We shall not cease from exploration
And the end of all our exploring
Will be to arrive where we started
And know the place for the first time.

T S Eliot, Little Gidding

This exploration began three 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, enabling the bringing forward an achievement of this initial goal.

Each year at this time I have spent time reviewing investment goals and how I plan to reach them.

This post explains findings from my annual review, details my updated portfolio goals and assumptions, and discusses how I will approach my financial independence voyage through 2020 and beyond.

The aim 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. The process also enables the updating of plans and assumptions for changes in circumstances, thinking, as well as data and evidence.

Initial landfall and the beckoning final voyage

Last year saw the reaching and passing of the updated Objective #1 more than a year earlier than targeted. This leaves the previous Objective #2 (set at $1 980 000 in 2018 dollars) as the only one left to reach, barring a significant equity market fall.

So to recognise this I intend to reconfigure my goal, simplifying it to a single Portfolio Objective.

This new single 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 re-based target is an increase of $200 000 on my previous Objective #1. The reason for this increase is revised investment return assumptions (discussed below), and updating the income target for movements in inflation and average earnings.

The passive income target for this objective is updated with 2019 data. It seeks to reflect in 2020 dollars the approximate equivalent of average Australian full-time ordinary earnings. It is also close to my current estimated annual spending of $89 000.

As with the previous Objective #2, this goal is designed to reflect a more ‘business as usual’ lifestyle, rather than a ‘leanFIRE’ existence. This is personal choice. Put simply, as I considered my goals for financial independence, it is closer to the level of expenditure at which I think I will be truly indifferent to working or not.

The actual Portfolio Objective target of $2 180 000 is estimated by dividing the passive income target by a real return of 3.99%, equivalent to a nominal return of 6.49%. The real return assumption is based on the portfolio allocation discussed further below.

Triangulating a position – setting the target timeframe

To reset the target timeframe for how long it would take to achieve this objective, I looked at three alternative measures. These were past average portfolio gains, taking into account just contributions, and a simple trend-line forward projection of progress based on monthly data points over the past three years.

Each of these are highly imperfect approximations, and cannot fully account for the volatility likely to be encountered in any projection into the medium term. They also cannot account for deviations in distributions, extra savings from past changes to the levels of emergency funds, or a dozen other complicating factors.

But a rough average of the approaches suggests that reaching the target by July 2021 – or only 18 months away – is feasible based on past progress.

Mathematically, as the portfolio grows in size the timeline for meeting the target is quite likely to be impacted more by market fluctuations over the next two years than raw saving and investment efforts. As an example the past two years have seen a month of gains in excess of $100 000, and some with losses well above $50 000.

A range of other outcomes are also entirely plausible.

Using pessimistic assumptions of no net portfolio growth at all over the next 18 months, the new portfolio target would not be reached until June 2022.

If equity market fell by 33 per cent through early 2020 with no offsetting gains in other portfolio elements, this could push out the achievement of the target to January 2023.

Mapping progress on the FI journey

With the reduction to a single portfolio objective, measuring progress is marginally simplified.

I will continue to measure my progress in simple percentage terms against the total portfolio value need to deliver the passive income target, as described above.

Last year I expanded the reporting of progress to recognise that I have some significant superannuation that currently sits outside of the financial independence portfolio. So I  will continue to assess progress on two metrics:

• the current measure based on reliance on the investment portfolio alone; and
• the ‘All Assets’ measure with superannuation assets taken into account.

The reason for this approach was that it felt entirely artificial to just ignore a substantial set of assets which were large enough to have significant implications for the FI target, even if they ultimately have some potential accessibility restrictions and some legislative risk.

Due to these risk and 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 this, I will continue to just report a total ‘All Assets’ measure, rather than detail or write about my superannuation arrangements (which are almost exclusively in a low cost index fund).

I will also continue to report against an expanded set of benchmarks, beyond just my formal investment objectives.

Currently I report against two additional measures.

My average annual credit card purchases (a ‘credit card FI’ benchmark) is one, and the second (Total expenses) is an aggregated rough estimate of total current annual expenditure ($89 000).

Both of these figures have been revised. The total expenses measure was revised after a re-estimation exercise late last year. A review of the average of actual annual credit card spending since 2013 in the past two weeks has led me to adopt a newly revised credit card measure of  $71 000, slightly below my past estimates of $73 000.

I will report these progress percentages as below in future monthly updates, using the portfolio position on 1 January this year as inputs in this example below.

Measure	Portfolio	All Assets
Portfolio Objective – $2 180 000 (or $87 000 pa)	81.6%	111.6%
Credit card purchases – $71 000 pa	99.6%	136.2%
Total expenses – $89 000 pa	79.8%	109.1%

Fighting against the currents?

One product of revising the portfolio up by $200 000 is that by the same measures, some progress made through last year has been apparently reversed. Normally, this would feel dispiriting, like a goal slipping further into the future, and out of grasp.

I don’t feel this discouragement, for three reasons.

1. More realistic return assumptions and recognising wage movements – First, to the extent that the past targets were informed by higher equity and bond return assumptions, and have been increased by bringing these down, this represents building a level of justified conservatism into the new targets. For example, the 2019 plan was effectively assuming a return above the commonly discussed 4 per cent safe withdrawal rate, whereas the revised return assumption is equal to it. Similarly, in adjusting the target for wages growth since 2018, I am ensuring I am accurately targeting an objective current standard of living.
2. Goals still met when ‘All Assets’ considered – Second, on an ‘All Assets’ basis, I have still comfortably reached each of the goals and benchmarks. It would take a significant correction – resulting in a whole of portfolio loss across all assets of around 10 per cent – to see this broader progress undone. This fact also explains why at this stage of the journey I am not intending to shift to a more conservative portfolio allocation to manage market risks in the lead up to reaching my target. Rather, the further my ‘All Assets’ total portfolio exceeds the target, the more compelling a case for an ‘equity glide-path’ approach of maintaining or increasing equity exposure becomes.
3. Targets are just necessary simplifications of reality – The third reason, and linked to the earlier discussion on market fluctuations and timing, is that I cannot fully control how the next 18 months or more play out in markets, or in my own work circumstances. Together, these sources of risk and volatility mean that reality is likely to evolve in a distinctly different way than can be planned or forecast with spreadsheets and assumptions based on long-term averages.

So my approach will be to focus on the portfolio target – taking it seriously, but also recognising that a run of good or bad months in the market, or changes in my career could easily swamp this specific plan and timeline.

The growth of the FI portfolio, and passive income over the past three years gives me confidence that I will be able to adapt to these events – which are both probable and not able to be forecast.

Reviewing the investment plan and assumptions

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

Last year I increased the equity allocation in the portfolio to 75 per cent. This remains the long-term target, and the overall target allocation remain constant for 2020. One exception is the allocation between global and Australian bonds, discussed below.

Specific asset allocation targets

• 75 per cent equity based investments, comprising:
  • 30 per cent international shares
  • 45 per cent Australian shares
• 15 per cent bonds and fixed interest holdings
  • 10 per cent Australian bonds and fixed interest
  • 5 per cent international bonds and fixed interest
• 10 per cent gold and commodity securities and Bitcoin
  • 7.5 per cent physical gold holdings and securities
  • 2.5 per cent Bitcoin

Reasons for allocation targets and assumed asset returns

Equity returns, safe withdrawal rates and international diversification

Equities provide the fundamental engine of returns in the portfolio, with the best chance of outperforming other asset classes, and maximising after inflation returns.

The overall asset allocation approach has been driven primarily by reference to a study How Safe are Safe Withdrawal Rates in Retirement: An Australian Perspective (pdf). This is public study which calculates safe withdrawal rates for a range of possible asset allocation mixes over a range of timescales, between 10 and 40 years, using historical Australian data.

At a 75 per cent equity allocation, a withdrawal rate of 4 per cent has had a 88 per cent success rate, and over 30 years a withdrawal rate of 4.0 per cent provides a 95 per cent success rate. In addition to this, I have reviewed Early Retirement Now’s brilliant US-focused safe withdrawal series. AussieHIFIRE and Ordinary Dollar have also produced excellent shorter and simpler analyses of Australia returns, which largely reinforce the findings from the study mentioned above, with slightly more recent data.

Calculation of the overall portfolio target and assumed return requires an estimate of  long-term real equity returns. I have previously adopted a value of  5.65 per cent for Australian equities, the mid-point of measured arithmetic and geometric long-run historical returns over risk-free assets over the past century.

This year I have adopted a more conservative estimate of 4.9 per cent, based on the geometric mean of Australian equity returns over risk-free assets from 1883 to 2018. For my specific purposes, the geometric mean appears to be more appropriate than last years average of the arithmetic and geometric mean, and its lower value also has the benefit of reflecting lower expectations going forward. As we have seen, this has a major flow on effect to the overall target return, and final portfolio target.

For global equities the real return estimate is 5.0 per cent, a historical figure sourced from the 2019 Global Investment Returns Study.

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 equities sub-targets above seek to achieve a target 60/40 split between Australian and foreign equities, which this academic survey published in 2013 estimates to be optimal for most Australian investors (see 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 the 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 to apply only to the extent that fundamental relationships between Australian and global equities have not changed since 2013. As time continues, that assumption potentially becomes more questionable, meaning that a 60/40 split provides no certainty of continuing to be optimal going forward.

Bonds and fixed interest

Bonds and fixed interest play a role in diversification, reducing overall portfolio volatility. The assumed return of 1.9 per cent for these assets is in line with long term global averages measured since 1900, sourced from the 2019 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.

Property, gold and Bitcoin

I have no formal property allocation, excepting my small exploratory investments through BrickX. In the current market environment my assessment is Australian property is likely to enjoy low yields and returns for a considerable period, and not offer much diversification benefit over Australian equities or other asset classes.

As described previously, the role of gold and Bitcoin in the portfolio are primarily as non-correlated financial instruments for diversification, and as an insurance against extreme capital market events. No real return is assumed for either asset, and I plan to only rebalance by purchasing low cost gold index ETFs if the overall alternatives asset class falls well below its 10 per cent allocation.

Bringing the estimates together to a portfolio return assumption

Taking into account the above asset allocation and return assumptions, the overall portfolio return is estimated on a weighted average basis at 3.99 per cent, down from 4.19 per cent last year. This is equal to a nominal return of 6.49 per cent based on an assumption of inflation being in the middle of the Reserve Bank’s target band over the medium-term.

The reduction in the assumed portfolio return makes up fully one half of the increase of $200 000 in the portfolio target.

Last year I accepted a higher return assumption as a approximate estimate, noting it was in excess of most safe withdrawal assumptions. The final figure of just under 4 per cent  sits squarely within most estimates and reflects the longest available set of historical returns, as an inevitably imperfect proxy for the future.

So with the annual review completed, I have unknowingly arrived back to a familiar port – 4 per cent – but with increased confidence that both my compass and course are set true.