Property Prices Decline in Melbourne and Sydney – Should I Buy?

After property prices have been going up for quite some time, there seems to be a considerable amount of anxiety in Australia as house prices start to fall. According to Corelogic, so far there have been price declines of about 10% in Sydney and Melbourne. However, this is an average and masks the finding that top-end properties have been declining much more than affordable properties e.g. the average Broadmeadows house in 2017 is $540k and in 2018 it is $560k, a slight increase. However, in Toorak house prices went from $5 million 2017 to $3.4 million in 2018, which is a 30% decline and $1.6 million wiped out of the average Toorak house.

Toorak house and unit prices as of February 2019, source: realestate.com.au

If you own a home, does this mean it is a good time to sell it? Alternatively, is it a good time to buy?

My answer is that I don’t know. In my opinion, it is rarely a good idea to try to time the market as studies show that most people fail to pick the bottoms and the tops. The better strategy is diversification. One form of diversification is diversification into different types of assets e.g. splitting your wealth across e.g. stocks, bonds, property, gold and cryptocurrency. However, with property there is little opportunity to diversify because each house is very expensive. The average family home in Melbourne costs about $800k. If you save up a 20% deposit of $160k and right after you buy there is a price decline of 30%, then you’ve lost $240k. Another major problem with expensive property is limited ability to dollar cost average. In a volatile market, you can invest a small amount every fortnight to smooth out the bumps, but this is clearly not possible if you’re borrowing to buy a house.

Will I buy a property?

I have been anti-property for a long time, preferring instead to live at my parents and invest in ETFs. My plan was to live off dividends and eventually use the dividend income to rent a place. When my dividend grew high enough, I’d retire early and travel the world forever, living in Southeast Asia. This plan was hatched during a time when I hated my job.

However, as my salary and dividend income rise, I am having mixed feelings about gallivanting in Southeast Asia for the rest of my life, especially when I am starting to enjoy my work, and I’ve realised that although renting can be cheaper in some suburbs, this does not apply to all suburbs. In many suburbs, it is cheaper to rent, but there are some suburbs where it is cheaper to buy. This depends on a number of factors e.g. rental yield but also how much you earn. The more you earn, the more likely it is that it is cheaper to buy rather than rent. This is because you rent with after-tax income. For example, if you paid zero tax, then if you had a choice between buying a $1 million apartment or renting it for $40k per year then it is preferable to rent because you could invest $1 million in an Australian equity ETF or LIC (e.g. A200, VAS, BKI, or ARG) and earn about 5% dividend yield of $50k per year, use the $40k to rent and have $10k leftover. However, if you were earning enough salary such that you are taxed at 40% (if you earn over $80k then you pay 37% in income tax in addition to a 2% medicare levy so it is approximately 40%) then rather than getting $50k in dividends you’d only be getting $30k after-tax (ignoring franking credits), which is not enough to pay the rent of $40k per year. In this case, it is cheaper to buy.

Although this may vary across different cities, as a simple generalisation, within Melbourne family homes tend to be cheaper to rent whereas units and apartments tend to be cheaper to buy. For example, using Toorak again as an example, the average Toorak house costs $3.43 million whereas it costs $965 per week (about $50k per year) to rent. If you had $3.43 million to afford a home, you’d be better off putting this in an ETF earning say 5% dividend yield of $171k per year. Even after tax and ignoring franking credits you’d have about $16k per year in dividend income. You’d then pay the rent of $50k and have $66k per year extra if you rented.

Home prices vs rent prices in Toorak as of February 2019, source: realestate.com.au

However, this does not apply if you are buying or renting a Melbourne CBD unit (which is where I’d rather live). A unit in the CBD is $484k to buy and $530 per week ($28k per year) to rent. Putting $484k into an ETF earning 5% dividend yield would only give you $24k before tax, which is not enough to afford the $28k rent. Given that it is cheaper to buy ignoring tax, it will definitely be cheaper to buy after tax. The higher your marginal tax rate, the more likely it would be that buying is cheaper. However, this analysis ignores the high body corporate fees that apartment owners typically pay. Furthermore, an argument can also be made that Toorak homes are better investments vs CBD apartments. Therefore, it may be worth buying a Toorak home vs an ASX200 ETF as there is some hope that the Toorak home will outperform the ASX200 whereas there is little chance a CBD unit will outperform the ASX200, and this may explain the differences in rental yields.

Melbourne CBD buy vs rent prices as of February 2019, source: realestate.com.au

Arguments for home ownership

As I said, I am considering buying a place of my own. One of the reasons is that I am starting to dislike commuting and would rather walk to work. Another reason is that over time I am starting to dislike living with my parents. Furthermore, buying a place is not that inflexible. Even if I move, retire early, or even dislike the place I live in, I can arrange for a real estate agent to rent it out the apartment and forward any leftover rental income to me, so I can still retire early and live off rental income, although rental income will likely be lower compared to dividend income because the real estate agent will take a cut of the rental income as a fee for managing the property. Furthermore, rental yields are typically lower than dividend yields.

Another concern with buying a property is debt. I believe that it is important to always be ready to retire because you never know when you’ll be fired or if you’ll hate your job. Buying a property usually incurs significant debt, and many people are tied to their jobs because of the mortgage. However, even though I own ETFs now, I still have a small amount of debt via a margin loan. I rationalise this by telling myself that the interest expenses is tax deductible and also in the event of a need to retire early I can easily sell off ETFs to pay off all the debt. This idea can be applied to property as well. If you buy an affordable property (e.g. $300k to $400k) and save up a large deposit (e.g. 50%) before you buy, even if you are fired you can sell the property and invest the proceeds into high dividend ETFs. Another alternative if you have enough equity in the property is to simply rent it out. If the equity is high in the property, the rental income should be higher than the interest cost as well as property management fee, which makes this a passive income stream similar to dividend ETFs.

Another option is to sell all my ETFs and buy a place outright, but I’ve decided against this idea because then I’d forego dividend income as well as trigger capital gains tax. When I buy ETFs, my plan is to hold it forever. Ideally, I’d like to hold any asset I buy forever and live off investment income (with the obvious exceptions being gold and cryptocurrency).

Conclusion

In my opinion, the best test of financial independence is to ask yourself how long will you survive if you have no job. If the answer is “forever” then you are financially independent.

Right now, in my thirties, I generate about $20k per year in dividend income, which in my opinion is enough to live a reasonable lifestyle in Southeast Asia e.g. Bangkok, Chiang Mai, Bali or Sihanoukville. If I really hated my job now or if I were fired, I could fly to Southeast Asia, live there for a few decades, and then come back to Australia to collect my superannuation.

However, even though I feel I could do it, I don’t feel comfortable relying solely on $20k per year in dividend income, and as I said, even though I hated my job many years back, I am starting to enjoy it more and more, so my plan is to stay in Australia and continue to invest and build more dividend income. However, if my plan is to stay in Australia for longer, I’ll need to consider my comfort, and two areas of discomfort in my life now are living with others and commuting. Basically being around other people bothers me. If I live with others, I have little privacy, and if I am on a packed train, it bothers me as well. Being at work with others bothers me if I am around the wrong people. The key is in having enough financial independence to allow you to have more say or control over the type of people you surround yourself with. Something I have learned about myself is that I am very much a people person. If I am around the wrong people, I feel extremely unhappy and depressed, but being around the right people can make a huge difference to your mood.

Buying a place in or close to the city will cut my commute, allowing me to walk to work, and it will also allow me to live by myself. If I save up enough cash deposit and buy a reasonably cheap place, even if I do decide to retire early, I’d still be able to “positively gear” the property by renting it out and generate passive rental income, which when coupled with my dividend income can boost my early retirement living standards.

Is Salary Sacrificing into Super Worth It?

Because I live in Australia, there are some financial ideas that are unique to Australians e.g. franking credits, negative gearing, and superannuation.

Firstly, what is superannuation? Superannuation (or super) is a retirement fund similar to the US’s 401k. When your employer pays you, they are required by law to put 9.5% of your salary into your super. This super is locked up until you are old (about 60 to 70).

Why salary sacrifice into super? Compared to many other countries, income tax is high in Australia. Any amount you earn over $37k has a 32.5% income tax rate applied to it. If you earn over $90k then any amount over $90k attracts a 37% income tax rate. However, suppose you earned $100k per year and you arranged with your employer to salary sacrifice $10k into your super fund, then this means that rather than paying $3700 tax on that $10k and receiving $6300 in your bank account, you instead have that $10k go into your super fund and where it is taxed at only 15% i.e. you pay $1500 tax. This means you save $2200 per year assuming you salary sacrifice $10k per year.

If the tax benefits are so good, why not salary sacrifice everything into super? The answer is that there is a limit. The amount your employer puts in (9.5%) and the amount you salary sacrifice cannot exceed $25k per year. Take the example of someone who earns $100k. This figure does not include super. The employer is paying $9500 (9.5% of $100k) per year into superannuation by law. However, if the worker wants to top this up by salary sacrificing, they should simply find the difference between $25k and the compulsory contribution amount ($9500) and then salary sacrifice this amount. In this case, the person earning $100k should salary sacrifice $15500 per year to fully take advantage of the tax benefits. If you get paid every fortnight, simply divide this by 26 and therefore salary sacrifice $596 per fortnight. In my opinion, you should always salary sacrifice a little bit below the limit because your salary will likely increase bit by bit over time. If the amount you salary sacrifice is exactly $25k then the next salary increase (e.g. due to inflation correction) can tip you over the $25k mark, which leads to punitive taxes applied to you. Therefore, I recommend aiming for $23k or $24k just to be safe.

Using the example of earning $100k per year, if you are salary sacrificing $10k per year you’d save $2200 per year. If you salary sacrifice to the max then you’d be making $3410 per year.

Assuming you save $3410 per year over 30 year, then assuming 8% per annum returns, you’d have $250k.

What are the downsides of salary sacrificing into super?

Even though there are tax benefits, the main disadvantage of salary sacrificing into your super fund is that you do not get access to this money until you are around 60 to 70. However, there are hardship provisions in superannuation that allows you to access your super under severe financial hardship. Given that I am a long-term investor, I normally buy and hold investments forever. I will only ever sell if there is severe financial hardship. Therefore, keeping money in super doesn’t make much difference. For most people who do not salary sacrifice into super, their main reason is that they need to pay the mortgage, but they are simply building up savings in their house, and because houses have high transaction costs, chances are they will only sell the house under severe financial hardship as well.

One common argument people use against superannuation is that the “rules can change.” That is, while your money is locked up in superannuation, the government could change the rules and e.g. increase taxes on it. However, this is not a good argument. The risk of government changing rules or legislation apply to all investments. For example, if you do not salary sacrifice and invest in property and shares outside of super, the upcoming proposed changes to negative gearing, capital gains tax and franking credits will affect you. Unless you invest in offshore accounts or cryptocurrency, you are at risk of “rules changing,” and even if you invest in, say, offshore accounts, then offshore jurisdictions are subject to changes in legislation, and cryptocurrency protocols can change, leading to “hard forks.” You can never escape the risk of legislative or protocol amendment. The only way to mitigate this risk is to diversify.

The key downside of salary sacrificing into super is that you do not get passive income, which impacts on your ability to be finacnially independent. If you salary sacrifice $10k into super, that $10k does not produce dividends that go into your bank account for spending. It simply accrues in the super fund and accumulates until you are, say, 60. This means that if you seek to be financially independent quickly or retire very early, salary sacrificing into super can be a problem. However, there are workarounds.

The four percent rule

The four percent rule states that when you retire you spend 4% per year. Suppose you retire with $1 million in net worth. You simply spend $40k per year. Now suppose you had $500k in super and $500k outside super. One strategy is to continue to use the 4% rule but to retire at a time such that you can use the 4% rule and then time it so that you run out of your $500k outside of super just before you have access to superannuation.

Coast FI or Barista FI

Another option is called “coast FI” or “barista FI” which are terms used among the online FIRE community (financial indepence retire early). Basically you can salary sacrifice to the max early in your career such that you have, say, $200k in super by age 30. Assuming 8% per annum growth, then this $200k in super will become $2 million by age 60 assuming no extra contributions. Therefore, through aggressive early savings, your 60s are covered. Having $2 million when you are 60 is more than enough. However, because you have locked up a considerable amount of money into super, you may live a lower standard of living up until you are 60.

One solution to this suggested by the FIRE community is “coast FI” which sadly has nothing to do with the Gold Coast. Rather, you coast to your 60s by taking it easy and doing easy jobs (e.g. a barista, although based on what I have seen being a barista is quite difficult). However, in my opinion, this is not a good strategy because even easy work is still work, and there is no guarantee that you will be able to find easy work in the upcoming age of automation. The whole point of financial independence is to enable you to live without a job so that you can pursue whatever you are passionate about.

Although there are problems with barista FI, the insight that barista FI brings up is that you don’t need to retire early. Once you live off dividends, rather than retire and stop working, you can keep working but simply don’t work as hard. You don’t need to work as a barista, but you can work the current job you work but simply work in a more relaxed manner. This may mean you spend more time at work chatting to coworkers or it may mean you work part-time and take more holidays. A more mainstream term for this is “semi-retirement.” Another option is to change jobs and do something you are passionate about e.g. you may build online social enterprises that help the world.

The solution to the superannuation dilemma

Superannuation presents many Australians with a complicated dilemma. Either you salary sacrifice and increase your wealth thanks to tax benefits but lock your money up unitl you are very old, or you do not salary sacrifice, reduce your wealth, but reach financial independence faster.

In my opinion, you should salary sacrifice to the max early in your career. However, to accelerate your chances of becoming financially independent as fast as possible, live as minimalist a life as possible (e.g. living with roommates or with parents, riding bikes or taking public transport, never having children, etc) and then with your money outside of super apply the Peter Thornhill approach by investing all your money into high dividend paying Australian equity ETFs and LICs (e.g. VHY, IHD, RARI, EINC, RINC, BKI, AFI, and ARG). Because Australian equities are blessed with high dividend yield and franking credits, this coupled with a highly minimalist lifestyle will allow you to quickly achieve financial independence. To use some example numbers, the cost of a sharehouse found via Gumtree or Facebook is about $700 per month. The cost of meal replacement drink Aussielent (which I use as the basis for the cost of food) is $256 per month. Then if you get a bike then you can cover all necessities for $1000 per month or $12,000 per year. Assuming dividend yield of 7% then this means you need to save up $170k. Adding income tax and offsetting it with franking credits, this means you’ll only need to save up about $200k in high dividend ETFs or LICs to be able to be financially independent. After you have $200k, you can start to diversify your portfolio away from Australian equity to reduce risk (e.g. into bonds and international equities). Then over time, as your dividend income increases, you can slowly increase your living standards, e.g. live by yourself rather than with housemates or parents. You can eat tastier food rather than Aussielent, etc. However, for the sake of financial indpendence, your living expenses should not exceed your passive income because you must minimise the amount of time you are dependent on your job.

Because you salary sacrifice into super, there is a good chance a large chunk of your net worth will be in illiquid assets, so your living standards will be low up until you are 60 and then suddenly after 60 you will have a very high standard of living.

Retirement (or semi-retirement) in Southeast Asia

If you salary sacrifice into super, you will have a considerable amount of money in your 60s or 70s, but before you are old, you will likely live a minimalist lifestyle assuming you live off dividends. A way to increase your standard of living is to retire early in Southeast Asia where the cost of living is lower. Before I spoke about how $1000 per month is enough to live a very minimalist lifestyle in Australia, but in many Southeast Asian cities e.g. Chiang Mai, Ubud or Sihanoukville, $1000 per month can afford a more comfortable standard of living. You can retire early and then come back to Australia in your 60s to collect your superannuation and then retire in Australia. Because Southeast Asia is a bit “rougher” than Australia, younger people in their forties or fifties can tolerate it better, so if you end up retiring early in your forties or fifties living off dividends, you can go to Southeast Asia for retirement and then come back to Australia to cash out your super. One of the benefits of living in Australia is its socialist healthcare system (Medicare) that provides free medical care for all. This is particularly useful for older people. That being said, if you reach the age of 60 or 70 with net worth of $2 million, that sort of money can buy good healthcare even in e.g. Thailand. Cities such as Bangkok have international-standard private hospitals that many people from all over the world travel to for medical treatment.

Disclosure: I currently own IHD.

Merry Christmas 2018! Thoughts about Socialising, Conformity and the Recent Market Turmoil

This post will go over some of my thoughts that have been on my mind over the Christmas holiday. In true minimalist style, I have not purchased a Christmas tree nor have I purchased any gifts for anyone, and I will not be attending any Christmas parties. I have caught up with some friends and family over the holiday period but little else. Although it is cliche to say this, Christmas is highly commercialised these days, and personally I don’t celebrate Christmas too heavily, but many other people do, and I think my lack of engagement in Christmas activities puts a distance between me and others.

Ultimately the main issue is that often the cost of human connection and intimacy is conformity, but conformity is often costly.

Socialising and conformity

As I have discussed, an idea that has been on my mind recently is the cost of socialising. Many of us like to think that we are independent, that we do what we want regardless of what others think, but going against the grain and being very different is harder than you may think. It is natural and normal to conform. In fact, I would argue that we are hard-wired to conform. It is something that we evolved to do. There is a famous psychology experiment (the Asch conformity experiments) that shows just how powerful conformity is and how susceptible we all are.

Even though I like to think of myself as independent, I do conform to a degree, and conformity is sometimes important because it allows you to fit in to a certain culture with which others are familiar. Taking the example of Christmas, if you do not give gifts or engage in any Christmas activities, this will clearly put a barrier between you and others.

There have been moments in my life when I have been too independent, too much of a freethinker, and this has isolated me from society, which leads to misanthropic feelings, and this can have very negative mental health outcomes and can lead to depression. It is important to find the right balance between independence and conformity. As a man who enjoys independence and freedom as well as systematically minimising all forms of obligations (debt, social norms, customs, tradition, etc) this has been one of the realisations I have come to this year, that there is some value in conforming, but it needs to be controlled and I need to practice conformity in a way that still allows me to be myself and to be authentic. Most importantly, conformity needs to be practiced from a position of independence and freedom. This reminds me of the concept of exit, voice and loyalty. You can be loyal i.e. you can conform to something or someone’s values, but you need to have the freedom to be able to voice your own views or values, and if your values or views conflict too much with those with whom you are loyal, then you need the ability to exit. This is where having huge passive income and minimal obligations helps. For example, if you have a huge mortgage and three children to support, and you work a job you hate, you are trapped in this job. You are forced to conform or be loyal in this arrangement without the freedom to voice or exit. However, if you suddenly hate your job but you live off passive income, have no debt, no children, no mortgage, and no obligation or commitments, then there is nothing stopping you from voicing your displeasure or exiting entirely.

Although I do believe there is some value in conformity, I should say that everyone is different and that I do believe there are many who value nonconformity. We are typically more comfortable when we are in environments that are familiar, that fit in with our own culture. When someone is noncomformist, e.g. to take an extreme example, if someone comes to work wearing clothes that are inappropriate (e.g. wearing underwear), then this creates discomfort. Something just doesn’t seem right. However, conformity can go too far. Too much conformity creates a fakeness that many find unappealing. Although familiarity can put people at ease and build human connection, you can go too far to the point where you are fake and this also creates unease. There is value therefore in conforming in moderation but it is also important to have the courage to be yourself, to reveal your true thoughts, and to be authentic. Usually the ability to be your true self and to be authentic comes when you are financially secure and when you have few obligations.

I should also add that conformity is not just about whether you give gifts or wear certain clothes to work. Most of us conform but aren’t really aware that we conform simply because we feel that what we do is what we are supposed to do. For example, most people drive cars, get married and have children without even thinking about it because this is seen as normal. If you’re a cycling, if you’re single, and if you’re childfree, this is seen as unusual, but I think society nowadays tolerates individual freedom, so even if you are a single childfree cyclist, you will be considered different but you will not necessarily be socially ostricised. In my opinion, it is very important to be aware of how much culture affects you because when individuals conform to most cultures, they usually impose upon themselves large obligations. Among most cultures there is an expectation that a person’s youth is a period of freedom. However, the expectation is that once someone has enjoyed his or her youthful freedom, they need to become adults, they need to accept adult responsibilities, and they need to “settle down.” I argue that you don’t need to ever settle down, that you don’t need to accept large obligations. You can be free forever.

The recent market turmoil

I will change topics now and talk about the markets. The markets have done very poorly over the last few months. In my opinion, we have gone through an eight-year-old bull market without a major correction, which is the longest in history, so we are due for a crash soon. This recent turmoil in stocks may be the start of the next financial crisis but there are many credible institutions (e.g. JP Morgan) predicting the next financial crisis will occur in 2020.

Donald Trump’s policies do not help, especially the tariffs between the US and China. Importers will need to pay the tariff and pass it on to customers, which creates inflation as the cost of living rises. Furthermore, corporate tax cuts and higher government spending increases money supply in the economy. All these factors increase inflation, which necessitates the central bank increasing interest rates. Higher interest rates means corporate profits fall as companies need to pay higher interest to service their debt. Furthermore, tariffs don’t just mean importing products into America become more expensive. Once tariffs are applied to Chinese goods coming into America, the Chinese will apply retailiatory tariffs, which block American exports going to China, which in turn hurt sales. Because Chinese companies cannot export to the US as much, this impacts on Australia as we export a significant amount of raw material to Chinese companies who then transform these raw materials into consumer goods to be exported to the US. History has shown that protectionism benefits no one. Both parties lose out.

In my opinion, throughout a market collapse it is important to stick with your investment plan rather than sell in a panic. In an earlier post I spoke about “age in bonds” or owning your age in government bonds e.g. if you are 30, own 30% bonds. This rule is a guide and can be modified to fit your risk appetite e.g. if you can tolerate more risk then consider putting 50% of your age in bonds (e.g. if you are 30, you own 15% bonds).

The problem most people have is they cannot predict their risk appetite. When markets are going up, they think they can tolerate high levels of risk, but once markets actually collapse and they are confronted with large and sudden declines in wealth, they realise that they cannot stomach volatility, and they panic sell and crystallise their losses. Therefore, in my opinion, if the recent bull market has lulled you into complacency and now you are feeling nervous, it is a good idea to reflect on what your true risk appetite is, and in the future you can buy more (or less) defensive safe-haven assets (such as bonds, gold or cash) in order to align the asset allocation in your investment portfolio to your actual risk appetite. Over time, as you live through more market crashes, you start to get a feel for what your actual risk appetite is. It is not something that is easy to predict. It is something you need to adjust as you experience it in real life. One of the biggest mistakes in financial planning is when the financial planner hands you a form and you fill how much risk you are willing to take. In my opinion, no one really knows how much volatility they are able to withstand until they actually expereince it in person. Until someone feels $100k of their wealth being wiped out in one day can they truly appreciate how much volatility they can stomach.

It is also important to keep in mind why you are investing. For me, investing in stocks is mostly about generating dividends, passive income, and thereby providing freedom. Therefore capital gains do not matter much because my intention is to hold these stocks or ETFs forever. The recent market correction therefore can be seen as an opportunity to load up on more high-dividend ETFs. For example, with the market collapse, the iShares S&P/ASX Dividend Opportunities ETF (ASX: IHD) currently has a dividend yield of 13% according to Bloomberg. Of course, even if you are a dividend investor, there are benefits in diversifying into bond or hybrid ETFs. Although high-dividend ETFs such as IHD currently have a yield of 13% whereas government bond ETFs such as BOND have yield of 2.3% and HBRD, a bank hybrid ETF, has yield of 3.7% it is important to remember that although dividend yields are higher than bond yields, dividends can be cut.

If the market correction we are currently experiencing gets really bad, I will not be surprised if companies start announcing dividend cuts. It happened after the GFC, and it can happen again. This is where bonds can be useful because bonds are more likely to be paid to investors. If a company faces distress, bondholders by law are paid before stockholders. Bonds or hybrids then can be useful for income investors seeking passive income because they provide not only stability in price but also stability in income. Even though yields are lower for bonds or hybrids, this reflects the lower risk, the fact that these payments are less likely to be cut in the event of economic distress.

Disclosure: I own IHD and HBRD.

ETFs (and other ASX-listed Products) that Pay Monthly Distributions

“If we have food and covering, with these we shall be content.” ~1 Timothy 6:8

Some time ago I wrote about the Betashares Australian Dividend Harvestor Fund (HVST), which as of now has a very high dividend yield (about 9%) and pays monthly distributions. Monthly distributions are very convenient if you are living off passive income because, for day-to-day expenses such as food, it is more convenient to receive your payment more frequently. Most ETFs pay distributions every quarter, which is quite a long time to wait.

That being said, quarterly or even yearly distributions may be convenient for spending on things you spend less frequently on e.g. a holiday. Suppose you had $100k invested returning 4% dividends. This is $4k per year but paid monthly this would be $333 per month, which means if you wanted to save up for a holiday you’d need to take that $333 per month and put it in a savings account and wait for it to accumulate to $4k before you take an annual holiday. However, if you put that $100k into an ETF that pays yearly distributions, then you’d get $4k once a year, and when you get your $4k, you can go ahead and book your flights and hotels online. The fact that the ETF pays yearly rather than monthly distributions acts to force you to save for those expenses that occur yearly (typically a holiday).

Therefore, I think it is useful to have a mixture of distribution payment frequencies to match what you spend your money on. However, when it comes to financial independence, you shouldn’t focus on holidays first. You should focus on the necessities, and even though I am an atheist, I like to quote 1 Timothy 6:8 in this instance: “If we have food and covering, with these we shall be content.” In many translations of the bible, it claims that you should be content with “food and raiment,” and the word “raiment” is often translated as referring to clothing, but really raiment refers to covering, i.e. not only clothing but also shelter i.e. four walls and a roof over your head. Why am I talking about food and coverings? Because generally food and rent consist of payments we make frequently. For most people, food spending consists of going to the local supermarket to buy e.g. bread. Rent or mortgage payments are usually monthly payments to the landlord or bank. As such, it is better to have monthly passive income if you’re living off passive income while covering the necessities of life.

In my greed to secure monthly passive income to cover the cost of necessities such as bread and almond milk, I invested a reasonable amount of money into HVST, which at the time was paying about 12% dividend yield. However, the problem with high yield funds is that they are high risk funds as well. In fact, most ASX-listed products that pay high monthly passive income perform quite badly in terms of capital preservation. This may be due to the rising interest rate environment. Many high-yield ETFs and LICs that have managed to achieve reasonable capital preservation have been those that pay quarterly distributions e.g. VHY, IHD, STW, and BKI. The reason I believe this is the case is that stocks provides higher yield than e.g. bonds, but there is greater risk in stocks. Unless we are talking about variable-rate bonds, most bonds are fixed-income products, e.g. a government bond pays you a fixed coupon amount. You can therefore rely on this coupon always being paid. There is little uncertainty. Dividends from stocks, however, may vary depending on market volatility and business activity. For example, recently BHP announced it was buying back shares and paying a special dividend thanks to the sale of a US shale asset to BP. If a fund manager holds BHP, it may receive a huge dividend one day and then the next month may receive little dividends. If economic conditions are challenging, dividends may be cut. As such, if a fund manager were relying on stock dividends to pay monthly distributions, there may be times when dividends are low, which means that in order to maintain the high monthly payout, the fund needs to eat into original capital.

When focusing on financial independence, it make sense to focus on the necessities first, i.e. food and raiment rather than holidays, and given that it is more helpful to have monthly passive income to fund these expenses, I believe it is necessary to look instead at medium-yield (not high-yield) exchange-traded products that pay monthly distributions. Assuming food costs $300 per month and rent costs $700 per month then this means you need $1000 per month for necessities, which means $12k per year. You only need $150k invested earning 8% to get this. This is the allure of high-yield funds. However, with high yield comes high risk, so a medium-yield fund may provide a good compromise.

Remembering that investing has a risk-return tradeoff, and remembering that food and raiment are necessities (you cannot live without food and covering), we should not rely on high-yield high-risk investment to fund necessities. We should at least rely on medium-yield medium-risk investments to fund necessities.

I make these comments because recently I have purchased Betashares’s hybrid ETF (HBRD), which pays about 4% monthly. I have found that HBRD pays very reliable income, almost the same every month whereas virtually all other investments pay variable passive income. Looking at the Bloomberg price chart of HBRD below, you can see that HBRD (in black) is somewhat correlated to the XJO (represented in orange by the STW ETF) but with a lower volatility (or lower beta). This makes sense because hybrids are lower risk than stocks but are riskier than bonds. (Hence they are hybrids as they have bond-like and stock-like characteristics.)

HBRD (in black) has lower volatility than XJO (in orange)
Source: Bloomberg

In fact, Betashares seems to have learned its lesson from HVST and have introduced a slew of other medium-risk ETFs (e.g. CRED and now BNDS) that pay monthly distirbutions to complement their existing inventory of low-risk income ETFs (e.g. AAA and QPON) and high-risk income ETFs (HVST, YMAX, EINC, and RINC).

Below is a table of ASX-listed products (mostly ETFs, LICs, and LITs) that pay monthly distributions. The products below are sorted by risk/yield. I have used my judgement to classify these are high, medium or low yield. Generally high-yield investments derive income from stocks and pay around 5% to 10% yield, medium-risk investments derive income from hybrids and corporate bonds and pay around 3% to 5% yield whereas low-risk investments derive income from cash deposits and government bonds and pay around 1% to 3% yield. Some of these products invest in highly risky areas e.g. QRI will invest in commercial real estate debt. Note that some of these investments have not been released yet and that this is a personal list that I keep that may not include all ASX-listed investments that pay monthly passive income. If I have missed any, please notify me in the comments section.

ASX TickerNameYield
HVSTBetaShares Australian Dividend Harvester FundHigh
PL8Plato Income Maximiser LimitedHigh
QRIQualitas Real Estate Income FundHigh
AODAurora Dividend Income Trust High
EIGAEinvest Income Generator Fund High
GCIGryphon Capital Income TrustHigh
MXTMCP Master Income TrustHigh
HBRDBetaShares Active Australian Hybrids FundMedium
CREDBetaShares Australian Investment Grade Corporate Bond ETFMedium
BNDSBetaShares Legg Mason Australian Bond Fund Medium
QPONBetaShares Australian Bank Senior Floating Rate Bond ETFLow
AAABetaShares Australian High Interest Cash ETFLow
MONYUBS IQ Cash ETFLow
BILLiShares Core Cash ETFLow

Disclosure: My investments include BHP, IHD, HVST, AOD, HBRD, and AAA.

How to Prepare for Upcoming Stagflation

Recently markets have been shook by rising interest rates in the US. Interest rates around the world are somewhat correlated because of globalization. Australian banks often borrow from overseas (even from the US), so if interest rates rise overseas, this affects the cost that Australian banks pay to borrow money. The ASX200 chart below shows the correction in recent weeks.

the beginning of an xjo crash september 2018
Source: Bloomberg

How may the stock market crash?

Even though it is not wise to try to predict markets, my hunch is that a very large correction is near, but it may be delayed until around 2020. During the 2009 GFC, the threat was deflation i.e. prices going down, which means prices of e.g. property and shares went down as well. The solution to this was unprecedented money printing around the world. The printed money was used to purchase government bonds (in the US) or even stocks or ETFs directly (in Japan). When there is deflation, money printing is an easy fix because money printing puts more money into the economy, generating inflation, which cancels out deflation.

However, this time the fear is that when the market crashes, it is not a deflationary crash. Rather, we have a downturn while there is inflation at the same time. Why would there be inflation at the same time as a downturn? For example, take the US-China trade war. If US companies and consumers cannot import cheap goods from overseas, consumers and US businesses face higher costs. Higher costs cut into margins, which reduce profits, which reduce stock prices. If the trade wars heat up, US equities should decline futher as inflation increases. Usually when there is inflation, the central bank can combat inflation by raising interest rates. However, US businesses are already highly indebted. If the US central bank (the Federal Reserve) increases interest rates to combat inflation, businesses face higher interest expenses, which cuts into their profit margins and reduces stock price.

This dilemma that the Fed faces, in my opinion, will present a problem in the future and may usher in a 1970s-style stagflationary recession.

What can be done to protect against a downturn?

In a previous post, I spoke about the importance of the “age in bonds” rule. The “age in bonds” rule is just a guide. It doesn’t literally mean you must hold your age in bonds (e.g. if you are 30 then you hold 30% bonds).  “Age in bonds” is a rule of thumb. The complication comes from the fact that some bonds are risky (e.g. emerging market bonds, corporate bonds, etc) whereas some shares are arguably safe (e.g. utilities, gold mining stocks, etc). The basic principle behind “age in bonds” is to reduce risk or volatility in your portfolio as you are nearing retirement so that you are not exposed to e.g. a 50% decline in your wealth just before you retire.

“My personal, non-retirement accounts are about 80 percent bonds and 20 percent stocks, reflecting my old rule of thumb that your bond allocation should roughly equal your age. It’s spread across different bond funds, like the Vanguard Intermediate-Term Tax-Exempt (VWITX). I’m a pretty conservative guy.”

~Jack Bogle, Vanguard Group Founder

Given that I live off dividends, consider myself somewhat semi-retired, and don’t really have a fixed retirement date, I feel it is wise for me to reduce risk in my portfolio much moreso than the average person. For the average person in their 20s or 30s, they may feel that they don’t need to worry about a huge market correction because they can simply make up for the lost wealth by working longer. However, I don’t like the idea of being forced to work when I don’t need to.

Furthermore, even though many people feel as if they can withstand a huge market crash, if a 70% decline eventually does occurs and the reality hits that they have lost hundreds of thousands of dollars without any guarantee that the market will recover in the long run (remember that in the recovery may be many decades away and may be in the next century), I feel that many people would succumb to panic.

Which ETFs perform best in a bear market?

During the recent market correction, I was observing the reaction of different ETFs. What I found interesting is that MNRS, a gold mining ETF, shot up as the XJO went down. See the Bloomberg chart below, which shows MNRS (in yellow) shooting up as the XJO (in black) heads down.

xjo MNRS HBRD QAU and BOND during september 2018 correction
Source: Bloomberg

The large increase in gold mining stocks contrasts with the price of gold, which is represented above by the QAU ETF (in red), which holds physical gold. This makes sense since holding pure gold only provides you with access to gold whereas gold miners usually hold debt, which means they are leveraged to gold. The blue and aqua above show hybrid and bond ETFs, which both remain very stable.

Looking at the last six months, we can see how these ETFs perform not only during a bear market but also during a bull market. We can see that as the XJO goes up, the gold mining ETF and physical gold ETFs go down, which is not ideal. The bond and hybrid ETFs are stable as expected.

Gold miners and bonds vs stocks
Source: Bloomberg

What does this tell us? If you were shaken up by the recent market correction and feel that more risk is coming, a quick way to reduce risk in your portfolio is to buy physical gold and gold mining ETFs. This can be ideal if you don’t want sell shares and trigger capital gains tax. Gold miners are also legitimate companies in their own right. However, the problem with physical gold is that it pays zero passive income, and gold miners historically pay little in dividends. In contrast, the government bond ETF (BOND) pays about 2% in yield whereas the bank hybrid ETF (HBRD) pays about 3% to 4% in monthly distributions, so if you feel you have far too much risk in your portfolio, you can correct it fast by buying gold, but once you have derisked your portfolio sufficiently but still want to tread cautiously, you can take advantage of passive income with bond and hybrids, as well as some high dividend ETFs as well (e.g. IHD, VHY, EINC, etc).

The Simplicity of Living off Dividends

Some people have made comments that many of my posts on this blog are not finance related, so I will make an effort to post more about ETFs and other financial topics in the future. Perhaps the reason why there are few finance topics on this blog is because living off dividends is such a simple technique that I rarely think too much about finance. The whole point of making money is so you do not need to think about money. You do not need to stress about making ends meet when you have few obligations and multiple streams of dividends flowing into your bank account.

Budgeting, tracking net worth, trading, and rebalancing are not worth it

While most people maintain spreadsheets to track expenses and net worth, living off dividends only requires you to invest all your work salary and spend your dividends. If you end up spending more than dividend income, simply “borrow from yourself” by maintaining a few thousand dollars in cash in a separate savings account that you borrow from but pay back with dividend income. Either use a spreadsheet to keep track of how much you own to yourself or ensure that this savings account has a fixed amount e.g. you have $2000 in it, run out of dividends to spend, so you “borrow” $500 to have a balance of $1500 and then when your next dividend payment comes in, put $500 into this savings account to top it back up to $2000.

I don’t recommend tracking your expenses or tracking your net worth because it is time consuming and because the information you get out of it is not valuable. If you track expenses, you can see where all your spending goes, but what matters is not what you spend your money on but how much you spend. If you spend such that your expenses are equal to dividend income, this ensures you don’t spend too much, and one of the benefits of living off dividends is that dividends increase over time as you invest more and as companies become more profitable, so there is a gradual increase in standard of living, which I think helps overcome the feeling of deprivation many feel when they are frugal. If you only spend e.g. $10,000 per year for the rest of your life, you are stuck on that level and do not feel as if you are growing or making progress, but if you live off dividends and your dividends grow, you feel a sense of personal growth. As for tracking net worth, when you diversify across multiple areas (e.g. retirement accounts, managed funds, ETFs, cryptocurrency, etc) then it becomes a huge burden to log in to each of these accounts to check the balance. What matters to financial independence is not net worth per se but passive income. You live off passive income, not net worth, and if you live off passive income then you’ll be able to assess automatically whether you have enough based on whether you are satisfied or not with your standard of living.

Because living off dividends is simple, there are only two things you need to consider: how to spend your dividends and what to invest your work salary in. Most people have no issue with figuring out how to spend their money (e.g. holidays, books, smartphones, and coffee). What to invest in is more complicated, and generally I recommend buying broad and diversified ETFs with a slightly heavier allocation towards high dividend paying ETFs (or LICs). However, more important than what you invest in, in my opinion, is the “buy and hold” mentality. You should buy with the intention of holding these investments for a long time, if not forever. I also do not bother with rebalancing. For example, in recent years the Australian stock market has underperformed whereas foreign stocks (particularly US stocks) have done very well. There are those who rebalance by selling off US stocks to buy Australia stocks to maintain a certain amount to certain countries. This is far more effort than necessary, adds administrative burden by triggering capital gains tax, and does not add much value because if you feel you have too little Australian stock, rather than sell US stock, you can simply buy more Australian stocks. For example, in recent years, as US equities has gone up, I have purchased more high-dividend paying Australian stocks and ETFs e.g. CBA and IHD.

Age in VDCO

For most people who ask, I recommend Vanguard’s diversified ETFs. You cannot beat the simplicity of these ETFs. Whatever your age is, hold that amount in VDCO and the rest you hold in VDHG. For example, if you’re 30 then hold 30% VDCO and 70% VDHG. These Vanguard diversified ETFs diversify across just about all asset classes (e.g. Australian shares, international shares, emerging markets, small caps, property, bonds, etc) so you don’t need to worry about mixing and matching. The reason why you hold your age in VDCO is to broadly follow the “age in bonds” rule, which is insurance against retiring just after a huge market crash. There are many people who are anti-bond and claim that they are a drag on performance, that stocks always go up on the long run, etc, but this is not true. In fact, this is dangerous advice. There is no guarantee that stocks go up in the long run as the value of stocks merely represent company profits and there is no guarantee that company profits will go up in the long run. Even if stocks do go up in the long run, there are huge market crash (e.g. 50% decline) that emerge, not just normal business cycles but debt supercycles that can take centuries to materialize. You do not want to be in the position of being in 100% equities and then losing 50% just before you retire as this can really set you back and impact on the quality of your retirement. Broadly following “age in bonds” (government bonds, specifically) is insurance against such a scenario. In fact, of all the rules of personal finance, “age in bonds” is, in my opinion, the most important. You can pretty much invest in any exotic high-risk asset class (e.g. emerging markets, tech stocks, robotics ETFs, cryptocurrency, etc) but if you own your age in government bonds, you are safe.

When markets go up, it is very easy to rationalize why defensive asset classes are poor quality. It is when markets go up that people easily covert to the cult of equity, but when there is a market crash or when there is a prolonged economic depression that lasts many decades or centures, many will understand and appreciate the wisdom of “age in bonds.” The reality is that when markets are booming, it’s easy to convince yourself why 100% equities or high leverage is a good idea, and the opposite is true when there is a market crash. It goes back to Warren Buffet’s quote about being fearful when others are greedy but also thinking about Ray Dalio’s idea that you must stress test your ideas because you are never be too sure in yourself  because it is easy to be moved by your emotions as well as other psychological biases.

 

 

Using Netflix for Ad-Free Background Music for Study or Work

I pay $14 per month to subscribe to Netflix, which is somewhat hypocritical as I generally try to avoid any ongoing recurring expenses because I feel that you are less likely to put scrutiny on your expenses when it is ongoing and recurring. If something is on autopilot, it is human nature to forget it. This is why “paying yourself first” and automating investing is a powerful tool. For example, if $1000 is deducted from your pay automatically and invested, you will save without effort. However, this principle works in the opposite direction, that is, if you automated your spending, you are more likely to spend more than you would otherwise.

Even though I apply this principle to e.g. phone plans (preferring instead to buy phones outright and use prepaid arrangements) I have made the exception with Netflix. There are many movies and series on Netflix that I enjoy, and if you stay home and watch Netflix, I rationalize that I am not going out and wasting money, and so Netflix is financially prudent.

Of course, you can watch videos for free e.g. YouTube, but over time I have noticed that free products have a downside in that even though you are not paying for the product, you are paying via watching advertising, and because advertising produces little revenue, the creators of free content don’t have an incentive to produce good art, and so much of the free content on the internet is simply people using it as an outlet to unload negative emotions (read the comments of most YouTube videos and you’ll understand) and being exposed to this negativity cannot be good for it. It makes sense to spend a little bit of money to shield yourself from the depravity of humanity.

Over time I have found that there are is such a variety of content on Netflix. I usually dedicate Friday or Saturday nights for Netflix, and during these times I’d watch something serious such as Ozark or Black Mirror. However, when I am eating dinner, I prefer to watch something that is not so heavy, that doesn’t require much concentration. There are many trashy docuseries that provide this e.g. Drug Lords or even Magic for Humans. However, often when I am browsing the internet, working at home, or even writing this right now, I want to listen to background music. The problem with using e.g. YouTube or Spotify is that these have ads, and having ads annoy you while you’re trying to relax is infuriating. This is why I have, of time, found various videos on Netflix that provide ad-free background music. Not only do these videos pay nice music but they also tend to have very beautiful visuals as well.

Note that many of these videos play not only music but e.g. the Slow TV videos may play long videos of train rides or firewood cutting. There are also many videos above that depict a fireplace in case you want to turn your television into a virtual fireplace without any of the mess and smoke.

Please also note that the list above applies to the Australian Netflix, and Netflix lists in other countries may vary.

What if I wanted to play specific music e.g. ambient music?

Even though I love to use Netflix as background music, there are some genres of music that I like e.g. dark ambient music and new age ambient music. These are not accessible via Netflix but they are available all over YouTube. In fact, just about all music is available on YouTube. The problem with YouTube, of course, is the advertising. However, there is an easy way to bypass this, which is to use Listen on Repeat.

Listen on Repeat allows you to set up playlists and fill them with your favourite YouTube music. Even though there is no audio advertising, there are many banner ads on the site, which clutters the sight greatly and slows it down, but at least it doesn’t ruin your music while you’re listening to it.

What if you are at work?

If I am at work and want to listen to music using my earphones, I prefer not to use Netflix, YouTube or Listen on Repeat because these sites are data intensive. Because these sites play not just music but also visuals, a considerable amount of data is used, and using a considerable amount of data at work for music may not be wise.

Thankfully there exists Public Domain Radio, which plays free public domain classical and jazz music. Because this music is old and in the public domain, there is no need to pay anyone royalties. Everything is ad-free and the site is very clean and minimalist. Beacuse it only play audio, there is little data used.

Photo by freestocks.org on Unsplash