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.

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.

Shifting Tides – New Portfolio Goals and Portfolio Income Update – Half Year to December 31, 2018

Posted on January 5, 2019January 13, 2022 by The FI Explorer

IMG_20180929_164734_692

A good plan violently executed now is better than a perfect plan executed next week

George S. Patton

Just over two years ago I set out on an exploratory voyage to try and build a passive income of around $58 000 by July 2021. With good initial progress, I reset the compass a year ago to seek to meet this initial financial independence objective by the end of 2018.

As I covered in detail in my recent year in review post, that accelerated timetable has not been met. The past few weeks have been spent reviewing my plans, assumptions and proposed approaches into the future to build both on what I have learnt and new information.

The half-year portfolio income update below forms part of this new information. To begin however, this post explains findings from my review, details my updated portfolio goals and assumptions, and discusses how I will approach my FI journey from here.

Shifting tides and new ports of call

To start with the ultimate goals, I have decided to refine my two complementary objectives, and re-base the target portfolio level of each.

Updated Objective #1 – The revised first objective is to reach a portfolio of $1 598 000 by 31 December 2020. This would produce a real annual income of about $67 000 (in 2018 dollars).

This is an increase of around $120 000 on my previous objective. This moves to a benchmark that I consider to be a better reflection of the original objective.

This new passive income benchmark equals the median annual earnings of an Australian full time worker. This is drawn from Australian Bureau of Statistics earnings data, which is updated at least annually, and which therefore can be consistently tracked through time. This replaces the previous goal of $58 000, a number which had not been inflation indexed since 2016, and which was taken from a variety of ad hoc sources.

Updated Objective #2 – The second objective is to reach a portfolio of $1 980 000 by 31 July 2023. This would produce a real annual income of about $83 000 (in 2018 dollars).

This is a small decrease on my previous Objective #2, a result of changes to some return and asset allocation assumptions discussed more fully in sections below.

The passive income target for this objective remains the approximate equivalent of average Australian full-time ordinary earnings, and a little above my average annual credit card liability. This second longer-term goal is designed to reflect a more ‘business as usual’ lifestyle, rather than more of a ‘leanFIRE’ concept – at least in my current phase of life – of $63 000 pa. As I have observed, it is closer to the level of expenditure at which I think I would truly become indifferent to working or not.

To set the target timeframe for both objectives, I have used very approximate and conservative estimates, based on previous average total portfolio increases over the past five years. This method largely ignores extra contributions arising from above average portfolio distributions, or any return impacts, given the relatively short time until both targets. Achievement of each target will inevitably be impacted by market fluctuations over the next few years, so constructing exact yearly forecasts of the impacts of average returns does not appear particularly worthwhile.

The portfolio targets levels are estimated by dividing the passive income target by a real return of 4.19%, equivalent to a nominal return of 7.19%. The real return assumption is based on the portfolio allocation discussed further below.

Measuring the journey

With the destination set, the next issue is how to measure the journey. So far I have just measured progress in simple percentage terms against the two objectives.

I plan to continue this, but to expand it in two significant ways.

First, recognising that I have some significant superannuation that currently sits outside of the investment portfolio, I will now seek to assess progress on two metrics:

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

The reason for this approach is that it increasingly seems artificial to entirely ignore a substantial potential contributor to a FI target, even if it comes with accessibility restrictions and some legislative risk.

Due to these risk and restriction factors, I continue to target financial independence through my private investment portfolio alone, with superannuation providing an additional margin of safety and buffer. Recognising this, I plan to simply report a total ‘All Assets’ measure, rather than detail or write about my superannuation arrangements (spoiler, they are almost exclusively in a low cost index fund).

Second, I plan to report against an expanded set of benchmarks, beyond just my formal investment objectives. Currently I plan to report against two additional measures. My average annual credit card expenditure (a ‘credit card FI’ benchmark) is one, and the second is an aggregated rough estimate of total current annual expenditure. This latter measure is quite approximate and results from adding some known fixed expenses to my total credit card expenditure. I recognise that it is by no measure a frugal existence, and how fortunate I am to be able to live in this way.

For simplicity 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.

Measure	Portfolio	All Assets
Objective #1 – $1 598 000 (or $67 000 pa)	82.5%	115.5%
Objective #2 – $1 980 000 (or $83 000 pa)	66.6%	93.3%
Credit card purchases – $73 000 pa	76.8%	107.5%
Total expenses – $96 000pa	57.6%	80.6%

What can be seen from this is that on a couple of measures, using an ‘All Assets’ basis that includes superannuation, I have already reached some of these basic FI benchmarks. On other purely portfolio measures I am still well-progressed, in sight of Objective #1 and about two-thirds of the way to Objective #2, for instance.

Plotting the course

Having set the objectives, the most critical part is planning how to achieve it. This is the purpose of an annual investment policy which I have been reviewing over past weeks.

From a review of articles and research on Australian safe withdrawal rates and asset allocation I have elected to move to a portfolio target of 75% allocation to equities with the following other target allocations.

Target allocationDec18-2 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
- 7.5 per cent Australian bonds and fixed interest
- 7.5 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% equity allocation, a withdrawal rate of 4% has had a 88% success rate, and over 30 years a withdrawal rate of 4.0% provides a 95% success rate. In addition to this, I have examined Early Retirement Now’s brilliant US-focused safe withdrawal series. Recently, AussieHIFIRE and Ordinary Dollar have produced excellent shorter and simpler analyses of Australia returns, which have largely reinforced the findings from the study mentioned above, with slightly more recent data.

This represents a 10% increase in my equity allocation. Separately, to help estimate the portfolio target, I have also reached long-term real equity return estimates. These are 5.65% for Australian equities, the mid-point of measured long-run historical returns over risk-free assets over the past century. For global equities the real return estimate is 4.5%, a historical figure sourced from the 2018 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 recent published academic survey determines 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.

Bonds and fixed interest

Bonds and fixed interest play a role in diversification, reducing overall portfolio volatility. The assumed return of 2.0% for these assets is in line with long term global averages measured since 1900, sourced from the Dimson, Marsh and Staunton book Triumph of the Optimists – 101 Years of Global Investment Returns.

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.

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 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% allocation.

Taking into account the above asset allocation and return assumptions, the overall portfolio return is estimated on a weighted average basis at 4.19%. This is equal to a nominal return of 7.19% based on an assumption of inflation being at the top half of the Reserve Bank’s target band over the medium-term.

This is a little above the safe withdrawal assumptions detailed above, but within a sufficient margin of error for current planning, considering that the above studies are all entirely based on patterns of realised historical returns, which will not necessarily be determinative of future returns.

Sailing out of port

Going though the process of testing assumptions and goals has been useful, even where the refinements have been modest. I am now more comfortable that my return assumptions are realistically modest, and that my goals accurately anchor my journey to points of greater psychological significance, rather than past rough approximations.

Remembering why a choice was made, and being forced to develop or find evidence for assumptions made is a critical part in my building greater confidence over time to tackle the remaining journey.

Portfolio Income Update – Half Year to December 31, 2018

A large income is the best recipe for happiness I ever heard of.

Jane Austen Mansfield Park

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

As discussed above, my goals are to build up 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 – $8 044
Vanguard Lifestrategy Growth – $444
Vanguard Lifestrategy Balanced – $539
Vanguard Diversified Bonds – $86
Vanguard ETF Australian Shares ETF (VAS) – $1 812
Betashares Australia 200 ETF (A200) – $2 194
Telstra shares – $146
Insurance Australia Group shares – $455
NIB shares – $188
Ratesetter (P2P lending) – $1 528
Raiz app (Aggressive portfolio) – $122
Spaceship Voyager app (Index portfolio) – $0
BrickX (P2P rental real estate) – $43

Total passive income half year to December 31, 2018: $15 602

Presented in a pie chart form, the following is a breakdown of the percentage contribution of each investment to the total half-year income.

PIPieChartDec18

A time series of past passive income delivered from the portfolio is below.

CorrectPortDisDec18

Comments

The half-year passive income from the portfolio was $15 602, the equivalent of $2 600 per month, falling significantly below my base expectations.

The fall from the previous half-year result in July 2018 was the largest ever experienced for the portfolio. It seems the ‘reversion to the mean’ I have previously mooted has arrived, sending the December half-year income back to around 2016 levels.

This is likely the result of the a few different factors, such as:

the overall poorer performance of nearly all asset markets in late 2018
lower realised capital gains from the Vanguard retail funds, after previous strong equity returns in the past two years
lower cash returns from a slow fall in the balance of the Ratesetter account, and a re-allocation of these funds to new equity ETFs with lower total distributions

The pattern of consistently lower distributions in the December half-year period continues. The results do exclude the value of franking credits, and so there is some understatement of total after-tax returns. My preference, however, is to seek to track cash actually delivered into my bank account as a tangible and easy to calculate metric.

The results do seem to suggest a focus on the overall portfolio objective, rather than narrowly interpreting this single half-year measure as a true indicator of the long-term income potential of the portfolio. Alternatively, it illustrates the value in viewing portfolio returns in smoother annual terms, such as on a whole of financial year basis. Interestingly, overall annual distributions have not fallen once over the past seven years. As a positive, as well, it is apparent that in calendar year 2018 just past, portfolio income was $61 600, not too distant from my revised Objective #1 target of $63 000 pa.

For forward planning purposes, I have settled on the average of the past five full years of distributions as a reasonable conservative estimate of future distributions. This implies an estimate of $45 000 per annum, which I use as one input into estimates of my required emergency fund and insurances.

Forecasting distributions from Vanguard managed funds has proved quite challenging. Based on past averages, I had expected higher distributions from the Vanguard High Growth fund. Using naive averages of overall portfolio distribution rates and averages had led to total portfolio income estimates for the half year of between $20 000-$25 000.

What has proved much more accurate in the case of the Vanguard funds is using past ‘cents per unit’ distribution data for the five previous December half years, which up to a few weeks ago I had never explored. Another method was to observe the overall change in value from 31 December to 1 January fund values, though this obviously has some market noise in it. These methods came within about 20-30% of the final lower distributions from Vanguard.

Some of these large variations I expect to be slightly reduced in the future by the increasing role of ETFs in my portfolio. These should have a more stable distribution profile that will be based on underlying firm earnings rather than the pre-mixed funds that are realising capital gains in an effort to seek to track a particular asset allocation. In this regard, it is pleasing to see that together the Vanguard VAS and A200 ETFs accounted for just over 25% of all portfolio income.

Over the hot summer days in prospect I will be eagerly waiting for the Vanguard fund and ETF distributions and then settling how to reinvest them. My current target asset allocation suggests purchases of more Australian equity ETFs such as A200, to reach my new target allocation for equities, and between Australian and international shares.

Overall, while the half-yearly income has not been what I expected, I still feel very fortunate to have had, on any measure, my portfolio providing additional income of $2600 per month over the last six months, meeting just under half of my typical monthly credit card expenses.

Just two or three years ago, these types of results were ambitious new highs. With each new investment in 2019, I will be looking forward to growing the total distributions income further in the future.

Reviewing the Log – Trends in Passive Income and Expenses

Posted on September 28, 2018February 20, 2020 by The FI Explorer

The world is too much with us; late and soon

Getting and spending, we lay waste our powers

Little we see in nature that is ours

Wordsworth The World is Too Much With Us

Reading the signal flags

As the journey progresses, some questions are increasingly pushing themselves forward. Questions such as: what does achieved financial independence look like in practical day-to-day terms? Will I recognise it when I see it? The answers to these questions will help recognise the length of the journey still to travel, and the signposts of arrival.

Over the last few years I have been recording my credit card expenditure, and more recently, have started comparing this against the income produced by the portfolio. This is on the theory that if my investment income matches or exceeds average credit card charges each month, then at one level some variant of FI has been achieved (is “credit card FI” copyrighted?). In July I mentioned this, and provided a snapshot. This post seeks to dig deeper into this data, to better understand where I am from a different perspective.

The portfolio goals I am working to are built from target incomes, which are then translated into lump sum targets, using an assumed average return (of 3.92%). Each month I report a percentage progress towards these goals. Currently I’m about 95 per cent of the way to Objective #1 and 70 per cent of the way to Objective #2.

There are some interesting subtleties to bear in mind in using a percentage based measure of progress, that are well discussed here. The goals also have a time frame based on progress to date, which means, for example, that I noticed the other day I was officially only around 100 days from Objective #1.

Each of these are useful measures for understanding progress, but at its most basic, financial independence is having a steady passive income sufficient to meet required daily expenses. There are different variants of this concept, with ‘leanFIRE’ and ‘FATfire’ referring respectively to a capacity to meet a modest, if not minimal lifestyle, or the capacity to live a relatively unconstrained, comfortable lifestyle from passive income.

Constant bearing, decreasing range

To better understand the answers to the questions above, I have stepped beyond credit card expenses records, to look at total expenditure from all sources. This includes items such as rates, energy and utility costs, day to day cash, as well as contributions to irregular major expenses such as holidays, house and car repairs, as well as eventual car replacement. It does not include income taxes.

This record has never focused on frugality of living expenses, or detailed expense analysis to a significant degree, and will not start doing so now. Rather, what I sought to understand was an estimated total cost of maintenance of my current lifestyle. Over the past few years my total credit card expenses have averaged around $72 600 per year. Adding all other expenses not paid by credit card ($24 300) gives a total current expenses of $96 972 (or around $8 081 per month). The figure below sets out a ‘credit card only’ and a ‘total expenses’ series against an averaged measure of monthly portfolio distributions. The green line effectively represents actual credit card expenses, added to an equal monthly contribution of other non-credit card expenses.

Total and credit 3 - Sept 18

This shows that while on average portfolio distributions have been around equal to credit card expenses since the middle of 2017, there is still some further progress before portfolio distribution can regularly meet total current expenses. As that is a quite busy graph, I have produced a simplification of the same data, expressing instead the proportion of total expenses being met by portfolio distributions over time.

Total expenses % of dist 2 - Sept 18

This data, and the trend line, shows steady progress through the last five years. Distributions have risen from meeting only around 20 per cent of expenses, to now meeting around 80 per cent. On current trends, it would appear that the next several months could see it passing the point at which annual distributions regularly fully meet my current lifestyle expenses.

Summary – Running before the wind

By definition, this log can only be a record of what has been. There are dangers in linear extrapolation on any course. For this moment, progress seems relatively steady and consistent beneath month to month market variations.

Yet there are a few cautionary points to observe:

Right target? My current estimated total expenses are above those assumed in my portfolio goals ($96 000 compared to $80 000 per annum), potentially implying the latter need to be revisited.
Irregular estimated expenses – The total expense estimate is influenced by some broad estimates of major but irregular spending requirements, which could turn out differently than expected.
Both income and expenses are variables – while portfolio income has been mostly stable over the long-term, there can be large variations in half-yearly totals. It is not impossible for future periods of higher expenditure to coincide with lower portfolio income.

The answer to the questions I posed may well be that I will not immediately recognise the cross-over point, that I will need to actively monitor for it. In the immediate term, it’s possible I will drift into a position in which notionally my entirely ordinary salary income is available to add to the portfolio, increasing portfolio growth strongly. This is an intriguing and motivating part of the mathematics of long-term portfolio investment.

As the portfolio reaches towards full expense replacement, there is a duality. Amongst steady but small changes and weekly habits it feels as if an inflection point, or some form of phase transition is creeping upon the stage. The task is to measure, notice, reflect and act on the result.