“If you aim at nothing, you will hit it every time.” Zig Ziglar
So now that you know how much of the paper life tokens you need to be able to buy your freedom permanently, how do you manage to roll up a sufficiently fat wad of them to get there?
You spend a lot less than you earn, and you invest the rest. Put your money to work, let compound interest do the heavy lifting for you.
There are a lot of ways to invest; some people invest in shares, some invest in real estate, some invest in bonds or term deposits, some invest in magic beans or bit coins. You should probably speak to a professional before investing (or at least read a lot of really good books). I’ve spent a lot of time reading investing books and I’m going to give an example of my approach and a description of why I made the decisions I did. I set myself a goal of reading a certain number of books on investing and to decide and write down my strategy only when I had finished.
I doesn’t matter how you manage to build enough wealth to satisfy the 4% rule; only that you earn an appropriate average return above 4% that will account for the compounding affect of inflation, and that you don’t lose your principal. What follows is only an example of the method that I am using, there are many others. This is not advice, only a description of the choices I have made and why.
I first of all set myself some principles to guide my decision making:
- I wanted it to be simple. I already have a full time job and didn’t want another
- I did not want to use any leverage. Leverage won’t make a bad investment good, but is more than capable of making a good investment bad. Furthermore if there’s a counterparty to every transaction and if that counterparty is a bank who is more sophisticated than and understands mathematics and risk better than you do, it’s more than likely that they are getting the better end of the deal.
- I wanted diversification. Humans are fallible (even me), and I didn’t want any one mistake costing me my freedom.
Asset classes and allocations: Growth vs Income
I then decided what asset classes I wanted to invest in.
Here is a chart showing the performance of some different asset classes over the last 20 years with $10,000 initially invested and all dividends reinvested:
Over a long time period stocks perform better than all other asset classes, however the price can be quite volatile. Hence I decided I also needed bonds to smooth out the fluctuations in my total portfolio. Appropriately rated bonds are safer than stocks, pay regular coupon payments (interest) and the price should be reasonably stable.
Stocks and Bonds are both reasonably liquid assets, but I didn’t want to have to sell any if anything unexpected happened and I needed cash. If you need to sell you’ll either have to pay capital gains tax if the market is up, or realise a loss if the market is down. So I also decided I needed an emergency fund which would sit in a high interest savings account and would pay for my living expenses if I lost my job or some other emergency occurred. I decided a year of living expenses (known from part 3) would be more than enough.
I then needed to decide my asset allocation. As stock prices can move quite substantially based upon fear, greed or the greater economy, your tolerance for watching the variation and potentially the total value of your portfolio plummet should feed into what percentage of stocks you hold. If you are likely to panic and sell if your portfolio plunges in price you will lock in the loss and demolish your returns. If you can set the asset allocation so that you can remain comfortable to stay the course through any kind of future crisis your returns will be good in the long run.
Here is a graph showing the best, worst and average yearly returns based upon the percentage of stocks and bonds that make up a portfolio over a long period of time. Stocks are seen as a growth asset with higher risk, bonds are seen as a defensive asset with lower risk.
I thought that for me the 70% stocks 30% bonds seemed like a good compromise between a good average return and lower magnitude negative returns in the negative years.
I also did an asset allocation questionnaire which you can do here which suggested that for me an allocation of 70% stocks and 30% bonds was appropriate.
Asset classes and allocations: International Exposure
Having decided upon the asset allocation to growth and defensive asset classes the next thing to decide was the weighting to Australian assets vs International assets.
A common split seems to be 50% Australian assets, 50% International assets. The theory goes that if your Australian assets go bad due to problems with the Australian economy your wealth will be somewhat protected.
I intend to spend a large part of my retirement in Australia or New Zealand and all things being equal, if the Australian economy goes bad Australian asset prices will head south, but prices of things you need to buy to live in Australia or New Zealand should get cheaper as well.
Furthermore when you invest in Australian publicly listed companies you have the benefit of being able to receive franking credits. Franking credits are a tax bonus when you get paid dividends. As Australian companies have generally already paid 30% tax on their earnings franking credits are a way to compensate you so that you aren’t taxed twice on the same earned income. For instance, if a company pays you a $100 dividend that is fully franked you receive $30 in franking credits which is used to offset the income tax you pay on the income from the dividend. For example if your marginal tax rate is 30% you don’t need to pay any tax on the $100 dividend. Taking this to the extremes, if you intend to live on an income low enough to pay no tax, your fully franked dividend payments will increase by 30%. For exampe a 5% dividend yield will turn into 6.5% gross. This is free money.
As I will live on a lot lower income that I do now in retirement (I save a large percentage of my income currently) I will drop down several tax brackets and franking credits turn out to be a pretty powerful bonus.
After considering all of the above I settled upon 70% weighting to Australia and 30% International.
Combining these gave the following Asset Allocation:
Australian Shares: 50%
International Shares: 20%
Australian Bonds: 20%
International Bonds: 10%
I included the emergency fund high interest savings account cash holding in calculating the bond allocation as well as they are similar asset classes.
If you’d like to model your own ideas about what your portfolio should look like, the returns, yields and exposures you should check out this site.
Having determined my asset allocation I needed to work out what type of investing to fill the respective allocation buckets with.
There are a few different types of investing; there is the active type where you are actively choosing which stocks to buy and sell based upon some kind of calculated or perceived value (value investing) or where you trade based upon trends in price movements (technical analysis), or there is passive investing where you buy small chunks of the entire market via a low cost fund that contains parts of the whole index or part thereof (index fund) not attempting to find better companies than the average, simply owning everything.
I have throughout my life tended to settle on the value investing side of the argument. This is the type of investing Warren Buffet, Charlie Munger, Ben Graham and the like are proponents of. I have believed that the market is often irrational and through being rational and patient you can take advantage of Mr Markets irrationality and make greater returns than average. More recently I’ve come around to a more passive investing approach. The men listed above are actually my heroes in a nerdy kind of way, and it’s been very hard to take a good hard look at one of my core beliefs and actually change my mind, but here are the reasons I have:
- If you’re actively investing you’re competing against highly paid investing professionals who have significantly more time and training than you do to put into their trades. They often have access to CEOs etc to obtain greater insights than you. When I say competing against I mean they can be directly on the other side of the trade from you with their greater time, knowledge and access to management.
- Research for active investing takes a lot of time, time that I don’t have. I used to enjoy reading financial statements and building discounted cashflow models, but now I’d rather go fishing or surfing.
- By picking individual stocks there’s always the chance that the financial reports are fraudulent and the company’s stock price can go to zero. If you buy the whole index there is no chance the entire index will go to zero.
- Once you work out how much money and the time it will take to reach financial freedom the variable that affects it the most is your expenses. Performing sensitivity analysis upon your rate of return will show that an increase in the return above what can be expected by an index fund perhaps won’t provide the benefit in time to reach financial freedom it should once the additional time, effort and risk is taken into account.
- The majority of professional active investors aren’t able to beat the average market return once transactions costs and fees are taken into account, my ego can be large at times, but not so large to think that I, as an amateur can do what many professionals cannot.
Market timing and rebalancing
While I had changed my ideas about Value investing, by implication this also meant that I needed to acknowledge that I probably shouldn’t be attempting to time the market. To reinforce this I needed to examine a key decision I made way back in 2008. During this time I was looking at buying a house in Melbourne. At the time houses were selling at a gross rental yield of approximately 2-3.5% depending upon the house, which was of course a lot worse from a net yield perspective. The more I looked into the market, the more convinced I became that this did not represent any kind of investment value and that any purchase of a house wasn’t investment grade due to the extremely low yield. I was convinced that anyone buying a house as an investment was in fact speculating with leverage for capital gains, and I thought that at any time there could be a market correction or mean reversion back towards the long term averages for several housing value metrics leading to a permanent loss of capital. Fast forward to 2015 and Melbourne house prices continued to increase as follows:
Solving for the amount that house prices in Melbourne could drop in 2015 and not be below 2008 prices gives a total of 35% before you would start to be behind where you were in 2008. This is of course ignoring inflation, interest on mortgage repayments, stamp duty, council fees etc. The humbling lesson I was forced to acknowledge here is that even though I may be convinced that the market is completely irrational it doesn’t mean at all that the market will become rational at any time in the future. In the words of John Keynes, “the market can stay irrational longer than you can stay solvent”.
Instead of trying to time the market I decided that as the different asset classes I had chosen to invest in weren’t 100% correlated I would periodically rebalance my holdings. This would by comparison of the different asset class prices force unemotional purely mathematical buying low and selling high from a relative comparison point of view. I decided that during the time that I was pumping cash into my portfolio I would rebalance with input funds, and after retirement I would periodically rebalance once a year.
Having decided upon my asset allocation and that I would be investing in index funds the next question was how? There are two main methods for index investing, I could either purchase Exchange Traded Funds (ETFs) through a stock broker, or use a managed fund that matched the asset allocation I was looking for. The way I made this decision was based upon the fees that I would be charged. I compared the fees that I would incur by using a fund such as the Vanguard LifeStrategy Growth Fund or using ETFs. Here is how the fees as a percentage of funds invested compared:
The ETFs would allow me to vary the asset allocation simply if I needed to, however the managed fund rebalances automatically and requires no effort, set and forget. In the end I decided to go with the ETF approach as it would let me change my asset allocation in retirement if I wanted to and it was slightly cheaper, however based upon the work by William Bengen there’s probably no need to change the allocation from 70:30 and the simplicity of the Vanguard LifeStrategy fund is appealing.
The next and final step is to write all of this down in an investment plan where forecast progress can be tracked and turned into actual progress over time. I’ll ramble about that and provide some useful spreadsheets that tie all of these ramblings together in the next post.