Act when you know.

Temple of Apollo, Delphi

Introduction

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.

January 2024

Disclaimer

This blog is a record of my journey and decisions, based on my circumstances.

The specific portfolio allocation and approach described in it has been determined solely based on my personal circumstances, objectives, assessments and risk tolerances.

It is provided for general information and entertainment purposes only. It is not personal financial advice, or a recommendation to invest in any particular investment product, security or asset, or adopt any specific strategy, and investors considering these issues should undertake their own detailed research or seek professional advice.