Early Navigations – Charting the FI Voyage

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If you want to build a ship, don’t drum up people to collect wood and don’t assign them tasks and work, but rather teach them to long for the endless immensity of the sea.

Antoine de Saint-Exupery

Every exploration begins with a leaving of the familiar. This post provides some details of ‘early navigations’ towards building a portfolio of investments to provide a passive income.

There are multiple points at which this exploration could be said to have begun. Finance and investments had interested me ever since income from my first casual job, even if my early financial literacy was low. My first investments were term deposits from Advance Bank (now St George), involving the investment of $500, $1000 or $1500 for now unheard of rates of between 4-6 per cent.

First charting of a course

Rather than give a comprehensive history of explorations, however, it may be best to focus on the process of my planning and developing of my goals in writing. My first written ‘Investment Policy’ was in 2007. Twice a year I check progress against my Investment Policy, and, sometimes, make adjustments to it.

The prompt that made me set fingers to keyboard that particular March 20 is obscure to me. Certainly in the past five years I had absorbed out of interest many personal finance and investing books, including Bernstein’s Four Pillars of Investment, Burton Malkiel’s A Random Walk Down Wall St, Your Money or Your Life, and the delightfully named Bodo Schaeffer’s The Road to Financial Freedom.

This last was a gift from my father. Each of these books I highly recommend, and I see most of them appear regularly on FI blogs recommendations lists. Across these these works, the concept of a written plan, a stable Investment Policy was recommended (in Four Pillars I believe most explicitly).

My first Investment Policy simply stated that the purpose was to build a source of passive income, and had a 15-year term horizon. The asset allocation was likewise simple – a 70 per cent allocation to equities, and 30 per cent allocation to bonds. This was to be achieved through variations in four Vanguard Lifestrategy funds, and two small direct share holdings.

Staying on course

In many ways, this first two-page document was a model of clarity. For example, the principles of management were confined to:

  1. To the extent possible the policy should be carried out through as few investment vehicles as feasible
  2. Emphasis should be given to maximising after-tax returns through low cost tax efficient vehicles
  3. Passive index-based management should be applied due to a lack of evidence that active management can reliably produce above-average returns
  4. The target allocation is to be achieved with as much diversification across time, markets and assets as consistent with efficient portfolio management

These still form the key principles of my investment approach today, and have been the least changed, fiddled with, and edited components of my plan. Principle (1) has probably seen the worst weather of any of the principles, due to my curiosity about new products.

Principle (2) is designed to keep a focus on the final objective, total returns. This is important, given some investments can offer superficially attractive yield that either is highly taxed, or which comes at the cost of better overall opportunities when both income and capital growth is considered.

The third principle is one I have applied most consistently. I exited my last actively based investment product in 2004, excluding small BrickX purchases which can be considered small active ‘bets’ on residential property.

The final principle is allocation across time, markets and assets, and this has been carried out by regular investments, accessing different asset markets, and wide portfolio diversification.

Filling in the chart

Over time the Investment Policy I have charted has expanded in detail and complexity. Most of the expansion has been to set out the assumptions underpinning the plan more clearly, for example, by including explicit long-term return assumptions for portfolio components, which feed into the overall portfolio return estimate. Currently this assumes a 5.5 per cent after tax real return on equity and a 2.0 per cent return on debt.

The second area of greater detail has been the explicit description of a range of portfolio risks, and approaches to addressing these risks. Examples of these types of risks include: liquidity risk, counterparty risk and operational risk. This forces a regular consideration of whether there are other less obvious risks that my portfolio is vulnerable to, aside from traditional market-based risk and volatility.

Making course adjustments

The discipline of reviewing my portfolio against the Investment Policy twice a year has been useful in developing my portfolio over time. It forces focused attention on portfolio choices around defined points, and acts as a brake to drifting away from the core intent of the investment plan.

It also helps provide a framework in which new investment options are assessed against the critical question – does this proposed investment help meet the portfolio’s objective. Each ‘course adjustment’ made is there in marked up form, as a documented change. The Investment Policy also provides a structured way in which to think about questions such as: what is the goal? How it will be achieved? Is progress towards the goal is being achieved?

Sometimes this has resulted in significant changes. In 2009 the goal was an unrealistically ‘lean’ one, to reach a portfolio target of $750 000, to produce an income of $50 000 annually. Over time, the goal has evolved in steps to a more realistic level of around $1.5 million to produce a passive income of around $58 000 per annum (close to the common FI ‘four per cent rule’).  This income level was set to reflect a benchmark of the ‘average’ or median income of an Australian employee.

As I progress closer to the goal the looming question is: what does it mean to achieve the goal? Is it a milestone to a longer objective? What might paid work look like after that point? Would I be satisfied with the standard of living which that would represent – or would I seek an additional ‘margin of safety’ or buffer either to reduce sequence of return risk, improve the level of passive income, or because working at that point would still interest me?

Like the familiar sights of home port, the mathematical elements of FI recede at that point, and hard thinking is needed on the direction of next voyage.

 

Monthly Portfolio Update – August 2017

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The truth is, we know so little about life, we don’t really know what the good news is and what the bad news is.

Kurt Vonnegut

This is my ninth portfolio update. I complete this update monthly to check my progress against my original goals.

Portfolio goal

My current portfolio objective is to reach a portfolio of $1 476 000 by 1 July 2021. My plan is that this should produce a real income of about $58 000. This is based on a real return of 3.92%, or a nominal return of 7.17%.

Portfolio summary

  • Vanguard Lifestrategy High Growth – $630 261
  • Vanguard Lifestrategy Growth  – $40 998
  • Vanguard Lifestrategy Balanced – $73 030
  • Vanguard Diversified Bonds – $105 335
  • Vanguard ETF Australia Shares (VAS) – $24 325
  • Telstra shares – $4 892
  • Insurance Australia Group shares – $16 187
  • NIB Holdings – $7 200
  • Gold ETF (GOLD.ASX)  – $76 559
  • Secured physical gold – $6 781
  • Ratesetter (P2P lending) – $57 655
  • Bitcoin – $59 549
  • Acorns app (Aggressive portfolio) – $6 901
  • BrickX (P2P rental real estate) – $4 487

Total value: $1 114 160 (+$54 131)

Asset allocation

  • Australian shares – 31%
  • International shares – 20%
  • Emerging markets shares – 3%
  • International small companies – 3%
  • Total shares – 55.7% (5.3% under)
  • Australian property securities – 4%
  • International property securities 3%
  • Total property – 6.7%
  • Australian bonds – 12%
  • International bonds – 11%
  • Total bonds – 23.2% (4.2% over)
  • Cash – 1.5%
  • Gold – 7.5%
  • Bitcoin – 5.3%
  • Gold and alternatives – 12.8% (2.8% over)

Comments

This month the portfolio increased by over $54 000. This in part is inflated by my ‘averaging’ in another contribution to Vanguard’s Australian Shares ETF, after strong distributions in July.

A significant component of the increase also comes from appreciation of Bitcoin holdings, which now quite unexpectedly makes up more than five per cent of the portfolio. Originally, because the amounts were small I folded this allocation into a ‘gold and alternatives’ category, but I have broken it out this update, so that I have better visibility on what is happening to both the gold and Bitcoin components. This reveals that my gold allocation remains under my benchmark of 10 per cent. An issue I have to think about is how much these two assets move together, or actually ‘covary’ (i.e. move in different directions, dampening volatility). Psychologically, I’m not sure if I really regard the Bitcoin gains as real.

This month I moved to a less costly online broker (directshares), which has halved the cost of buying ETFs. It’s not the least cost provider, but due to my banking set up, was a good compromise for ease of access and speed of moving funds. As a portfolio monitoring  device, I have also stumbled onto Sharesight, which I have yet to explore fully. It’s free for small simple portfolios and seems a really smooth and polished way to understand portfolio returns, and their capital and dividend parts.

Equity markets continue to hold up, which means that even if I take account of a further Vanguard Australian shares increment still to be fed into the portfolio, my equity allocation is still sitting below my target, at market highs. This is not a comfortable position to be. To date I have always relied on new contributions to slowly readjust my allocations back to target. At some point, though, this becomes mathematically problematic, because the new contributions simply won’t ‘shift the dial’ enough.

This uncomfortable truth is currently meekly sitting alongside another, my dislike of transaction costs and triggering tax events. Increasingly, equity market conditions – especially in the United States, has made me consciously start playing out in my mind what a sharp turnaround might practically look like in my portfolio. My base case is a potential halving of equity markets (in the short term), knocking out around $300 000 of equity value.  The difficult question – would this be good news or bad news at this point in portfolio accumulation?

Finally, the Brickx real estate platform has recently expanded to offer an Adelaide property for investment, so to maintain and enhance diversification I have made a small expansion in holdings. So far the portfolio has produced total returns of 5.5 per cent and delivered total distributions of $39.

Progress

Progress to goal: 75.5% (+4.2% ahead of target) or $361 840 further to reach goal.

Summary

Passing the 75 per cent milestone has been a significant surprise, and focused attention on just how definable and potentially close is my investment target. Four years ago, if I had been measuring, this figure would have been 33 per cent. Barring a major external market event, reaching my goal within two, three or four years is beginning to sink in as a concept.

 

Monthly Portfolio Update – July 2017

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Life is not an illogicality; yet it is a trap for logicians. It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait.

G K Chesterton

This is my eighth portfolio update. I complete this update monthly to check my progress against my original goals.

Portfolio goal

My current portfolio objective is to reach a portfolio of $1 476 000 by 1 July 2021. My plan is that this should produce a real income of about $58 000. This is based on a real return of 3.92%, or a nominal return of 7.17%.

Portfolio summary

  • Vanguard Lifestrategy High Growth – $619 834
  • Vanguard Lifestrategy Growth  – $40 712
  • Vanguard Lifestrategy Balanced – $72545
  • Vanguard Diversified Bonds – $104 665
  • Vanguard ETF Australia Shares (VAS) – $12 093
  • Telstra shares – $5 465
  • Insurance Australia Group shares – $16 661
  • NIB Holdings – $6 888
  • Gold ETF (GOLD.ASX)  – $73 240
  • Secured physical gold – $6 108
  • Ratesetter (P2P lending) – $57 251
  • Bitcoin – $34 125
  • Acorns app (Aggressive portfolio) – $6 276
  • BrickX (P2P rental real estate) – $4 166

Total value: $1 060 029 (-$37 729)

Asset allocation

  • Australian shares – 31%
  • International shares – 20%
  • Emerging markets shares – 3%
  • International small companies – 3%
  • Total shares – 56.6% (4.4% under)
  • Australian property securities – 4%
  • International property securities 3%
  • Total property – 7.0%
  • Australian bonds – 13%
  • International bonds – 11%
  • Total bonds – 24.2% (5.2% over)
  • Cash – 1.6%
  • Gold and alternatives – 10.7% (0.7% over)

Comments

The absolute level of the portfolio fell this month, by over $37 000. This is largely a result, however, of the distributions from the previous financial year, and choices made around those payments. Around a quarter has been set aside for meeting the likely tax liability, arising from the distribution. Another quarter has been invested in a Vanguard ETF (VAS). The remaining half is set aside for two further investments in ETFs, on a dollar cost averaging basis over the next six months.

Holding funds outside of the portfolio affects the measured equity component of the asset allocation, slightly understating the future equity holdings (which would otherwise sit at around 58% closer to my target).

My leap into Vanguard ETFs was one of my primary investment goals for the year, and has been easy to execute so far. The choice of VAS (Australian shares) was based on low fees, access to tax-advantaged dividend payments and exposure to Australian dollar denominated equity assets. Future ETF purchases are likely to be in that same security, or an internationally exposed Vanguard ETF. Valuations in equity markets still appear stretched, making me comfortable with a more cautious averaging in approach. Wildness does seem to lie in wait, a sense only enhanced by my current post-apocalyptic audiobook fare, The Mandibles.

Aside from the payments of dividends, and reduction of the capital value of fund assets, there have been only minor changes in valuations. There has been some further volatility, and further appreciation of the Bitcoin holdings in the portfolio, while new available properties on the Brickx real estate platform has meant a small expansion in holdings.

Progress

Progress to goal: 71.8% (+5.5% ahead of target) or $415 971 further to reach goal.

Summary

Last month I hoped that distributions payments would provide signposts of how far I still have to travel. The large distributions didn’t really clarify that, as they were so far above expectations that it is hard not to discount their reoccurrence. Positively, however, they provide the interesting opportunity to trial equity ETFs, and continue my goal of exploring different investment vehicles.

Portfolio Income Update – Half Year to June 30, 2017

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The life of every man is a diary in which he means to write one story, and writes another; and his humblest hour is when he compares the volume as it is with what he vowed to make it.

J.M. Barrie

My goal is to to build up a passive income of around $58 000 by July 2021, and this is my second passive income update since starting this blog.

Twice a year I prepare a summary of the total income from my portfolio income. As part of the transparency and accountability of this journey, I regularly report this income.

Passive income summary

  • Vanguard Lifestrategy High Growth – $37 662
  • Vanguard Lifestrategy Growth  – $2 280
  • Vanguard Lifestrategy Balanced – $4 408
  • Vanguard Diversified Bonds – $4 830
  • Telstra shares – $118
  • Insurance Australia Group shares – $241
  • Ratesetter (P2P lending) – $1773
  • BrickX (P2P rental real estate) – $29
  • Acorns – $23

Total passive income: $51 363

Passive - Jun17

Comments

This half-year result took me completely by surprise and is difficult to process. The passive income outcome for the half-year to June 30 has increased beyond any of my expectations or forecasts. My target for this year was $28 000, and investments have delivered nearly double this in just six months.

Taken as a past financial year, this means in theory that I more than met my financial independence target goal of $58 000 per year. This feels strange as a sentence to write in 2017, rather than in 2021, but a good dose of caution is warranted. First, past distributions have been uneven, and where there have been past upside surprises, these have sometimes been reversed in subsequent periods. Only future updates will provide more ‘signal’ against the elements of noise of recent market movements.

Yet even accounting for this, the result gave me pause for thought. It felt as though a significant threshold had been reached, beyond which a different set of issues jostled for attention. This set of distributions, for example, is larger than any salary bonus I have ever received, or am likely too in the near future. Even if there are backward movements in the overall level of distributions to come, this result seems an appreciable step towards my end goal. Taken as a monthly figure ($8560), it sits well above my current level of normal expenses.

The most immediate of the issues now pressing for attention is: how should the distributions be allocated? After some thought, I have finally pushed the button on the exploration goal of trying Vanguard’s Exchange Traded Funds, buying around $12 000 of the Vanguard Australian Shares ETF (VAS). I have also set a schedule to dollar cost average two more equal amounts in September and November. This accords with my portfolio currently being underweight in equities. Buying into Australian shares at these market levels feels like a risky move, hence the dollar cost averaging approach.  I chose the Australian shares ETF mostly because they have lower fees than Vanguard’s retail managed fund equivalent, to take advantage of franked dividends, and to simplify tax returns (avoiding the US domiciled ETFs).

I have also set aside around $12 000 of the most recent distributions into a bank account specially designated for meeting future tax liability, to recognise that this recent windfall will come with tax consequences over the year ahead.

Recently I have stumbled on a University of NSW online course on personal finance, which I highly recommend. The videos clearly and accessibly explain the ‘snowball’ effect of past savings and investments. Today, at least, it felt like I was off and rolling.