Monthly Portfolio Update – May 2019

Posted on June 1, 2019July 14, 2020 by The FI Explorer

Truth is confirmed by inspection and delay; falsehood by haste and uncertainty.

Tacitus

This is my thirtieth portfolio update. I complete this update monthly to check my progress against my goals.

Portfolio goals

My objectives are to reach a portfolio of:

$1 598 000 by 31 December 2020. This should produce a real income of about $67 000 (Objective #1)
$1 980 000 by 31 July 2023, to produce a passive income equivalent to $83 000 (Objective #2)

Both of these are based on an expected average real return of 4.19%, or a nominal return of 7.19%, and are expressed in 2018 dollars.

Portfolio summary

Vanguard Lifestrategy High Growth Fund – $745 158
Vanguard Lifestrategy Growth Fund – $43 119
Vanguard Lifestrategy Balanced Fund – $77 915
Vanguard Diversified Bonds Fund – $105 821
Vanguard Australian Shares ETF (VAS) – $80 408
Betashares Australia 200 ETF (A200) – $246 012
Telstra shares (TLS) – $1 937
Insurance Australia Group shares (IAG) – $13 376
NIB Holdings shares (NHF) – $8 178
Gold ETF (GOLD.ASX) – $85 424
Secured physical gold – $13 652
Ratesetter (P2P lending) – $23 262
Bitcoin – $132 720
Raiz app (Aggressive portfolio) – $15 130
Spaceship Voyager app (Index portfolio) – $1 883
BrickX (P2P rental real estate) – $4 629

Total value: $1 598 624 (+$57 037)

Asset allocation

Australian shares – 40.9% (4.1% under)
Global shares – 22.3%
Emerging markets shares – 2.6%
International small companies – 3.3%
Total international shares – 28.2% (1.8% under)
Total shares – 69.1% (5.9% under)
Total property securities – 0.3% (0.3% over)
Australian bonds – 5.5%
International bonds – 10.5%
Total bonds – 16.0% (1.0% over)
Gold – 6.2%
Bitcoin – 8.3%
Gold and alternatives – 14.5% (4.5% over)

Presented visually, below is a high-level view of the current asset allocation of the portfolio. Port Alloc May 2019

Comments

The portfolio has experienced strong growth through the month, with a total increase of around $57 000.

This fifth month of continuous growth has seen an important event occur ahead of schedule. Portfolio Objective #1 – which is the ‘median income’ FIRE target that was the goal set at the start of this record in December 2016 – has been narrowly achieved. Port hist - May 2019

My expectation at the beginning of this year was to reach this particular goal only at the end of 2020. This itself was shifted forward from the original goal of passing a slightly lower median income objective by July 2021. The net result of all of this is that a higher absolute portfolio objective has been reached more than two years early.

This achievement may be temporary, as it comes following the equal second longest run of monthly gains in this record. Just an average monthly fall could easily see the portfolio dip well below the objective again, and a prolonged downturn in share markets could easily lead to major declines which would take some time to recover from. At this stage, given that my final Objective #2 is still some distance away and further accumulation is planned, this prospect does not overly concern me.

The portfolio performance this month largely reflects the same drivers that have dominated performance since the journey began. These drivers have been new contributions and increases in Australian shares (through Betashares A200), particularly since the Federal election. In addition, there has been a significant increase in the price of Bitcoin. This led to a portfolio growth which was the sixth highest in the record to date. Port chng - May 2019

Credit card spending has been significantly lower than average over the past month. It has been the lowest level in six years in fact. As the series below indicates, however, it is a volatile measure. Credit card monthly - May 2019 Once financial year 2018-19 figures on distributions are finalised early next month, it’s likely the the red line of distributions, which currently is an estimate based on low December half year figures, will be revised up. This in turn could mean a return to distributions on average coming close to meeting credit card expenses.

Progress

Progress against the objectives, and the additional measures I have reached is set out below.

Measure	Portfolio	All Assets
Objective #1 – $1 598 000 (or $67 000 pa)	100.0%	137.3%
Objective #2 – $1 980 000 (or $83 000 pa)	80.7%	110.8%
Credit card purchases – $73 000 pa	91.8%	126.0%
Total expenses – $96 000pa	69.8%	95.8%

Summary

Progress over the last few months has been swift and surprising. Timelines set less than six months ago have been met, and the portfolio has entered into the ‘between’ phase of being above my minimum objective, but some distance from my ultimate goal (Objective #2).

Part of the process of adapting to this phase is understanding its true nature – its permanence or otherwise, and looking through short-term movements to try to discern the underlying picture. In short, inspection and delay.

This what lies behind recent posts seeking to analyse the income potential of the portfolio, and longer term trends in distributions and expenses. Seeking the additional data point of what this portfolio delivers currently is the reason I am straining forward to see the size and shape of the end of June distributions.

The advice commonly offered in the financial independence community at this point is crystal clear. Pay less attention to the numbers, and start exploring and building the life you desire now. The advice is so universal, and so intuitively sensible that I do not ignore it. With Australian and global equity markets poised as they are, however, I feel a resisting force going too far down this path. This is mostly stemming from a suspicion that prior to the goal being reached there might be one or more unavoidable challenges to come.

This may be linked to an increased probability of Australian interest rate reductions, and even the entry by Australian monetary authorities into some form of quantitative easing. As inflation stalls, and housing markets decline, the macroeconomic conditions appear less predictable than at any time since 2009. Some of the global financial trends and developments that are of most concern are well discussed in the most recent Incrementum AG In Gold We Trust report, which has as its theme declining trust across the global financial system.

While that outlook might suggest protective action, overall I am comfortable with the extent of my diversification across less-correlated assets. It should be remembered that I felt similar unease two years ago – and that indulging in market timing at that point would have had high opportunity costs.

In any case, more and more it is evident that the performance of the portfolio is not something that can be materially altered by one or two monthly investment decisions. Rather, it is a function of the interaction of unstable markets with the compound effect of hundreds of smaller individual investment contribution decisions taken over the past decade or so across a range of different market conditions.

Following on from my quick Bitcoin and gold correlation analysis last month, I was interested to see this ‘portfolio optimisation’ based analysis on the role of Bitcoin in a portfolio, using just seven years of historical data. Also, this What’s Up Next podcast on finding the right time to retire is a fascinating discussion of the issue of knowing when it is time to put into action FIRE plans. Finally, Aussie HIFIRE has recently pulled together a post highlighting the different voices in the Australian FIRE blogging community for readers.

As winter takes hold, the portfolio is prepared for as yet undefined challenges and storms that may emerge, and I remain intensely curious at what the coming set of distributions will disclose about the distance I still have to travel. One port gained, the next leg of the journey beckons.

Set and Drift – Estimating Future Income from the Portfolio

Posted on May 18, 2019January 15, 2022 by The FI Explorer

Cultivate an asset which the passing of time itself improves.

Seneca, Letters XV

The focus of the voyage to financial independence so far has been designing the portfolio, and measuring the distance still to travel. There is more basic question to be asked as the journey progresses – will the portfolio produce the income targets set for it, or will something need to change?

Currently, the income estimates from the portfolio targets – $67 000 from a short-term target of around $1.6 million and $83 000 from a target of around $2.0 million in several years – are set on an assumption of a total portfolio return of 4.19 per cent.

That does not mean, however, that the portfolio will simply automatically produce an income of that level. Just pointing the ship in the direction of travel is not enough. This is because the total return assumes both capital growth and distributions or interest.

This analysis examines what income the portfolio is likely to produce when the targets are achieved, and assesses whether or not selling down or changing the portfolio in other ways to meet the income goals may be necessary.

To answer this question, history and three different methods of estimating the potential income produced by the portfolio are reviewed.

Approach #1 – Navigation by landmarks

The first approach is to simply use what is already known to establish one’s position.

Previous analyses have discussed the overall trends in portfolio distributions, and reached some approximate estimates of the likely underlying level of distributions. These estimates differ according to the precise method chosen, and time period considered. So far, these analyses have established that the portfolio appears to be generating between:

$5 000 per month or $60 000 per year, if an approach where the moving average of the past three years of distributions is used; or
$3 800 per month or $45 000 per year, if a conservative approach of an average of the past four years of distributions is applied.

This is healthy progress, however, both of these figures are short of the Objective #1 income requirement of $67 000 per year (or $5600 per month), and even further from the projection of $83 000 (or $6 900 per month) under Objective #2.

Will the future look like the past?

These historical figures are useful because they are real data based on holdings in the actual portfolio. Their disadvantages are that they are backward-looking. This has two possible impacts.

First, the growth of more than 50 per cent in the total portfolio size over even the past three years means that the level of historical distributions will underestimate the income generation potential from the now larger portfolio. In short, this is like trying to estimate interest from a bank account by looking at your balance three years ago.
Second, the distributions of three or four years ago will reflect past asset allocations, and investment products. As an example of this, two years ago the portfolio contained over $55 000 invested in Ratesetter’s peer to peer lending platform. This was earning an average income return of 9.1 per cent. Today, Ratesetter is less than half of this size, due to a slow asset reallocation process and withdrawals as loans mature.

This suggests a purely backward view of the actual achieved distributions may be incomplete and misleading.

Taking an average distribution rate approach

The other potential way of estimating the income return of the portfolio is to use the average distribution rate of the portfolio in the past.

The rate is calculated as total distributions over a defined period divided by the average portfolio level over the same period.

This eliminates any errors from the first impact discussed above of growing portfolio growth size, as it is a rate rather than a level measure. It does not eliminate the second impact. For example, higher interest rates meant that cash holdings in 2013-14 could make up over third of total distributions, a position not likely to reoccur in the short or even medium term.

Yet it still may be an approximate guide because while overall portfolio asset allocation has shifted in the past two and half years, it has remained within some broad bounds. As an example, total equity holdings were at 70 per cent of the portfolio both 5 and 10 years ago. Additionally, using a median long-term average of 4.4 per cent will tend to reduce the impact of one-off changes and outlier data points.

As established in Wind in the Sails the average distribution rate over the past two decades has been around 4.4 per cent.

SAD Dist Average This implies that the portfolio would produce:

$5 900 per month or $70 300 per annum income when the portfolio is at Objective #1 (e.g. this suggests that the target income at Objective #1 would be met, with around $3 000 to ‘spare’).
$7 300 per month or $87 100 per annum income when the portfolio is at Objective #2 (e.g. as above it suggests meeting Objective #2 would produce around $4 000 more income than actually targeted).

An interesting implication of this is that the portfolio has been producing distributions (at 4.4 per cent) at a rate that is higher than the overall rate of assumed long-term total return (around 4.2 per cent).

This is consistent with the fact that the Vanguard funds, and to some extent shares and other ETFs have been realising and distributing capital growth, not just income. This means that if I truly believe my long-term total return forecast is more accurate than the distributions estimate, I would need to re-invest the difference, to ensure I was not drawing down the portfolio at a higher rate than intended.

Approach #2 – Navigation by ‘dead reckoning’

A different approach to reaching an income estimate from the portfolio is to forget about the actual history of the portfolio, and look to what the record shows about the average distribution rate from the asset classes themselves.

That is, to construct an hypothetical estimate of what the portfolio should produce, based on external historical data on average income from the individual portfolio components of Australian shares, international shares, and fixed interest.

To do this, estimates of the long-term income generated by each of the asset classes in the portfolio are needed. For this ‘dead reckoning approach’ I have used the following estimates.

Table 1 – Asset class and portfolio income assumptions

Asset class	Allocation	Estimated income	Source
Australian shares	45%	4.0%	RBA, 1995-2019, May Chart Pack
International shares	30%	2.0%	RBA, 1995-2019, May Chart Pack
Bonds	15%	1.0%	Dimson, Marsh and Staunton Triumph of the Optimists 101 Years of Global Investment Returns, Table 6.1
Gold/Bitcoin	10%	0%	N/A
Total portfolio	100%	2.55%

This analysis suggests that at the target allocation for the portfolio, based on long-term historical data, it should produce an income return of around 2.6%.

This equates to:

$3 400 per month or $40 700 per year when the portfolio is at Objective #1
$4 200 per month or $50 500 per year when the portfolio is at Objective #2

These figures are also well short of the income needs set, and so imply a need to sell down assets significantly to capture some of the portfolio’s capital growth.

Abstractions and obstructions

Of course these figures are highly averaged and make some simplifications. Year to year management will not benefit from such stylised and smooth average returns. Income will be subject to large variations in distribution levels and capital growth will vary across asset classes and individual holdings.

Another simplification is that is analysis does not include the value of franking credits. If it is assumed that Australian equities continued to pay out their historical level of dividends, and the franking credit rate remains at the historical average of around 70 per cent then Australian shares dividends should yield closer to 5.2 per cent, lifting the total income return of the portfolio to around 3.1 per cent. In turn, this would marginally reduce the capital sell-down required. Adjusting for this impact means the portfolio income would be $4100 per month at Objective #1, and $5100 per month Objective #2

Yet these assumptions can be challenged. It is possible that the overall dividend yield of the Australian market will fall and converge with other markets. This would be particularly likely to happen if further changes to dividend imputations or the treatment franking credits to occur. It could also occur due to a maturing and deepening of Australian equity markets and domestic investment opportunities available to Australian firms. Shorter term, uncertainty around the future ability of shareholders to fully benefit from franking credits could encourage a payout of credits currently held by Australian firms.

Approach #3 – Cross-checking the coordinates

Due to these simplifications and assumptions, it is appropriate to cross-check the results of one method with other available data. An alternative to either a purely historical approach using distributions received, or the stylised hypothetical above discussed in Approach #2, is relying on tax data.

Specifically, taxable investment income can be estimated as the sum of the return items for partnerships and trusts, foreign source income and franking credits (i.e. items 13, 20 and 24) in a tax return.This has been previously discussed here.

Using this data is – of course – not independent of my own records of distributions. Its benefit is that it strictly relies on verified data provided in tax calculations. This will include income distributions and realised capital gains from within Vanguard funds, for example, but will not pick up unrealised capital gains.

As with Approach #1, as the portfolio has changed in size and composition the absolute historical levels of taxable will not necessarily produce the best estimate of the expected level of distributions looking forward. For example, because it is drawing on a period in which the portfolio was smaller, a five year average of investment income would suggest future annual investment income of $32 300 or $2 700 per month.

So instead an ‘average rate’ approach can be used to overcome this. Over of the past five years, the portfolio has produced an annual taxable investment income of around 3.5 per cent of the value of portfolio. This in turn implies an average taxable investment income of:

$4700 per month or $56 000 per year when the portfolio is at Objective #1; and
$5800 per month or $69 000 per year when the portfolio is at Objective #2

Once again, these estimates imply the existence of a significant income gap remaining at reaching both portfolio objectives.

Summary of results

So far historical data from the portfolio and three different approaches have been set out to seek to answer the question: how much income is the portfolio likely to produce?

Comparing estimates and income requirements

These individual estimates (blue) and the average of all estimates (green) are summarised in the charts below, and compared to the monthly income requirements (red) of both of the portfolio objectives. The chart below sets out the estimates for Objective #1. SAD Chart Ob1 The following chart sets out the same data and projections for the portfolio when it reaches Objective #2 (a portfolio total of $1 980 000). SAD Chart Ob2-corr The analysis shows that:

Portfolio income is likely to be below target at reaching Objective #1 – Using the approaches and history as a guide the portfolio should on average produce an income of around $57 000 per annum at Objective #1
And also below target at Objective #2 – When Objective #2 is reached portfolio income should on average be around $71 000
Therefore an income gap does exist to solve – Under most estimation approaches there will be a significant income shortfall at reaching both Objective #1 and #2
The gap is significant, but not disastrous – Assuming an equal weighting to the three approaches and actual historical distributions over the past three years the size of the income gap will be around $900 per month at Objective #1 (or $10 200 per annum) and greater, around $1000 per month at Objective #2 (or $12 000 per annum)
Only one estimation approach doesn’t identify a gap – Only if the ‘average distribution rate’ approach under Approach #1 is accurate will there be no income shortfall.

This implies that at the $1.6 million target of Objective #1, a small portion of any portfolio gains (around 0.6% of the value of the total portfolio) would need to be sold each year to meet this income gap. An identical result applies at the Objective #2, around 0.6% of value of the total portfolio would need to be sold annually.

Another intriguing implication of the reaching the average estimates is that it allows for an approximation of the required portfolio level to rely entirely on portfolio income, and avoid any sale of assets. At both portfolio Objectives the average of all estimation approaches indicate portfolio income of around 3.5 per cent.

Reversing this figure for the target portfolio income (e.g. for $67 000 at Objective #1 is 0.035/67000) implies a portfolio need of $1.91 million. For the higher target income for Objective #2, the implied portfolio required to not draw down capital is close to $2.4 million. This would require many additional years of future paid work to achieve.

Trailing clouds of vagueness

There are many caveats, inexactitudes and simplifications that should loom large in interpreting these results. The level of future returns as well as their income and capital components are unknowable and volatile.

In particular, the volatility of returns introduces key sequence of return risks that are simplified away by the reliance on deceptively stable historical estimates or averages. Particularly sharp movement in asset prices could change the asset allocation. Legislative or market changes could change the balance of income and capital appreciation targeted by Australian firms.

For these reasons, the analysis does not make me consider any particular remedial action. It indicates that under a range of assumptions and average outcomes, there will need to be a sale of some investments to meet the portfolio incomes targeted.

The same analysis shows that the superficially attractive choice to live only off portfolio income would in reality mean aiming for a target around 20 per cent higher – needing an extra $300 000 to $400 000 – potentially adding many years to the journey.

The relatively small scale of the required sales is the most surprising outcome of this analysis. Selling around 0.6 per cent of the portfolio annually does not on its face appear to be a high drawdown in most market conditions.

Another potential issue to consider is what this result means for asset allocation. There is no doubt that history would suggest that the income gap could be reduced by either reducing the bond allocation, or lower yielding international shares.

To give a sense of the magnitudes of this – using the ‘dead reckoning’ Approach #2 set out above – allocating 100 per cent of the equity portfolio to Australian shares would produce around $900 per month (or $10 300 per year) additional distributions at the Objective #1 portfolio of $1.6 million.

In theory, this domestic shares only option would all but close the income gap. Yet the benefits of diversification and risk reduction bonds and international shares offer make this a trade-off to consider, not a clear choice. At present, my plan would be to revisit this issue at my annual review of the portfolio asset allocation.

In the meantime, having produced these estimates has helped starting to think in more concrete terms about the draw down phase, its challenges and mechanics. In a small way, this seems to clear some of the clouds away, and enable me to glimpse some possible futures more clearly.

* Note: The historical average estimate for this purpose has been proportionally adjusted to increase based on the increased size of the portfolio between now and reaching Objective #2

Monthly Portfolio Update – April 2019

Posted on May 1, 2019January 15, 2022 by The FI Explorer

Consider anything that is humanly possible and appropriate to lie within your own reach too.

Marcus Aurelius, Meditations VI.19

This is my twenty-ninth portfolio update. I complete this update monthly to check my progress against my goals.

Portfolio goals

My objectives are to reach a portfolio of:

$1 598 000 by 31 December 2020. This should produce a real income of about $67 000 (Objective #1)
$1 980 000 by 31 July 2023, to produce a passive income equivalent to $83 000 (Objective #2)

Both of these are based on an expected average real return of 4.19%, or a nominal return of 7.19%, and are expressed in 2018 dollars.

Portfolio summary

Vanguard Lifestrategy High Growth Fund – $756 860
Vanguard Lifestrategy Growth Fund – $43 529
Vanguard Lifestrategy Balanced Fund – $78 182
Vanguard Diversified Bonds Fund – $104 579
Vanguard Australian Shares ETF (VAS) – $79 067
Betashares Australia 200 ETF (A200) – $231 216
Telstra shares (TLS) – $1 801
Insurance Australia Group shares (IAG) – $13 742
NIB Holdings shares (NHF) – $6 900
Gold ETF (GOLD.ASX) – $83 465
Secured physical gold – $13 438
Ratesetter (P2P lending) – $25 278
Bitcoin – $81 867
Raiz app (Aggressive portfolio) – $15 154
Spaceship Voyager app (Index portfolio) – $1 880
BrickX (P2P rental real estate) – $4 629

Total value: $1 541 587 (+$61 677)

Asset allocation

Australian shares – 41.6% (3.4% under)
Global shares – 23.4%
Emerging markets shares – 2.7%
International small companies – 3.5%
Total international shares – 29.7% (0.3% under)
Total shares – 71.3% (3.7% under)
Total property securities – 0.3% (0.3% over)
Australian bonds – 5.9%
International bonds – 10.9%
Total bonds – 16.8% (1.8% over)
Cash – 1.2%
Gold – 6.3%
Bitcoin – 5.3%
Gold and alternatives – 11.6% (1.6% over)

Presented visually, below is a high-level view of the current asset allocation of the portfolio.

Apr 19 - Pie

Comments

The portfolio has experienced a positive month, with a total growth of $61 677. This places the portfolio well above its previous highs and potentially within two to three average months of reaching Objective #1.

Port level - Apr 19

The portfolio grew by the third highest absolute monthly amount since start of this record. Growth in the value of both Australian and international equities was a major part of this increase. This was assisted by the final dividends from Australian equities ETFs Vanguard VAS ($903) and Betashares A200 ($1894) that were received this month. These were reinvested in the A200 ETF with a small proportion being set aside to meet future associated tax liabilities. Apr 19 - Mnty chng

Nearing the end of ‘the big rebalance’?

As the end of the financial year draws closer, choices around where to allocate future contributions and reinvestments may become slightly less clear cut than they have been for much of the journey.

This is because barring any major market movements, the portfolio is nearing the end of what could be called ‘the big rebalance’ that commenced at the start of this record. This has involved consistently targeting higher equity allocations (first 65 per cent, then 75 per cent) and lower bond holdings.

The movements involved in this rebalancing phase have been significant. Contributions and capital growth have lifted the portfolio’s overall equity allocation from around 60 per cent over 2017 to around 71 per cent currently.

Apr 19 Big shift 2.png The value of total equity holdings has increased from around $630 000 to close to $1.1 million since January 2017. Within this expanded equity portfolio, a significant change in composition has also occurred, as the chart above shows. Gradually, Australian shares have moved from representing a minority of total equity holdings – around 40 per cent of all shares – to now approaching 60 per cent. In pure value terms, Australian share holdings have increased from $277 000 to around $641 000 since the start of this record. The split between Australian and international shares is now close to my selected optimal position.

Over the same period portfolio bond holdings have fallen from around 25 per cent, to just 16.8 per cent. This has occurred by total bond and fixed interest holdings remaining at approximately $250 000.

This all means that future contributions, reinvestments or portfolio decisions may over time become less singularly focused on the purchase of Australian shares ETFs such as A200. The focus may shift to more a diverse and dynamic re-balancing approach, in which the objective is to gently and directionally ‘nudge’ the portfolio into alignment with its target allocations using a mix of new contributions and reinvested distributions. This will not happen all at once, as the equity portfolio is still just short of the target of 75 per cent, and market movements can have their own unpredictable impacts.

Role of Bitcoin: uncorrelated manoeuvres in the dark

An unusual source of around one-third of the portfolio growth this month has been an appreciation in the value of Bitcoin holdings. This increased by around $18 000 this month.

Over the past year or so Bitcoin has more frequently made a negative contribution, reducing the overall portfolio. I still regard it as a highly speculative element of the portfolio included not because I recommend its purchase by an investor, but simply by virtue of not wishing to ignore its current value and its contribution to net portfolio value.

It also remains in the portfolio as an asset under an assumption that it is uncorrelated to other similar defensive holdings, whilst sharing some of the characteristics of gold (for example, it does not represent another party’s liability). Over this month reflecting on these issues, I had time to undertake a brief analysis of whether it had actually delivered on this goal or promise of being a non-correlated asset, and whether it moved in a distinct way compared to the existing gold holdings in the portfolio.

The chart below sets out the measured correlation between the main portfolio gold holdings (GOLD.ASX) and Bitcoin, over the past three or so years.

Bitcoingold From the chart it can be seen that the correlations are highly unstable, and do average close to zero over the period. This means that compared to the gold holdings, Bitcoin is likely to be delivering some diversification benefit – and adding to overall portfolio stability.

Progress

Progress against the objectives, and the additional measures I have reached is set out below.

Measure	Portfolio	All Assets
Objective #1 – $1 598 000 (or $67 000 pa)	96.5%	133.7%
Objective #2 – $1 980 000 (or $83 000 pa)	77.9%	107.9%
Credit card purchases – $73 000 pa	88.5%	122.7%
Total expenses – $96 000pa	67.3%	93.3%

Summary

The past month has brought the portfolio to within a short distance of Objective #1. Indeed, it could be only around 2 to 3 months away using the average monthly trend of the past three years.

This is causing further reflection on the exact psychological meaning of reaching that first target. It is most definitely not a trigger point to retire early. The existence of the second portfolio objective is clear recognition of that. Rather, it feels more like a minimum threshold, that once crossed, is some assurance of a minimum future living standard set around the Australian average, regardless of employment or common life events.

Each step beyond this point will, I think, feel like an additional protection, building towards Objective #2. Therefore the gap between Objective #1 and #2 feels like a large ‘safety zone’ in which life events can be viewed with a greater detachment and objectivity. That is, they can be viewed as simply opportunities and inevitable change, rather than as threats or obstacles to achieving the security of financial independence.

This need to be tempered always with the caveat that, viewed over the long term, no simple ‘rule’ of 4 per cent or otherwise will offer a complete guarantee. Simply put, over long periods nothing is safe from adverse events. This recent podcast of some of the most well-known US financial independence bloggers – including those with a quantitative and analytical bent such as Big ERN – provided some excellent insights into assessing the risks of FI in a balanced way.

A point emerging from the discussion is agreement that over period above 30 years, financial independence plans that rely on amortisation – consumption or a drawdown of capital – are not amenable to simple set and forget ‘4 per cent rule’ style approaches often promoted. Rather, they require a more nuanced approach, and an appreciation that even ‘successful’ outcomes can feel indistinguishable from failures, potentially for years or a decade or more. Flexibility is recommended, yet as BigERN’s analysis shows, this is no panacea.

The Australian FI community continues its pleasing growth, with Snowball Journey recently joining the community. Through the Easter holidays I also listened to an intriguing ChooseFI podcast on dividend investing and read through an interesting report from the Grattan Institute on retirement incomes (pdf).

As Autumn begins to fade, I cannot help but wonder if a period of strong market gains will themselves fade and transform themselves in coming months. Even amidst such movements, however, I will be looking down the path towards the June distributions with curiosity and anticipation at what could lay within reach.

On the Wind – Reviewing the Record of Distributions and Expenses

Posted on April 17, 2019February 14, 2021 by The FI Explorer

But no new findings will ever be made if we rest content with the findings of the past.

Seneca, Letters XXXVII

Measuring distributions and expenses

Over the last three years the investment portfolio has delivered substantial distributions, leading to a brief period in which it appeared that an accidental goal of ‘Credit card FI’ might have been met. Subsequently that prospect receded, due to a sharply lower set of distributions for the half year to December 2018.

Over six months ago Reviewing the Log examined the issue of how my current passive income from distributions compared against both my credit card expenditure and total spending.

This article seeks to update that previous analysis, but also to go further and reach a fuller and more robust picture of overall trends in how distributions and expenses compare over time.

In particular, this article seeks to identify the likely current ‘gap’ between distributions and monthly expenses. This represents a different and arguably more empirical way of viewing and measuring actual day-to-day progress to FI, compared to simply tracking progress to a numerical portfolio goal.

Even so, they are in some senses also different sides of the same coin. This is because the portfolio goals I am aiming for are reverse engineered from target FI income levels, which are translated into lump sum targets, using an assumed average return (currently 4.19 per cent). Each month I report a percentage progress towards these goals. Currently, by this simple lump sum measure, the portfolio is around 90 per cent of the way to Objective #1 and just under 75 per cent of the way to Objective #2.

Re-examining the logs and records

When the monthly record of credit card expenses, total expenses and distributions is examined it is clear that credit card expenditure is volatile, but has a comparatively stable average of around $6000 per month, or around $72 000 per annum. The distributions, on the other hand, have been either stable or growing for most of the past six years, with the exception of the large reduction in the half year to December 2018. During this last half year to December, distributions averaged at around $2 600 a month.

The chart below sets out a ‘credit card only’ (blue) and a ‘total expenses’ series against an averaged measure of monthly portfolio distributions (in red). The green line represents actual credit card expenses, added to an equal monthly contribution of other non-credit card expenses. Total expenses here just includes items such as rates, energy and utility costs, day to day cash, as well as contributions to irregular major expenses such as holidays, house and car repairs, as well as eventual car replacement. Fig 1 - monthly

Note that all segments of the red line reflect annual distributions, except the last period from July 2018 onwards. The red line from July 2018 to the present will need to be revised once the June 2019 half year distributions are known.

This revision is highly likely to lift the currently assumed average distribution for 2018-19 of about $2600 per month. This lift is likely because currently the red line from July 2018 onwards is based on a simple extrapolation or continuation of the traditionally lower December figures. The true underlying level of distributions this financial year may well be higher. In fact, June half year distributions have usually been well above the interim dividend amounts of the December half year.

Depending on the estimation method used, the June 2019 half year distribution could be in the range of $23 000 to $51 000, with an average estimate of around $42 000. This in turn could lead to total annual distributions for financial year 2018-19 being in the range of $39 000 to $66 000 (or between $3 250 to $5 500 per month respectively). For comparison, the five year average of distribution is around $45 000 (or $3 750 per month). The final figure will simply be an unknown factor until early July.

Off-course or temporary shallows?

The same considerations are relevant for examining a second measure of progress. The below figure charts the proportion of total expenses met by annual distributions. Fig 2 - Total Ex Dist Since the last update of this graph more than six months ago, the proportion of expenses met by portfolio distributions has fallen, and for the same reason – the low distributions in the half year to December 2018.

Even with this significant fall, from July 2018 to the present, these lower distributions have generally been sufficient to meet between 30 to 40 per cent of total expenses. In overall trend terms, it also suggests the true underlying distributions potential of the portfolio is likely to be sitting at around 60 to 70 per cent (see dotted trend line).

Looking through the weather – adjusting the view

These two ways of viewing progress each have their advantages, but suffer the same disadvantage of being volatile measures of progress. This volatility arises from both monthly variations in expenses, and large variations in distributions between and within years. These variations occur due to a range of factors, such as realisations of capital gains related to rebalancing within some pre-mixed Vanguard retail funds, as well as changes in bond yields or interest rates.

To address this the following chart seeks to account for these multiple sources of variation by adopting a three year moving average for both credit card expenses and distributions. The trade-offs in using this approach is that a three year moving average reduces the time period able to be covered, and can also mute broader emerging trends that should be of concern. Additionally, three years is not close to a complete economic cycle. Thus it is quite possible, for example, for distributions that are abnormally high for two consecutive years to impact this moving average measure.

The advantages of an averaged approach are obvious, however. By reducing the variations and monthly ‘noise’, and taking a relatively conservative assumption (in an increasing portfolio) that the last three years may provide an approximate guide to the true underlying level of distributions, a clearer and more stable picture of overall progress can be gained. Fig 3 no outline From this particular view, a few points emerge:

Credit card expenses have remained very stable at around $6 000 across the past three years with no systematic movements up or down
From January 2017 onwards distributions increased steadily until they reached around $5 000 per month in the middle of 2018
Since that time they have levelled off, and even slightly reduced, as the lower recent distributions form a greater part of the average

The data in the chart suggests a remaining gap of approximately $1 000 per month between distributions and credit card expenses, or distributions being sufficient to meet approximately 80 per cent of credit card expenses or 60 per cent of total expenses. In turn, this means that viewed as a multi-year average, ‘credit card FI’ has not been receding as sharply as volatile month to month figures suggest. It remains, in short, in view if not yet in range. The true average gap measured in these term is likely to continue to gently increase in the lead up to June 2019 distributions, but then potentially either level off or continue to close.

Overall this measure better reflects how the journey has felt so far. A beginning from a firm basis, constant steady progress over the time of the journey, but some significant distance to close yet.

Taking new bearings – an alternative approach

To reach the best view of where one is, it is sometimes useful to use cross-checks that relies on slightly different data.

An alternative approach to reaching a sound estimate which takes into account more stable annual data is to use tax assessment data. The chart below is based on assessed taxable investment income. It is taken from the tax return items of income from partnerships and trusts, foreign source income, and franking credits (i.e. items 13, 20 and 24, excluding capital gains) over the past ten years. This taxable income then given as a proportion of my portfolio objective #1, of $67 000 per year.

Fig 4 - Taxable From this chart some observations can be made:

For the past three years the equivalent of around 50 to 60 per cent of my first financial independence objective of $67 000 has been met by investment income
The past two years have been materially higher than other years – this could perhaps represent an anomaly, however, the overall portfolio that was producing distributions also grew by around 70 per cent since 2015-16, which would tend to support the higher later figures being sustainable
Annual variations do occur – with two out of 10 years registering some backward movement

The picture from taxable investment income then seems to support a gradual movement over the past three financial years materially closer to Objective #1, and some confidence that this is more likely than not to be maintained in the current financial year. Taking a three year average it suggests in investment income terms that around 55 to 60 per cent of Objective #1 income is likely to be covered by current distributions.

Summary – on the wind or a voyage becalmed?

Looking at the data highlights a few different points. Progress is not always linear, or exponential, even with compounding effects and well into the FI journey. Yet equally it shows it is possible over the course of several years to go from distributions making a small supporting contribution to ongoing expenses, to the equivalent of paying off the majority of a monthly credit card bill.

From reviewing the records and expanded data it is apparent that ‘credit card FI’ – not exactly a universally recognised stage of FI – is not yet achieved. Longer term progress on the goal will be clearer when June distributions are finalised in the next three months.

Depending on their final levels, between 55 and 90 per cent of annual credit card expenses will be covered by annual distributions. Reviewing past averages of card expenditures and distributions indicates that about 80 per cent of journey may be complete already, leaving a gap of only $1 000 per month.

Moving beyond credit card expenses – the lower distributions over the past six months have been equivalent to only 30 to 40 per cent of total expenses. Using independent tax assessment data indicates that the portfolio is currently generating between 50 and 60 per cent of the total yearly expenditure target under Portfolio Objective #1, with recent portfolio growth meaning the higher end of this range is a more probable guide than the lower.

In the first examination of these trends more than six months ago I observed the inevitable issue of volatility and noted that is was not impossible for future periods of higher expenditure to coincide with lower portfolio income. This could still occur, and clear precedents exist for it. Averages and forecasts have the power to mislead as well as guide.

Yet overall, looking back at the record puts some firm underpinnings to the progress already made – and leads me to strain forward for the next set of bearings.