If you want to build a ship, don’t drum up people to collect wood and don’t assign them tasks and work, but rather teach them to long for the endless immensity of the sea.

Antoine de Saint-Exupery

Every exploration begins with a leaving of the familiar. This post provides some details of ‘early navigations’ towards building a portfolio of investments to provide a passive income.

There are multiple points at which this exploration could be said to have begun. Finance and investments had interested me ever since income from my first casual job, even if my early financial literacy was low. My first investments were term deposits from Advance Bank (now St George), involving the investment of $500, $1000 or $1500 for now unheard of rates of between 4-6 per cent.

First charting of a course

Rather than give a comprehensive history of explorations, however, it may be best to focus on the process of my planning and developing of my goals in writing. My first written ‘Investment Policy’ was in 2007. Twice a year I check progress against my Investment Policy, and, sometimes, make adjustments to it.

The prompt that made me set fingers to keyboard that particular March 20 is obscure to me. Certainly in the past five years I had absorbed out of interest many personal finance and investing books, including Bernstein’s Four Pillars of Investment, Burton Malkiel’s A Random Walk Down Wall St, Your Money or Your Life, and the delightfully named Bodo Schaeffer’s The Road to Financial Freedom.

This last was a gift from my father. Each of these books I highly recommend, and I see most of them appear regularly on FI blogs recommendations lists. Across these these works, the concept of a written plan, a stable Investment Policy was recommended (in Four Pillars I believe most explicitly).

My first Investment Policy simply stated that the purpose was to build a source of passive income, and had a 15-year term horizon. The asset allocation was likewise simple – a 70 per cent allocation to equities, and 30 per cent allocation to bonds. This was to be achieved through variations in four Vanguard Lifestrategy funds, and two small direct share holdings.

Staying on course

In many ways, this first two-page document was a model of clarity. For example, the principles of management were confined to:

1. To the extent possible the policy should be carried out through as few investment vehicles as feasible
2. Emphasis should be given to maximising after-tax returns through low cost tax efficient vehicles
3. Passive index-based management should be applied due to a lack of evidence that active management can reliably produce above-average returns
4. The target allocation is to be achieved with as much diversification across time, markets and assets as consistent with efficient portfolio management

These still form the key principles of my investment approach today, and have been the least changed, fiddled with, and edited components of my plan. Principle (1) has probably seen the worst weather of any of the principles, due to my curiosity about new products.

Principle (2) is designed to keep a focus on the final objective, total returns. This is important, given some investments can offer superficially attractive yield that either is highly taxed, or which comes at the cost of better overall opportunities when both income and capital growth is considered.

The third principle is one I have applied most consistently. I exited my last actively based investment product in 2004, excluding small BrickX purchases which can be considered small active ‘bets’ on residential property.

The final principle is allocation across time, markets and assets, and this has been carried out by regular investments, accessing different asset markets, and wide portfolio diversification.

Filling in the chart

Over time the Investment Policy I have charted has expanded in detail and complexity. Most of the expansion has been to set out the assumptions underpinning the plan more clearly, for example, by including explicit long-term return assumptions for portfolio components, which feed into the overall portfolio return estimate. Currently this assumes a 5.5 per cent after tax real return on equity and a 2.0 per cent return on debt.

The second area of greater detail has been the explicit description of a range of portfolio risks, and approaches to addressing these risks. Examples of these types of risks include: liquidity risk, counterparty risk and operational risk. This forces a regular consideration of whether there are other less obvious risks that my portfolio is vulnerable to, aside from traditional market-based risk and volatility.

Making course adjustments

The discipline of reviewing my portfolio against the Investment Policy twice a year has been useful in developing my portfolio over time. It forces focused attention on portfolio choices around defined points, and acts as a brake to drifting away from the core intent of the investment plan.

It also helps provide a framework in which new investment options are assessed against the critical question – does this proposed investment help meet the portfolio’s objective. Each ‘course adjustment’ made is there in marked up form, as a documented change. The Investment Policy also provides a structured way in which to think about questions such as: what is the goal? How it will be achieved? Is progress towards the goal is being achieved?

Sometimes this has resulted in significant changes. In 2009 the goal was an unrealistically ‘lean’ one, to reach a portfolio target of $750 000, to produce an income of $50 000 annually. Over time, the goal has evolved in steps to a more realistic level of around $1.5 million to produce a passive income of around $58 000 per annum (close to the common FI ‘four per cent rule’).  This income level was set to reflect a benchmark of the ‘average’ or median income of an Australian employee.

As I progress closer to the goal the looming question is: what does it mean to achieve the goal? Is it a milestone to a longer objective? What might paid work look like after that point? Would I be satisfied with the standard of living which that would represent – or would I seek an additional ‘margin of safety’ or buffer either to reduce sequence of return risk, improve the level of passive income, or because working at that point would still interest me?

Like the familiar sights of home port, the mathematical elements of FI recede at that point, and hard thinking is needed on the direction of next voyage.