No one would have crossed the ocean if he could have gotten off the ship in the storm.

Charles Kettering

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

Portfolio goal

My objective is to reach a portfolio of $2 180 000 by 1 July 2021. This would produce a real annual income of about $87 000 (in 2020 dollars).

This portfolio objective is based on an expected average real return of 3.99 per cent, or a nominal return of 6.49 per cent.

Portfolio summary

• Vanguard Lifestrategy High Growth Fund – $772 191
• Vanguard Lifestrategy Growth Fund  – $44 099
• Vanguard Lifestrategy Balanced Fund – $81 139
• Vanguard Diversified Bonds Fund – $111 360
• Vanguard Australian Shares ETF (VAS) – $174 810
• Vanguard International Shares ETF (VGS) – $32 294
• Betashares Australia 200 ETF (A200) – $250 949
• Telstra shares (TLS) – $1 844
• Insurance Australia Group shares (IAG) – $8 083
• NIB Holdings shares (NHF) – $5 580
• Gold ETF (GOLD.ASX)  – $114 375
• Secured physical gold – $18 455
• Ratesetter (P2P lending) – $13 971
• Bitcoin – $149 920
• Raiz app (Aggressive portfolio) – $17 424
• Spaceship Voyager app (Index portfolio) – $2 446
• BrickX (P2P rental real estate) – $4 485

Total portfolio value: $1 803 425 (-$69 900 or -3.7%)

Asset allocation

• Australian shares – 42.1% (2.9% under)
• Global shares – 22.3%
• Emerging markets shares – 2.3%
• International small companies – 3.1%
• Total international shares – 27.7% (2.3% under)
• Total shares – 69.8% (5.2% under)
• Total property securities – 0.2% (0.2% over)
• Australian bonds – 4.6%
• International bonds – 9.7%
• Total bonds – 14.3% (0.7% under)
• Gold – 7.4%
• Bitcoin – 9.7%
• Gold and alternatives – 15.7% (5.7% over)

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

Comments

Equity markets fell significantly this month, resulting in a portfolio loss of around $70 000. This is the largest monthly fall across the three years of this record in dollar terms, and the third largest as a proportion of assets.

The falls follow a large increase in the portfolio value last month, and have occurred amidst increasing global impacts and fears from the spread of the Corona virus. The losses are mainly in Australian and global equities and have been concentrated in the last two weeks.

Overall, the portfolio fell around 6 per cent from a peak in mid-February. Amidst this downward movement, gold and Bitcoin have performed relatively positively, with the price of gold increasing and Bitcoin mostly maintaining its value. Consistent with their role of diversifying portfolio risks, the value of bond holdings slightly increased over the period.

The equity market losses have left the portfolio below its target Australian equity weighting, so contributions this month have been made to Vanguard’s Australian shares ETF (VAS).

In better news, this month expenditure has been lower than over the summer holiday period, continuing the broader declining trend. The most significant development in looking at the rolling three-year comparison of distributions and expenditure, however, is a new downward slope in distributions.

This is the first in this particular record, and results from the three year averaging window starting to move beyond a period of exceptionally high distributions in 2017. So it is an artefact of the chosen time period, and, for example, the equivalent four year comparison does not show this.

Relocating the emergency stores

This month has also seen a small re-entry into exploration of the world of fintech, through opening an account with Neo-bank Xinja. The motivation was an interest rate of 2.25 per cent, with no complex bonus eligibility rules. Added to this was curiosity about the experience with the product.

The sign-up process was quick and easy, and I am planning to use it instead of a previous Ubank USaver online account – paying less than half of that in interest – for my emergency fund. So far the process has been smooth, and the pre-tax benefit of the switch from the improved rate is around $33 per month.

Worse things happen at sea – modelling future portfolio risks

With a range of markets at or close to highs, pushing progress towards my financial objective forwards in past weeks, I had been considering the issue of downside portfolio risk. Needless to say, the past week has reinforced the value of reflecting on that risk.

To keep this issue steadily in view I have for the past year kept a rough and ready data series, called ‘Market Event’, which rather crudely assumes a rapid 25 per cent fall in equity values. Over the past month I have spent time considering and building a slightly more sophisticated way of modelling the impact of market falls on the portfolio.

This allows some simple scenarios to be modelled, and recognises the potential for different behaviour of individual parts of the portfolio (for example, equities, bonds, gold and Bitcoin) in equity market falls. The value in this is that it allows better visibility of what the portfolio could look like after what are, in historical terms, quite regular occurrences.

The three illustrative scenarios modelled are:

1. Normal 10% equity market decline – These are fairly routine over any length of time investing in equities, and could easily be expected in any given month. The past week – at least so far – is an example of this kind of event.
2. ‘Bear market’ – This scenario is a 20 per cent decline, which could occur in a given month or over a sustained period of decline.
3. ‘Global Financial Crisis Mark II’ – This is broadly based on the equity impact of the Global Financial Crisis on US share markets, including up to a 50 per cent fall.

These are imperfect simplifications of a myriad of possible events over different timeframes. Yet they are still sufficient to give a sense of the range of underlying risks in equity markets.

The question they help answer is: just how does diversification actually reduce risk and volatility? In the scenarios below it is assumed that losses in equities are partly offset by gains in alternative diversifying assets (such as bonds, gold or even – more speculatively – Bitcoin).

The reactions of these alternative assets to equity market falls are not a constant. In fact, research indicates (pdf) that from the early 2000s bonds have transitioned from being negatively correlated to equity (rising when equity prices fall), to be mildly positively correlated at times.

Therefore, populating the three scenarios in Figure 1 has included some assumptions, drawing typically on long-term historical averages and some judgement, rather than just extrapolating performance over the past 15 years.

Testing the waters – the scenarios results

The results of each of these scenarios are set out below.

Figure 1 – Illustrative Effect of Three Market Scenarios on the FI Portfolio

Some observations on the scenarios and model outputs are:

• Downside risk is real and unavoidable in an equity dominated portfolio – There is no escaping that a large fall in equity values will have a significant portfolio impact, even with around 30 per cent of assets being non-equities.
• Diversification helps soften the fall – In large market events, assuming equities move in the opposite directions to other portfolio components, the current portfolio construction tends to reduce losses by around 10 per cent.
• Equity market falls can make a difference to the journey time – A normal to moderate bear market would put the overall portfolio back the equivalent of 6 and 9 months of progress. A Global Financial Crisis style crisis would put the progress of the portfolio back around 24 months

Critically, the results of this thought experiment are sensitive to correlation assumptions.

Relationships between assets returns change over time, in both direction and magnitude. This means reliance on historical relationships is not a certain guide. In the case of Bitcoin, especially, no long historical pattern of relationship exists. Changing the magnitudes or the plus or minus sign from the correlation assumptions I have adopted produces quite different results.

Progress

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

Summary

This month has seen a transition from the heat of summer, smoke, into storms and an unsettled period. This has been reflected in both daily life as well as in the continuing volatility in markets and the portfolio. It has felt like a changing of perspective, and a shifting vantage point upon the world.

The last post sought to trace my shifting perceptions and actions while investing through the Global Financial Crisis. A barrier to this was reconstructing contemporaneous thoughts from the persistent embrace of hindsight bias. This record is partly designed to overcome that problem.

My perceptions on current falls are that they are unsurprising given the strong record of equity markets over the past decade, but that it is simply unknown and unknowable whether they represent a ‘typical’ pull back that routinely occurs, or the opening stages of a sustained downturn in equity markets lasting 12-24 months.

These times can lead to a sense of being a passive observer of events beyond our control. The potential loss analysis above – which was started before the recent downturn – is designed to at least start to put some boundaries around these uncertainties, and volatility.  To ‘practice’ – as it were – facing possible outcomes before we come upon them. Regularly reviewing downside exposures helps re-check that the portfolio risk is at the right level, and avoid complacency from past market gains by reinforcing their potentially temporary nature.

Another method of addressing the same issue is to maintain flexibility around future spending rules or withdrawal rates. This paper (pdf) from Vanguard proposes a particular ‘dynamic spending rule’. This places moving ‘guardrails’ around a spending level, partially recognising the value of market gains (or losses). As a concept, this is potentially a helpful update to simple ‘rules of thumb’ such as the 4.0 per cent safe withdrawal rate (or its 2012 updated version, the 4.5 per cent ‘rule’).

On the same topic, from a different direction, I have been interested in the findings of this research paper (pdf) based on a century of data of Australian equity returns. It makes a strong case for lowering expectations for future returns. Similarly, this interview provides an intriguing suggestion of how the next global financial crisis may originate from central banks, rather than private debt or equity markets.

Finally, Credit Suisse have released their annual yearbook of global investment. This year unfortunately only a partial snapshot of global returns is given. This work highlights the changing nature of global investment through time, as sectors and technologies change, and provides useful historical checks on past global equity returns (5.2 per cent on a geometric basis).

Backed by a century of data, it also reinforces the truism that most journeys are defined by their end, even though storms and uncertainties may assail us on the passage.