even if superannuation holdings ultimately have some potential accessibility restrictions and some legislative risk.

Due to these risk and restriction factors, my first preference is to continue to target financial independence through my private investment portfolio alone, with superannuation providing an additional ‘margin of safety’ and buffer.

Recognising this, I will continue to just report a total ‘All Assets’ measure, rather than closely detail or write about my superannuation arrangements.

I will also report against a revised set of benchmarks, beyond just the formal investment portfolio objectives.

Previously, I have reported against a metric of Total average expenses.

This measure is defined as percentage progress toward a portfolio value capable of sustaining a moving average of nominal estimated expenditure since 2013. The benefit of this is that it means if my average expenses rise over time, the actual impact on progress is highlighted dynamically.

Currently this figure sits at $84,700 per year.

I will also continue to report a second metric added more recently, being Target equity holding. This measure, which I have reported consistently since 2022, will be equal to the current equity holdings in the portfolio, divided by the final targeted equity allocation, which will be further discussed below.

I will continue to report these progress percentages in future monthly updates. An illustrative example of this reporting, using the portfolio position on 1 January of this year as inputs, is set out below.

Revised FI measures – Example

Measure	Portfolio	All Assets
Portfolio objective – $2,750,000 (or $94,800 pa)	89%	117%
Total average expenses (2013-present) – $84,700 pa	99%	132%
Target equity holding in portfolio – $2,200,000	83%	N/A

Constant bearing, increasing range

The portfolio review, and updating the goal, is now a fixture for this time of year. The process coincides with when additional leisure time allows scope to review evidence and think systematically through the issues in an uninterrupted way.

This year the reversal of the portfolio through 2022, the impact of historically high inflation rates, and a slightly lower assessed safe withdrawal rate combine to shift backwards progress on the journey, even as the destination stretches a little further into the future.

The easy rejoinder would be to suggest this is evidence of ‘one more year’ syndrome, or a subconscious desire to shift targets slightly out of reach. There are a few problems, however, with this confident diagnosis by remote.

Part of the purpose of undertaking a formalised, and mathmatically formularised, review of the target is to ensure the portfolio income and resulting goal is based on objective movements in prices, average earnings, and realistic safe withdrawal rates.

Equally important is examining in a quantified and replicable way the best evidence of the potential, and limitations, of flexibility strategies. Reviewing and understanding the numbers provides the necessary confidence for sound action, rather than a reason for avoiding it.

Too often in broad discussions of financial independence, the complexities and realities of potentially defining an effective living standard for approximately one half of one’s life are underplayed, and covered over with reasonable sounding and comforting assurances about the potential for future paid work, or unquantified assumptions about the value of flexibility.

Often, these flow from the understandable and positive motivation of seeking to avoid the risk of perpetual deferral of early retirement based solely in fear of the unknown.

Uncritical adoption and implementation of the ‘4 per cent rule’ represents a similar risk for those contemplating life changing decisions around future employment. It may appear to work, until it doesn’t.

In the case of this review, applying the evidence and data results in a lift of $130,000 in the portfolio target, which at first – and second – glance seems material.

Around 70 per cent of this increase arises, however, from the impact of inflation and earning adjustments. That is, the change to the nominal target is made simply to stand still in ‘real’ dollar terms.

The remaining component reflects the small decrease in the safe withdrawal rate, which reflects a marginally better and more robust estimate than that which guided previous targets.

Viewed in this way, and remembering the volatility of prior half-year periods – which often saw unforecast portfolio increases of $150,000 to $250,000 – the lift in the target does not seem an unreasonable or arbitrary new barrier to be overcome.

As noted previously, even as fine course adjustments are made, it is inevitable that one set of new specific circumstances and risks – now unknown and unknowable – will prevail over the next crucial 5-10 year period, rather than an ‘average’ of historical outcomes. And having occurred, they will appear after the fact as foreseeable or even probable.

Faced with such traps and imponderables, we should aim to be at least as wise as we were yesterday and – in regularly retesting our assumptions with new evidence – perhaps a little more.

Reviewing the investment plan and assumptions

In the midst of winter, you feel the inventions of spring.

Lawrence Durrell, Alexandria Quartet

Each year I review my investment policy to ensure it stays relevant to available data and evidence, and will serve my ultimate investment goal of financial independence.

The summary is based on my past reviews and decisions. It is designed to serve as a reference for the chain of reasoning underpinning portfolio design and allocation decisions through the year – so it remains unchanged where my conclusions have not changed.

In 2019 I increased the equity allocation in the portfolio to 75 per cent. In 2021 the policy was adjusted to move towards a long-term target of an equal allocation of global and Australian equities over the next several years.

The most significant change following the 2022 review was to slightly increase the overall equity allocation, to 80 per cent, by reducing the target bond allocation.

The goal of reaching an equal allocation of global and Australian equities remains. The current approach is reflected and discussed further below.

Specific asset allocation targets

Based on the review and considerations below the portfolio allocation targets are as follows:

• 80 per cent equity-based investments, comprising:
  • 40 per cent international shares
  • 40 per cent Australian shares
• 5 per cent bonds and fixed interest holdings, comprising:
  • 2 per cent Australian bonds and fixed interest
  • 3 per cent international bonds and fixed interest
• 7.5 per cent physical gold holdings and securities; and
• 7.5 per cent Bitcoin.

Reasons for allocation targets and assumed asset returns

Assumed equity returns

The equity component of the portfolio provides the fundamental engine of returns in the portfolio, with the most sustained historical record of outperforming other traditonal asset classes, and maximising after inflation returns.

Calculation of the overall portfolio target previously involved setting an assumed return for each asset class, however, this has been replaced since 2021 with the use of the safe withdrawal rate.

To anchor forward expectations, however, I still find the estimation of assumed returns a question of interest.

In terms of long-term real equity returns, last year I adopted an estimate 5.0 per cent this year based on the geometric mean of Australian equity returns over risk-free assets over the period 1883 to 2020. This figure remains unchanged this year, based on additional equity returns data up to 2022.

For my specific purposes, the geometric mean appears to continue to be more appropriate than the previously used average of the arithmetic and geometric mean, and its lower value also reflects lower expectations going forward.

For global equities, the equivalent real return estimate used last year was 5.2 per cent, a long-term historical figure sourced from the 2020 Global Investment Returns Study. This year this figure has been lowered to 5.0 per cent on the basis of Credit Suisse’s most recent update (pdf) of the same analysis.

Allocation between Australian and global equities

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 specific equities sub-targets changed in the investment policy review of 2021.

Previously, I had sought to achieve a target 60/40 split between Australian and foreign equities, which an academic survey published in 2013 estimated to be optimal for most Australian investors (see Klement, Greenrod and O’Neill 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 that study is that Australian equity exposures at higher rates significantly increase portfolio volatility, and maximum potential losses.

The specific optimal 60/40 split suggested by the study is, importantly, a product of the historical data and the characteristics of volatility in past markets.

As such, it retains value in application only to the extent that fundamental relationships between Australian and global equities may not have changed in the period since 2013. I have previously noted that as time passes, that assumption becomes more questionable, meaning that a 60/40 split provides no certainty of continuing to be optimal going forward.

In 2021 I changed the target allocation to a 50/50 split of Australian and foreign equities. This approach is adopted to:

• Assume a ‘neutral’ position on relative equity market performance – Over the long-term in conceptual terms, an equal allocation reduces the portfolio risks of any future Australian equities underperformance compared to global equity indices.

• Recognise the after-tax benefits of franking credits – The remaining 50 per cent weighting to Australian equities still sits close to the optimal balance for reduced portfolio variance and maximisation of franking credit benefits suggested in the Klement et al paper discussed above.

• Reduce portfolio variance – A 50/50 per cent weighting is supported as a minimum variance (i.e. lowest volatility) portfolio allocation by this 2012 Vanguard study (pdf).

• Recognise that pure ‘market capitalisation’ weighting is not required – Due to correlations between Australian and global markets, and the specific benefits provided by the current franking credit regime, it is not optimal to hold the Australian market at the low weighting (2-3 per cent) which would arise from a pure market capitalisation weighting approach.

The Vanguard study (pdf) mentioned above provides an excellent structured framework for individual investors thinking about these issues (see in particular Figures 4 and 11).

Having set this target, I have not realised capital gains in Australian equities to seek to immediately meet it. Nor has it necessarily a rule-based approach of seeking to meet it by exclusively redirecting new investments and distributions to global shares, although this was in practice what did occur over 2022. Rather, it sits as a longer-term goal to directionally guide, but not fully determine, the pattern of future investments.

The reason for this is that exclusively switching to purchases of global shares across these particular relative market valuation and currency regimes would effectively embed a set of risks into the portfolio which are better diversified by regular investments over time. In this way, time itself can be employed as a diversifying factor, in a similar way as dollar cost-averaging.

Over the past year significant progress has been made towards this equal allocation, meaning it is likely to be achieveable over the next year or so.

Bonds and fixed interest

Bonds and fixed interest are intended to play a role in diversification, reducing overall portfolio volatility.

The assumed return of 2.0 per cent for these assets is in line with long term global averages measured since 1900, sourced from the 2021 Global Investment Returns Study and based on data from the Dimson, Marsh and Staunton book Triumph of the Optimists – 101 Years of Global Investment Returns.

A separate review of bond holdings in the portfolio and the relevant investment literature has reinforced the value of a small bond holding, but caused a slight adjustment in the target allocation from a simple equal weighting of Australian and foreign bonds, to a position that reflects the greater diversification benefits of international bonds.

Last year the target bond allocation was reduced from 15 per cent to 5 per cent.

This was due to my personal assessment that the expected real return and diversification benefits of bonds going forward are significantly reduced in market conditions likely to persist over the next 5 to 10 years.

At that time it was difficult to see bonds producing returns close to their long-term historical results in the near-term, following a multi-decade fall in interest rates that has acted as a sustained tail-wind for returns. Last year I observed that with rates at near decade lows, the prospect of significant capital loss was much more likely than any continuation of capital gains that investors have enjoyed since the early 1980s.

The substantial rise in bond yields through last year has supported this view, and delivered deeply negative real returns for bonds. Despite the recent yield rises, at the point of investment, many bonds would currently still be expected to produce near zero or negative real returns in income terms.

Falls in bond prices and rises in yields are suggestive of potentially better returns ahead, however, this remains critically contingent on inflationary outcomes over the short and medium-term.

My assessment remains that current and potential future government policies and monetary policy authority decisions are likely to dampen or eliminate the potential for bonds to profitably serve their traditional role in portfolio design.

This is a set of circumstances – with such policies sometimes termed ‘financial repression’ – that has been experienced at other times of relatively high public sector debts at a global level.

Gold

Gold is as described previously in the role of gold and Bitcoin in the portfolio primarily included in the portfolio as a non-correlated financial instrument for diversification, and to act as an insurance against extreme capital market events or conditions. I have invested in gold, principally through an exchange traded fund, since mid-2009.

No real return is assumed for gold assets held.

Bitcoin

For a significant period it has been uncertain exactly what role Bitcoin may or may not play in investment markets, or as an emerging store of value. As such it remains a high risk and volatile component of the portfolio. No real return is assumed for Bitcoin held, despite its strong performance across the past decade.

Bitcoin is included as an asset in the portfolio following the unexpected growth in value of a small exploratory investment (representing around 0.5 per cent of 2015 portfolio value) to a sizeable component of current overall portfolio value.

At different times Bitcoin has exhibited different correlations to equities, but its overall and enduring investment characteristics going forward cannot yet be clearly disentangled from price impacts from its wider adoption to date.

Generally, over the medium-term it has had an extremely low correlation to the price of gold, potentially making it a valuable additional source of diversification at times where gold fails to serve its intended objectives within the portfolio. Bitcoin also represents, in some senses, an ‘option’ on some forms of monetary policy breakdown and market disorder.

In this way, I view it as broadly part of the ‘alternatives to equity’ portfolio (including gold and bonds) which has constituted between 20-25 per cent of the target portfolio over recent years.

The purpose of this component of the portfolio is diversification and protecting real wealth and purchasing power in circumstances where the primary ‘engine’ of the portfolio – equities – may temporarily be adversely impacted by market events.

Recognising this, and in line with its sharp volatility, and the potential risks and costs of seeking to actively trade Bitcoin, I have not and do not propose to trade to target the specific Bitcoin target allocation.

Rather, the allocation level of 7.5 per cent represents an aspirational average level that I would be comfortable with holding over an extremely long-time frame.

The achievement of this target allocation in any particular year or even five year period is a matter of less importance to me in my personal circumstances. Of more significance is seeking to target over time around 20 per cent of the portfolio being non-correlated to the performance of equities.

Property

I have no formal property allocation for investment purposes, excepting my tiny exploratory investments in fractional residential real estate through BrickX.

In the current market environment my assessment is Australian property is likely to enjoy low yields and returns for a considerable forward period, and not offer sufficient diversification benefits over Australian and global equities or other available asset classes.

Overall long-term portfolio return estimate

Taking into account the above asset allocation and return assumptions, the overall portfolio return is estimated on a weighted average basis at 4.10 per cent, marginally down from 4.18 per cent last year.

This is equal to a nominal return of 7.1 per cent based on an assumption of inflation being at the upper end of the Reserve Bank’s target band over the long-term.

Though providing some guidance around expectations, as discussed above, this estimate no longer plays any role in setting the level of the portfolio goal. Instead, this goal is now calculated by reference to the 3.45 per cent safe withdrawal rate assumption.

Each year I have found it valuable to return to the base of evidence and assumptions underpinning this investment plan, and to review it in the context of developments in markets.

This investment approach has arguably been particularly touched by some cold and searching fingers of winter over the past year. Yet the mild increase in the overall portfolio estimate is perhaps some tentative indication that the inventions of spring could be in prospect.

_{* This specific portfolio allocation and approach has been determined based on my personal circumstances, objectives, assessments and risk tolerances. It is not a recommendation to invest in any particular investment product, security or asset, and investors considering these issues should undertake their own detailed research or seek professional advice.}