The sea is calm tonight.
The tide is full, the moon lies fair
Upon the straits

Matthew Arnold, Dover Beach

This recorded journey towards financial independence started seven 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 being achieved from March 2023 onwards, as well as temporarily before that.

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 including the measures and assumptions I will assume, and discusses how I will approach the closing stages of my financial independence journey through 2024 and potentially beyond.

The aim each year 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.

The full tide on the voyage to financial independence

This year represents a different task to many of those faced before. Last year, the challenge was to rebuild after the most substantial falls in dollar terms that that portfolio ever experienced.

For 2024, however, the task is to build on the tentative and contingent achievements of the past twelve months – in particular, the passing of the portfolio goal, and the secondary target equity level in the portfolio.

While this tide is full the immediate tasks are two-fold.

• First, to provide for a reasonably assured passive income which is consistent in real after-inflation terms with the target chosen.

• Second, to set aside the reserves of cash that will be essential to movement to potential reliance entirely on investment returns and the application of the safe withdrawal rate to the portfolio over an extended multi-decade period.

While the tide is currently full, it can of course turn – quite easily.

The past two years have been an object lesson that arbitrary numerical targets can be exceeded, only for markets to fall back sharply. This is simply what markets do, at times.

So all the plans for the year must bear this caveat: that with a turn of fate, the primary task may revert to what it has before, restoration and achievement of the overall portfolio level, and an equity target.

Begin and cease, and then again begin: updating the target portfolio goal

The target portfolio goal was lifted to $2.75 million at this time last year, largely to account for shifts in annual ordinary earnings, following a much more significant upwards to fully implement a ‘safe withdrawal’ rate approach in 2021.

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

The new objective is to seek to maintain a portfolio of at least $2,870,000 through 2024. This should be capable of producing an annual income from total returns of about $99,000 (in May 2024 dollars).

This updated target is an increase of $120,000 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 2024 dollars in a period of relatively high inflation. Moving the previous target into nominal 2024 dollars and updating average ordinary earnings for real changes fully accounts for the increase of the target.

The passive income target for the objective is updated using May 2023 Australian Bureau of Statistics data (of average earnings of $1839 per week). This is escalated for an expected change of in consumer prices of approximately 3.5 per cent across the period from May 2023 to mid 2024. This figure is a judgement based on the current range of CPI forecasts by the Reserve Bank.

The goal therefore seeks to reflect the approximate equivalent of average Australian full-time ordinary earnings in mid-2024. It remains above my current estimated average annual spending between 2013-2023 of around $88,000.

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

The goal is a key and fundamentally personal choice.

In some circumstances, making this choice represents an irreversible ‘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.

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 relatively 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.

In this way, the 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.

A darkling plain: the use of a safe withdrawal rate approach

Three years ago I changed my approach to setting the portfolio goal by explicitly incorporating a safe withdrawal rate into its calculation. I propose to continue with this approach.

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 noted 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 earlier stages of 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.

The change in approachin 2021 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 continue to be used.

This figure underpins the updated portfolio goal (i.e. $99,000/0.0345 = $2,870,000, with some rounding).

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. In 2023 I reviewed this, and adjusted it slightly downwards to 3.45 per cent.

This year I have not seen any new evidence that would warrant changing this revised estimate, and so propose to maintain it.

On the coast the light: safe withdrawal rate estimate maintained

The reasoning for the decision to maintain an estimate of 3.45 per cent remains the same as in 2023, and is reproduced below.

The choice was 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 found 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.

Two additional factors, supported by some market evidence, might have the impact of lowering the safe withdrawal rate.

These are 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 in 2022 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 recent 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 approximate 30 per cent ‘buffer’ in dollar terms over the new target, 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 2024 figures, the target income of $99,000 would represent a 2.7 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.

To lie before us: changing role of the goal and pre-conditions of financial independence

‘What is the significance of a target one has passed?’ is a reasonable rhetorical objection to the ongoing value of a portfolio goal, at this stage.

Last year was focused on restoring the portfolio to a target already briefly met after reverseals, and this experience lights the way in terms of the potential value in retaining the concept of a portfolio goal.

Even with the upward adjustments to retain the real purchasing power of the revised portfolio income target, the headline portfolio currently sits beyond this.

Yet even leaving aside the volatility of Bitcoin, the role of chance and standard equity market volatility means that the reaching of this target cannot be taken for granted.

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.

This shows that even consecutive monthly falls in the financial porfolio can easily lead to losses in the range of $200,000 – $300,000, as occurred across February and March 2020. Movement through early 2022 also saw losses in this broad range

The implication of this is that future losses could easily push the portfolio, and especially the core equity component of the portfolio, well below the portfolio goal. This could reverse the progress made, and turn the focus again to rebuilding and re-attaining of the portfolio target, and the equity component.

Yet the graph above, and the overall history of the portfolio means another outcome is perhaps more likely – that further gains push the portfolio further above the target, and that once passed, the current portfolio level will not necessarily be revisited.

Interestingly, though the more rationally plausible outcome, this is not the one that feels more probable in anticipation.

The probable should be in focus as plans are made, however, not just the potentialities.

Given this, planning should take into account that the most normal scenario that might occur is variations, but a generally upward movement in portfolio value over the next 12 months.

Round earth’s shore: conditions for the end of the journey to financial independence

The 2021 review highlighted that this closing phase of the journey could turn out to be less about whether a particular portfolio value is reached than previous parts of the journey.

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?

At the end of last year, two of these three conditions were met.

The second condition, the minimum equity target, however, does require updating to reflect the increase in the overall portfolio objective detailed above. This revised equity target is estimated by multiplying the overall portfolio target with the target equity allocation (of 80 per cent, or 0.8).

Taking this into account, the equivalent minimum equity target for 2024 is (with some small rounding), around $2.3 million. This is an increase of $100,000, and has not yet been reached.

Therefore a key secondary focus through 2024 will be achieving the revised minimum equity target, which is $2,300,000, prior to any changes in work status.

All three conditions 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 #2 and #3.

By current estimates, condition #2 should be met in the first six months of the year, with this estimate being based on average monthly equity portfolio increases since 2017. Yet it could also be met easily enough in a strong month or two of equity market growth, or delayed significantly by any sharp falls.

The cash reserve may take through to the end of 2024, there is not as much data and evidence around this, as it will in part rely on cash being set aside, and uncertain future distributions.

Ebb and flow: the measures on the journey to financial independence

The question of what measures to apply to this stage of the journey is not a straight forward one.

Applying benchmarks I have passed would seem redundant, were it not for the potential for backward movements in markets and asset prices. In the case of the portfolio level, it would only serve to mark how much the portfolio might lose, while leaving intact the meeting of the portfolio goal and condition #1.

Generally, I have used a variety of measures over the past twelve months to get a general bearing on the extent of the journey remaining – including dollar deficits compared to the target, or percentage based measures.

The two key benchmarks used have been:

• 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.

The ‘All Assets’ benchmarks increasingly appear to be less relevant at this stage of the journey.

There does not seem particular insight or value in knowing whether, once superannuation is accounted for, one is 40 per cent or 50 per cent above the portfolio target. In circumstances of a catastrophic market fall, perhaps this measure would have some restored salience.

The measure was introduced so as to not ignore a substantial set of financial assets that are large enough to have significant implications for the achievement of financial independence.

Due to the legislative risk and accessibility restriction factors, my 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 these consideration, I may continue to report a total ‘All Assets’ measure from time to time in updates, rather than regularly report the benchmark, or closely detail or write about my superannuation arrangements.

For this – hopefully – late stage of the journey I propose to continue to report two metrics used so far, but to add two others.

I will continue to track the ‘headline’ level of the portfolio against the new revised portfolio goal – noting that it currently sits substantially above it, but that corrections might easily reverse this.

Also, the metric of Total average expenses will continue to be reported, but on a different basis than previously.

This measure is previously defined as percentage progress toward a portfolio value capable of sustaining a moving average of nominal estimated expenditure since 2013 (using the 3.45% safe withdrawal rate). The benefit of this is that it means if my average expenses rise over time, the actual impact on progress is highlighted dynamically.

Currently average total expenditure sits at about $88,000 per year.

This measure will be adapted to be based on a notional income equivalent to the safe withdrawal rate not on the whole portfolio – which includes Bitcoin, but on the narrowly defined ‘financial portfolio’ assets.

This is to recognise that as a non-traditional asset, Bitcoin holdings can not necessarily be assumed at supporting a regular safe withdrawal rate approach. It means it is a conservative movement in the measure, as it is the equivalent of effectively declaring no value at all to the Bitcoin holdings.

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	Progress
Portfolio objective – $2,870,000	116%
Financial portfolio income as % of total average expenses (2013-present) – $87,800	103%
Target equity holding in portfolio – $2,300,000	98%
Financial portfolio income as % of target income – $99,000 pa	92%

Reflections: in the sound, a thought

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

The year ended with significant progress and the achievement of the current portfolio and equity targets.

Resetting the portfolio goal to account for the growth in average earnings since May last year has resulted in a lift of $120,000 in the total portfolio goal, and a consequent $100,000 increase in the equity target.

This change is smaller than last year, as the safe withdrawal rate used to calculate the target has stayed the same.

The magnitude of the change – a 4.4 per cent increase in the raw target, highlights the impacts of higher inflation on a fixed target. Failing to make this adjustment would involve accepting a loss of purchasing power, comparated to the position envisaged in the original target.

Undertaking a understaking a formal, 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.

This review increasingly needs to come to terms with a broader set of issues than the prospective achievement, or not, of a specific headline portfolio, projected forward to a time in the future.

The new set of metrics, added to the existing ones, should help better inform me about relevant benchmarks, now that the focus is broadening beyond a binary focused approach of whether a single number is reached.

The new metrics themselves indicate that the journey is close to completion. Even with the increase in the equity target, the target itself could be reached with just a few quite normal months of equity market advancements. Achieving the entire portfolio using only financial assets could take a little longer, but it again is subject to the same forces, and could easily be within grasp within 6 months, based on prior history.

Indeed, the tide is full, and while there will be ebbs and flows, it is becoming harder to ignore its force and power. While the fates may test this, the most probable result will be that this tide will carry the portfolio in all its dimensions across the shallows in 2024.

Reviewing the investment plan and assumptions

The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelope our future.

J.M.Keynes

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 target allocation adopted in 2023 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 2023.

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 5.0 per cent, a long-term historical figure (from 1900-2022) sourced from the 2023 Global Investment Returns Study.

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 did not realise capital gains in Australian equities to seek to immediately meet it. Rather, equal allocation was gradually achieved over 2023 through new investments and re-investment of distributions.

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.

In early 2022 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 would be 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. In 2022 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 2022 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 only narrowly positive real returns.

The recent 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. Where tax effective avenues exist to exit this allocation, they will be taken.

Overall long-term portfolio return estimate

Taking into account the above asset allocation and return assumptions, the overall portfolio return is estimated to remain at a weighted average basis of 4.10 per cent.

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 approach, it is important to say, could fail to deliver the anticipated real returns and value protection sought. There are no guarantees in investment markets. Rather, each approach represents a contingent deployment of knowledge, and resources to seek to at least hold at bay the forces of time and ignorance, and prevent them from enveloping us.

_{* 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.}