Tallying the Stores – Estimating Current and Future Expenditure

Posted on August 17, 2019February 14, 2021 by The FI Explorer

Annual income twenty pounds, annual expenditure nineteen pounds nineteen shillings and six pence, result happiness.

Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

Charles Dickens, David Copperfield

At the centre of most definitions of financial independence is the ability to meet current expenditure through income generated from a portfolio of assets. Earlier this year I started monthly reporting of how close the FI portfolio was to being able to meet an estimate of total annual expenses of $96 000 per annum.

This expenses figure was a rough estimate of total current spending, and resulted from adding some known fixed expenses to my total average credit card expenditure. Yet this figure has seemed higher than anticipated, so this analysis examines what my record of actual past spending suggests for a reasonable estimate of current and future spending.

Just as provisioning a ship for a voyage should take into account actual journey time, my own FI measures need to be as accurate as feasible to make sure plans are set based on realistic estimates. This article – it should be emphasised – is focused on reaching the right estimate for my personal circumstances. Its focus is not offering advice on the process of budgeting or achieving a high savings rate, subjects better covered by others.

Drawing up the manifest – reviewing the initial estimate

The process for estimating total expenditure at around $96 000 was simple in principle. It involved adding a number of known individual fixed expenses to the past twelve months of actual credit card spending. Examples of these fixed expenses include: utilities, local government rates and insurances. They also include some irregular items, such as contributions to housing repairs and a sinking cash fund for car replacement over time.

These fixed expenses are not typically paid by credit card, and so the logic was that the sum of these and the annual credit card total would reach a total overall spending estimate.

In doing this calculation, however, I overlooked that for some large annual expenses that I set aside money for regularly and which I had counted as fixed expenses, I have actually used my credit card for some or all of final payments. This applied to health insurance and some car related costs, for example.

This had the effect of double counting a couple of large expenses, because I was counting both the cash set aside monthly to meet the future cost as an expense, and also the actual expense as incurred through the credit card.

Re-estimating the level of current expenses

Over the past month I have removed the double-counted items and re-estimated all fixed expenses based on the latest actual bills. Indeed, I have allowed some small headroom across the board to allow for modest price increases in the year ahead.

The impact of this is quite significant.

The effect of removing the double-counting is to reduce the monthly fixed expenses estimate from $2 025 to $1 414. This means fixed expenses are around 30 per cent below initial estimates. In turn, this permits some revised estimate of total expenses to be made. Using thus adjusted and corrected data, expenditure appears to be:

$7 420 per month or $89 000 per year if based on average credit card expenses of around $6000 per month since 2013; or
$7 000 per month or $84 000 per year if based on average credit card expenses of around $5 800 per month over the past year

Both of these figures are below the original $96 000 (or $8 000 per month) total expenditure estimate.

The chart below compares the revised figures against monthly income and expenditure estimates, including the income targets that are contained in both of my FI objectives as well as a historical average of portfolio distributions.

Monthly bar - Expenditure

The revised total expenditure estimate also makes it possibly to present a more accurate and less inflated picture of month to month expenditure compared to portfolio distributions received. Adjusted to account for the new estimate, the monthly progress is set out in the revised chart below.

Monthly exp with new figures - Aug 19

Implications for measures of progress and required FI portfolio

The new estimates for total spending show that I have been materially overestimating current expenditure.

A benefit of recognising this is that it immediately brings forward the progress I have made against the “total expenses” benchmark reported each month. Using last months portfolio value and the $89 000 per year spending estimate, for example, it brings progress to meeting this benchmark from 74.9 per cent to 80.8 per cent.

This is a more than five percent advance in apparent progress simply from a more accurate estimate. The revised spending figure also makes the chart below – the proportion of monthly total expenses met by current distributions, look more encouraging still. Revised total expendit Aug 19

Viewed in a different way, the revised spending figure reduces the total FI portfolio required by around $167 000. This represents months and years of saving and investment now not needed, and potentially returned in the form of free time.

A further implication is that the second estimate above which uses the past 12 month of credit card expenses is within a small margin of my Objective #2 target income (of $83 000 per annum). This gives some confidence that this target is set approximately at the level of my current expenses. That is, reaching this target my current standard of living could be maintained in the absence of any employment income.

Summary

So far historical data from credit card and additional fixed costs have been drawn on to seek to answer the question: what level of provisioning for future spending is warranted?

The analysis shows that:

The total expenditure benchmark being targeted was set too high – When corrected for double counting and using history as a guide average total expenditure is closer to $89 000 rather than $96 000 per annum.
A new lower and more realistic benchmark is needed – Based on this, I intend to replace my total expenditure assumption from next month, reducing it from $96 000 to $89 000. This is a conservative figure which is based on the sum of the average credit card expenditure over more than five years and the more recent accurate individual fixed cost estimates.
The income target under Objective #2 is close to my current spending level – This lessens the chance that adjusting to the income it produces will be difficult when this this portfolio level is achieved.
The past years spending is significantly lower than the average since 2013 – with credit card expenses of around $67 000 annually or $5 800 per month.

Taking the time to carefully consider current and future expenses can be painstaking work. It will be critical, however, to ensure the avoidance of the second of Micawber’s income and expense scenarios, and the need to rest plans for the voyage on the hope that something will turn up.

Monthly Portfolio Update – July 2019

Posted on August 1, 2019March 24, 2022 by The FI Explorer

If it not be now, yet it will come.

The readiness is all.

Shakespeare, Hamlet, Act V, Scene ii

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

Portfolio goals

My objectives are to reach a portfolio of:

$1 598 000 by 31 December 2020. This should produce a real income of about $67 000 (Objective #1) – Achieved
$1 980 000 by 31 July 2023, to produce a passive income equivalent to $83 000 (Objective #2)

Both of these are based on an expected average real return of 4.19%, or a nominal return of 7.19%, and are expressed in 2018 dollars.

Portfolio summary

Vanguard Lifestrategy High Growth Fund – $769 050
Vanguard Lifestrategy Growth Fund – $43 826
Vanguard Lifestrategy Balanced Fund – $79 826
Vanguard Diversified Bonds Fund – $108 036
Vanguard Australian Shares ETF (VAS) – $90 076
Vanguard International Shares ETF (VGS) – $20 250
Betashares Australia 200 ETF (A200) – $265 413
Telstra shares (TLS) – $2 116
Insurance Australia Group shares (IAG) – $15 051
NIB Holdings shares (NHF) – $9 588
Gold ETF (GOLD.ASX) – $95 251
Secured physical gold – $15 309
Ratesetter (P2P lending) – $21 070
Bitcoin – $157 290
Raiz app (Aggressive portfolio) – $16 358
Spaceship Voyager app (Index portfolio) – $2 092
BrickX (P2P rental real estate) – $4 388

Total value: $1 714 990 (-$1 713)

Asset allocation

Australian shares – 40.6% (4.4% under)
Global shares – 22.6%
Emerging markets shares – 2.5%
International small companies – 3.2%
Total international shares – 28.2% (1.8% under)
Total shares – 68.9% (6.1% under)
Total property securities – 0.3% (0.3% over)
Australian bonds – 5.1%
International bonds – 10.1%
Total bonds – 15.2% (0.2% over)
Gold – 6.4%
Bitcoin – 9.2%
Gold and alternatives – 15.6% (5.6% over)

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

Comments

The portfolio experienced a small decline this month, with a decrease of $1 700. This slight downward movement comes after six months of continuous increases in the value of the portfolio. Progress - Jul 19

The fall also comes at a time in which some significant new investments were made, masking the size of the fall somewhat. A substantial likely contributor to the decline, however, is the natural impact of distributions being paid from shares, as well as ETFs and retail index funds.

In short, around $30 000 of distributions were paid out across July, decreasing the value of portfolio securities by around the same amount. Not all of these distributions have been re-invested, creating a temporary illusion that this value has been removed. A comparable effect led to a similar reduction in July 2017. Monthly - Jul 19

Generally movements this month within the portfolio have been relatively limited. One of the larger movements has been an increase in Australian and international shares, with Australian share markets just reaching post Global Financial Crisis highs.

A fall in the price of Bitcoin, and a smaller countervailing increase in the value of gold holdings has provided a live example of some of the issues in my last post on the potential value of non-correlated alternatives. Having said this, the fall in the price of Bitcoin is the major factor in this months downward movement. Evidently following some real estate revaluations, my BrickX holdings have also decreased in value by nearly 6 per cent since the last month. This most recent research into the actual realised returns from real estate investing suggests I should not be surprised, and usefully highlight the specific risks facing individual property investments.

This month has also seen my first investment of July distributions. These were placed in Vanguard international shares ETF (VGS). The remainder of the distributions will be placed into either into VGS, or Australian shares (A200 or VAS) over the next four months, on a dollar cost averaging approach alongside new contributions.

Reviewing of insurance needs and adjustments

Following distributions last month I have also re-examined my insurance requirements, taking into account updated portfolio values, existing savings, insurance through superannuation, and future financial obligations. This has led me to continue to reduce both my life insurance sum insured (from $315 000 to $100 000) and my income protection insurance (from $3000 to $1000 per month).

I have taken a conservative approach, and based the adjusted coverage on the goals of providing of sufficient income, at an assumed safe withdrawal rate of 3.75 per cent, to still meet my Objective #2.

In other words the target has been offering full income replacement from all assets and insurance of at least $83 000 in perpetuity. Still, this adjustment has led to a substantial savings – nearly $1 000 per annum. An alternative way to think about this is that I have lowered my ongoing expenses by just under $20 per week, reducing the final portfolio sum required to support this cost by around $28 000.

Progress

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

Measure	Portfolio	All Assets
Objective #1 – $1 598 000 (or $67 000 pa)	107.3%	145.3%
Objective #2 – $1 980 000 (or $83 000 pa)	86.6%	117.3%
Credit card purchases – $73 000 pa	98.5%	133.3%
Total expenses – $96 000 pa	74.9%	101.4%

Summary

The steady reinvestment of July distributions should give a small upward push to monthly results through to December. This is tempered by an effect of the growth in the overall size of the portfolio, and its exposure to equities.

As a simple example – a daily movement in equities of 0.5 per cent at the beginning of the journey meant a loss or gain of just over $3 000 in a day. The same movement now with the current portfolio would mean a gain or loss of nearly $6 000.

This makes the path less clear – as new contributions can more easily be swallowed into a daily market movement. The portfolio value effect has generally been – to borrow a phrase – a little akin to watching the movement of a yo-yo being used by someone walking up or down some stairs. Psychologically, it detaches effort from reward in a way that still feels relatively new in this journey.

An interesting post to think about in this context, is this from Collaborative Fund, which shows the sharp, volatile multi-year paths equities can take to reach a single destination. Usefully, it also points out the futility of many ‘fine adjustments’ to sectoral exposure, and unnecessary complexity in portfolio construction.

A further truth illustrated by the data in the piece is that general consumer sentiment, and economic growth, do not align with stock returns in any systematic way. In short, buying or selling shares because of a view that the economy or consumer confidence is strengthening, or weakening, is a futile guesswork, which has no historical basis in the past behaviour of returns.

These findings and new realities are reminders that taking the actions that support forward progress and continued regular investments are the immediate focus. This matters more than whether the portfolio sits above or below an arbitrary number on any given day. Planning and readiness for that day is the priority.

Setting of the Sails – Role of Gold and Bitcoin in the Portfolio

Posted on July 20, 2019January 15, 2022 by The FI Explorer

One ship drives east and another drives west
With the self-same winds that blow.
‘Tis the set of the sails
And not the gales
Which tells us the way to go.

Ella Wheeler Wilcox, The Winds of Fate

Future returns are unknowable with any degree of precision. A portfolio must contend with all that future market prices and developments put before it, whilst seeking to earn the best possible return for the level of risk assumed.

This uncertainty is a core issue for portfolio design. Part of my approach to building my FIRE portfolio has been to target a small allocation to alternatives such as gold and Bitcoin to deliver reduced portfolio volatility, and improved returns. My current target allocation set earlier this year is 7.5 per cent gold and 2.5 per cent Bitcoin. This post explores the reasons for, and basis of, this approach.

Portfolio design – one wind, different directions

In designing the FIRE portfolio, the key guiding principle has been maximising the overall risk-adjusted return, whilst minimising unnecessary volatility.

The important implication of this is that it is not the performance of the individual portfolio parts that I am trying to maximise. Rather, it is the performance of all of the component parts as they interact that is of prime concern.

The objective is for the mix of all of these different holdings to play their part together to enhance portfolio returns or reduce volatility. Decisions on asset allocation – or the mix of assets held – has been repeatedly been shown in academic studies to explain around 90 per cent of the volatility of portfolio returns.

This approach is consistent with the simple guidance to diversify. Underlying it, however, are some observations of modern portfolio theory and the Capital Asset Pricing Model, that can be summarised in the following insights:

the investor should seek to mix assets with non-correlated returns (i.e. returns that move in different directions) to achieve an optimum balance of likely returns and portfolio volatility
not all extra risk taken by an investor is automatically compensated by higher returns
the investor should consider each additional investment security or asset from the perspective of how it will contribute to overall portfolio risk and return

At any given time this can mean that one ‘wind’ will send the individual portfolio components in different directions. In short, the approach is not one that will deliver a portfolio without any losses or low returns in the set of assets held at any given time.

Asset correlation – assessing the crosswinds

The critical ingredients for the approach to be effective are assets that do not move together – that is, uncorrelated assets. A traditional example used in portfolio design are equities and bonds, which have over time often tended to move in opposite directions (e.g. be inversely correlated) in many markets. This is the basis for traditional investment guidance to include greater bond holdings to dampen the volatility of equities.

Gold has tended to have a low correlation to other asset classes. An example of the effects of this on equity portfolios is described in this research paper (pdf) – from the World Gold Council – which found that adding gold holdings to an all equity portfolio both lowered the volatility of returns and increased total returns over the 1968-1996 period (see p.47 and Figure 4.6). The academic evidence for the low correlation of gold to equity returns is, in fact, strong over multiple periods.

Moreover, this diversification benefit appears when most needed. As this recent paper in the International Review of Financial Analysis notes:

…we think that a review of the results from earlier papers on this issue,
coupled with our findings, points to the fact that gold is always a hedge or, at
worst, always an excellent diversifier of portfolio risk. Gold’s usefulness in
managing risk does not disappear in a crisis when the prices of the vast
majority of assets tend to be perfectly correlated. (He, 2018)

That is, gold seems to generally hold up as providing non-correlated returns, even when extreme market conditions prevail. Globally, central banks – including Australia’s Reserve Bank – also seem to recognise this characteristic. It is in part why central banks collectively own around 17 per cent of gold currently above ground.

Setting the level of gold exposure – competing evidence

There is considerable discussion and debate on the right level of gold holdings to maximise the diversification benefit, and few definitive answers.

The optimum level will vary under most estimation approaches, which inevitably are based on models that build on historical observed relationships and correlations. These correlations themselves vary over time and between markets and countries.

An original study by Jaffe for institutional portfolio managers recommended a 10 per cent allocation against a basket of international equities. Additional studies (pdf) by other authors have recommended 9.5 per cent, and between 0.1 per cent to 12 per cent depending on which country the investor is in. As an example, the country-specific weights typically fell within 3 to 8 per cent for developed countries.

More complex methods than classical mean variance analysis, which take into account the positive skew of gold returns, produce different results again. A 2006 study which examined 1988-2003 data recommended a holding of 4-6 per cent under classical portfolio optimisation approaches, but a lower figure of 2-4 per cent taking return ‘skewness’ into account.

Diversification and Bitcoin – looking at the record

My purchase of Bitcoin began as an exploration of a new financial technology driven by curiosity. The present question is, however, does it deliver any additional diversification benefits beyond gold holdings?

Conceptually, Bitcoin can be said to share some characteristics with gold that might be expected to reduce any diversification benefit. They both represent highly liquid assets that when held personally are no other parties liability. They are not issued by central banks or other monetary authorities, and they can be transferred. So is there a case for holding just one or the other?

The tentative answer is that despite some conceptual similarities, they do appear to behave differently.

So far, in the decade between July 2009 and February 2019, Bitcoin has shown a low positive correlation to gold (see In Gold We Trust (pdf), p.245). This is consistent with my own observations in my portfolio in the last three and a half year period, with a low correlation of 0.1 over the entire period in the chart below. Bitgold correl

On its face it appears Bitcoin may well be a useful complementary alternative holding, offering diversification benefits distinct from other combinations of holdings.

Unlike gold, there is not a clear empirical or academic basis for setting a ‘right’ level of exposure to Bitcoin. The recent In Gold We Trust report (pdf) discusses and analyses one possible approach – a 70/30 split between gold and Bitcoin, indicating that this delivered similar maximum drawdowns to a gold only portfolio, but with higher returns. Yet this finding is only a function of the extraordinary positive returns from Bitcoin to date, and may not be repeated.

Trade-offs, risks and limits of exposure to alternatives

There are acknowledged trade-offs and risks to investing in alternatives such as gold and Bitcoin.

First, they produce no income or cashflow. Their return is based entirely on capital gains. This is often cited as a definitive proof that they do not represent part of any proper investment portfolio.

Yet, as a part of a portfolio, alternatives can reduce the absolute volatility of the capital value of the portfolio, and – historically in the case of gold, can also increase overall returns. Given final capital value and returns over time are critical inputs into FI, these characteristics are relevant and worth considering.

A potentially stronger objection is that while alternatives may have been useful in the past, they cannot be guaranteed to be so in the future.

That is, the correlations and diversification benefit that has been observed, may disappear. This is entirely possible, and ultimately unknowable. The diversification benefits of gold have a far longer history. Its roles in industry, manufacturing and jewellery would seem likely to continue to guarantee that at any given time there will be some minimum demand for gold, and a relationship between its price and other asset prices that is not perfectly correlated.

For Bitcoin, the same cannot be said. There are many plausible scenarios in which Bitcoin’s value declines, it falls in usage, and becomes the equivalent of niche digital collectible with little residual value.

The disappearance or long-term reversal of ‘known truths’ in finance is not impossible. There are significant periods in capital markets in which bonds outperformed equities, negative yielding debt has moved from something previously unobserved, to a commonplace across many world bond markets. By some measures, global interest rates are at 5 000 year lows. Few developments should be dismissed as inconceivable looking forward.

This suggests that any analysis based on historical trends should be relied on with modest expectations around its accuracy. Yet importantly, this applies not just to speculation around the role and benefits of alternatives. It also applies to traditional investment classes, such as equities or bonds.

For example, the continuation of a positive equity premium for Australia, or any other nation, is not foreordained. Australia’s comparatively high equity returns are in fact an anomaly looking across developed countries. There are no particularly strong reasons to suggest this will necessarily continue.

Set of the sails – applying the evidence to a FIRE portfolio

The role of gold and Bitcoin are primarily as non-correlated financial instruments for diversification, and as an insurance against extreme capital market events. No actual positive return is assumed for either asset. The evidence discussed above leads me to the following conclusions, for my personal circumstances and risk tolerance.

Reliance on equities as the engine for portfolio growth. Long term equities continue to have a strong record of providing higher total returns, earning their place as the centrepiece of the portfolio.
Reliance on history of performance of gold to reduce volatility. Some exposure to gold appears to reduce volatility and potentially enhance returns historically, making it a potentially beneficial addition to my FIRE portfolio.
A small role for gold based on tested academic evidence. Past evidence suggests a gold allocation of between 5 to 10 per cent is sufficient to capture diversification benefits, without compromising long-term portfolio returns
With Bitcoin potentially adding further diversification. Bitcoin appears to be non-correlated to equities, bonds, and gold, meaning it potentially is a useful further additional source of diversification benefit.
But with modesty about what the future holds. Aside from Bitcoin being volatile, there is an inadequate history to know how it will perform compared to other assets through a full cycle, or whether it has a long-term future.
Recognising the limits of knowledge and history. Asset performance, diversification benefits, volatility and returns which are historically based can and do reverse at times, meaning the ‘best’ portfolio will only ever be known in retrospect.

The alternatives target allocation set earlier this year is 7.5 per cent gold and 2.5 per cent Bitcoin. As of July 2019, a strict reading of these targets suggests I need to moderately lift my exposure to gold, and sell approximately 75 per cent of my Bitcoin holding.

I currently plan to do neither of these things. This is because:

The volatility of Bitcoin is such that ‘chasing’ a target allocation by buying and selling is likely to incur high transaction costs (including realising capital gain tax).
A plausible scenario is the apparent over-allocation to Bitcoin resolving itself through substantial price declines as previously experienced (at its previous low, the allocation was close to the 2.5 per cent target).
Similarly in the case of gold, both price volatility and the goal of minimising transaction costs suggest it is better to seek to adjust holdings only when they fall well outside the target allocation for a sustained period.
The overall size of the entire alternatives allocation (a 10 per cent target) is more significant than the individual sub-targets.
Before making new investments to pursue my portfolio allocation I perform a ‘with and without’ test, notionally removing the Bitcoin holdings for a moment from the portfolio, to identify if recent fluctuations in the value of Bitcoin are driving a perverse allocation choice which would be entirely different were it not for Bitcoin. While not theoretically ‘pure’, this is a pragmatic adaptive approach that recognises the lack of clear history and knowledge about the portfolio behaviour and characteristics of Bitcoin.

So the sails are set, and the wind will come. These settings allow me to feel that whatever direction they happen to blow, there is the best chance possible based on evidence that they will help in the journey that remains.

Sources

In Gold We Trust 2019 – Extended Report

Harmston, S. Gold as a Store of Value, Research Study No.22, World Gold Council, 1998

He, Zhen et al. “Is Gold Sometimes a Safe Haven or Always a Hedge for Equity Investors A Markov-Switching CAPM Approach for US and UK Stock Indices”, International Review of Financial Analysis, Vol. 60, October 2018

O’Connor, F et al. “The Financial Economics of Gold – A Survey” in International Review of Financial Analysis 41 · July 2015

Disclaimer: This article does not provide advice and is not a recommendation to invest in either gold, Bitcoin or any alternative assets. Its sole purpose is to provide an explanation of why – in my personal circumstances – I have chosen this exposure.

Portfolio Income Update – Half Year to June 30, 2019

Posted on July 7, 2019January 15, 2022 by The FI Explorer

IMG_20190117_144205_272

Set your course by the stars, not by the lights of every passing ship.

Omar Bradley

Twice a year I prepare a summary of the total income from my portfolio. This is my sixth passive income update since starting this blog. As part of the transparency and accountability of this journey, I regularly report this income.

My goals are to build up a portfolio providing for a passive income of around $67 000 by 31 December 2020 (Objective #1) and $83 000 by July 2023 (Objective #2).

Passive income summary

Vanguard Lifestrategy High Growth – $25 606
Vanguard Lifestrategy Growth – $1 626
Vanguard Lifestrategy Balanced – $1 630
Vanguard Diversified Bonds – $53
Vanguard ETF Australian Shares ETF (VAS) – $1 761
Betashares Australia 200 ETF (A200) – $4 513
Telstra shares – $43
Insurance Australia Group shares – $209
NIB shares – $120
Ratesetter (P2P lending) – $1 373
Raiz app (Aggressive portfolio) – $107
Spaceship Voyager app (Index portfolio) – $0
BrickX (P2P rental real estate) – $36

Total passive income in half year to June 30, 2019: $37 077

The chart below sets out the passive income received on a half-yearly basis from the portfolio over the past three years. HY Jun19 Series Income

The following figure is a breakdown of the percentage contribution of each investment type to the total half year income.

HY-Jun19 Pie

Comments

The total half year passive income from the portfolio was $37 077, the equivalent of $6 180 per month, and above my recent expectations. This was a significant rise from the previous half year to the end of December, consistent with the usual pattern of June distributions being higher.

This June half year result is, however, significantly lower than the equivalent 2017 and 2018 figures. It is now apparent that these previous two results were outliers, as they included significant payments arising from realisations of capital gains and the re-balancing activities of the Vanguard diversified retail funds.

Stepping back and examining distributions over the full financial year presents another longer-term perspective. Full year distributions have recovered from the poor start in the half to December 2018, and the full financial year results are $52 524, or just under $4 400 per month. This is fairly close to my recent estimates of the likely income potential of the portfolio at current levels.

In the chart below of the history of total portfolio distributions, green indicates periods covered by this record. Total dis FY Jun19

From this chart it is apparent that annual distributions have fallen significantly – around 20 to 30 per cent – compared to the past two financial years. Yet it is also clear that they have moved structurally above the years previous to this due to the continued growth in the size of the portfolio.

A year-on-year fall in annual distributions such as experienced this financial year is relatively rare – having not occurred since 2012 – but not unprecedented in the history of the portfolio. It has occurred on three other occasions over the past two decades. To date, a consecutive yearly decline has never happened.

Journey to credit card FI – a steadily closing gap?

The full financial year data also makes it possible to recalculate comparative trends in distributions and monthly credit card costs as well as other expenses on a more representative basis than the previous unusually low December half-year income.

This chart below shows that from April 2019 and for the first time in about a year, credit card expenses have dipped temporarily below annual distributions. Credit card FI Jun19

This may not be sustained over time, as this series is naturally quite volatile. As expected, there is still a gap between estimated total expenses and distributions.

To provide a clearer picture of progress towards passive income meeting my ‘credit card FI’ goal, the following chart takes a three-year moving average of both distributions and credit card expenses. Closing gap 3 yr Jun19

This shows the gap continuing to close, to a remaining gap of less than $1 000 per month between credit card expenses and average distributions.

Changing composition of distributions and sources of variations

Over time the level of distributions will be affected by ongoing changes in portfolio composition.

The fall in the Ratesetter account balance and fixed income holdings overall will tend to reduce future distributions. Similarly, the large and growing investments in ETFs such as VAS and A200 will, at least in a relative sense, reduce the overall portfolio impact of the more volatile Vanguard fund distributions.

The reason for this can be seen in this new chart below, which tracks the major components of distributions through time. Dist by Type Jun19

This highlights the dominating influence of variations in the distribution payouts from the Vanguard High Growth Fund through time on overall distributions. It also shows that up until five years ago Ratesetter interest income represented one of the single largest components of distributions compared to just four per cent now.

The half year composition of distributions already given also reflects their cyclical payout pattern, with around 70 per cent being from the single largest Vanguard High Growth fund. Over time, the lower than average distributions from the Betashares A200 ETF – reflecting its market entry and rapid growth – should normalise, possibly representing a slight upward factor in its role in future distributions.

For a point of comparison against the half year result, the composition of the full financial year distributions is set out in the figure below. Comp FY dist Jun 19

From this it is apparent that collectively the distributions from the Vanguard High Growth fund, the A200 ETF and Vanguard’s VAS ETF decisively shape overall distributions currently, making up nearly 85 per cent of total payments.

The overall portfolio distribution rate (e.g. distributions as a percentage of the portfolio value) for this half year has been 3.5 per cent, one of the lowest rates recorded so far. This is likely due to falling fixed interest returns and the increased use of ETFs with lower payouts of capital gains than the Vanguard retail funds. The average (median) distribution rate over the past two decades remains steady at 4.4 per cent.

Av dist rate Jun19

Making course adjustments – putting distributions to work

The imminent payment of the July distributions from Vanguard funds, as well as the distributions from the Betashares A200 and VAS means that a total of around $30 000 will need to be reinvested or allocated in weeks ahead.

I will set aside around 25 per cent of this sum to meet the associated tax liabilities, and then expect to reinvest the remainder in even increments on a regular basis over the next six months. While market performance and history suggests a single lump sum investment would be financially optimal, my general practice is to use dollar cost averaging for large sums, to manage the risk of investing prior to a large market movement, and recognise the potential power of ‘decision regret’.

My current intention is to reinvest these distributions in Vanguard’s global shares ETF (VGS). This will be my first investment in this ETF, and flows from the fact that ‘the big rebalance’ to reach my intended 60/40 allocation split between Australian and international equities is now effectively complete.

Historically, I have been wary of this ETF’s high US equity market exposure, and its past returns have been strong (indicating the potential for a reversion to lower returns). However, I am seeking to follow my planned asset allocation, and have some expectation that any external events likely to reduce US and global returns will also likely impact on the Australian dollar, potentially partially offsetting some negative impacts. I am also attracted to the broad simple diversification it offers into areas not well covered by Australian equities.

A further step following from finalising the half year income estimate is to revise the level of my emergency fund. This is set at providing the equivalent of one year of expenses at a level equal to my Objective #2 target income – that is, $83 000. It has been primarily designed to cover expenses in any unexpected periods without employment income.

This most recent set of distributions takes the five-year average of distributions to just over $50 000. On that basis, I am reducing my emergency fund to $33 000, and using the additional capital this frees up as new contributions to the portfolio. Over time the growing average portfolio size should have the impact of tending to lower my emergency fund as the associated flow of distributions rises to replace it. Despite this, I always intend to keep a modest contingency cash allotment for liquidity and unanticipated cash requirements.

Observations

Around 251 years ago, Captain James Cook set sail for a journey across the entire Pacific Ocean to reach the island of Tahiti. His instructions were to witness and record the transit of Venus – that is, the journey of that planet against the disc of the Sun. Scientists and astronomers at that time hoped that by taking a range of measurements as the transit occurred, they might divine the distance between the Earth and Sun.

Similarly, this set of observations helps me understand some of the key measurements in my narrower universe – for example, my distance to a lifestyle funded by passive income, and the broad boundaries around the variability in that income that I might expect.

For much of the past six months, my curiosity about this particular result has been growing. While as a half year it is less spectacular than some past results, it feels like a firm foundation of what the portfolio might be expected to deliver on average over time. It also reasonably matches my previous analysis of the portfolio income potential.

On an annual basis, $52 000 of income represents a more than adequate level of basic financial security in my circumstances. The new figures also provide a cross-check on other measures of progress I use, reinforcing that I am now in a phase of consistently seeking to close the remaining gap between expenses and average total portfolio returns.

As global and domestic markets appear more ominous and finely poised, the relative stability of this income source compared to absolute capital values will also play a psychological role in allowing continued strong investments in equities ahead. Whether this be into storms or calms seas will soon enough be seen.

Explanatory Notes

Income distributions reported do not include franking credits. My current preference is to seek to track cash actually delivered into my bank account as a tangible and easy to calculate measure. In this past half year franking credits valued at just under $2200 were received from shares and ETFs (not including the Vanguard retail funds).
There has been a small downward revision to the half year to December 31, 2018 income estimate of $15 602 to $15 447. This reflects the availability of better data from the annual tax statement, and substituting that data for projections made in December 2018.