Living Through Inflation and Rising Rates: Leveraged Real Estate vs Living Off Dividends

Now that interest rates are rising, there are many people who are wondering if they should fix or not. However, they are faced with a very difficult decision as fixed interest rates are higher than the variable rates. What we are seeing now is that rising interest rates are making many people realise that buying a house is not without risk. House prices now are indeed going down. Furthermore, many people are under significant stress due to rising interest rates.

Meanwhile, those who live off dividends seem to be doing fine. Assuming that you own enough dividend stocks or ETFs and do not have any debt, living off dividends is a stress-free alternative to leveraging into real estate. It is true that dividends can be cut (e.g. during COVID), but you should structure your lifestyle such that you are able to reduce your spending when dividend payments decrease.

The way human psychology works is that risk is not perceived until a disaster happens. For example, if you drive a car without wearing a seat belt and have never crashed, you are unlikely to truly appreciate how risky it is to drive without a seat belt on. However, if you crash your car and slam your head into the windshield and almost die, you are likely to always wear a seat belt from then on. In psychology this is called recency bias: “Recency bias is a cognitive bias that [favours] recent events over historic ones; a memory bias. Recency bias gives ‘greater importance to the most recent event.'”

As I mentioned earlier, the current economic conditions highlight just how risky real estate can be. All that is necessary to create a perfect storm that results in rising interest rates and declining house prices is inflation, and although inflation may have been rare in the last few decades, it is certainly a phenomenon that I think will be more pronounced as the world deals with emerging challenges such as overpopulation and dwindling natural resources.

The benefit of owning an ETF is that you have a more diversified portfolio. For example, if we look at the dividend payments from owning one unit of the high-dividend IHD ETF, you’ll notice that dividend payments are still high and have been slightly trending upward over time (in the chart below, the more recent dividend payments are at the left of the chart, not the right). Even though companies are struggling with inflation and rising interest rates, the benefit of a diversified ETF is that you have exposure to multiple sectors, so while during the recent downturn you would have sustain losses from sectors such as tech, you gain from other sectors such as energy. When you buy real estate, you are leveraged into one asset, which significantly increases risk.

Dividend payments from the IHD ETF have been trending upwards over time.

Of course, just as it is unfair to compare leveraged property to unleveraged ETFs during good times, it is also unfair to compare leveraged property to unleveraged ETFs during bad times. If you are able to buy a home to live in without any debt (i.e. paying cash) then this can give you safety during the recent economic crisis by shielding you not only from rising interest rates but also rising rents. Furthermore, having an investment property (as opposed to a home you live in) insulates you more from rising interest rates because the rising interest costs are offset by rental income. Another consideration is that Australian equities are naturally low in tech stocks and high in energy stocks relative to other countries e.g. in the US there is a much higher percentage of tech stocks.

The Recent Economic Downturn Highlights the Importance of Reducing Risk as You Approach Early Retirement

It’s been a while since I last posted on this blog, so I feel I should give an update especially as there has been a lot happening in the economy, and it has mostly been bad news.

Inflation seems to be the main concern, and central banks are increasing interest rates in an attempt to control inflation. This seems to be associated with large falls in the stock, crypto, and possibly the property markets.

With a high exposure to the stock market and crypto markets, overall my net worth has declined by about 40% from the peak, which is quite a lot, but I am mostly calm as I believe this is just the price I need to pay if I invest in volatile assets. That being said, the overall volatility of my net worth right now I think is too high for comfort, so my plan going forward is to dollar cost average into broad market ETFs in order to gradually reduce volatility. My focus will be on high-dividend ETFs.

What has surprised me most during the recent decline is how well Australian equities are doing compared to other assets. Looking at 2022 YTD results, Australian equities are beating not just crypto, US equities, and US tech, but it also seems to be safer than bonds.

Investment 2022 YTD Returns
Ether (ETHAUD)-55.04%
Dogecoin (DOGEAUD)-54.49%
Bitcoin (BTCAUD)-35.07%
US Tech (NDQ)-24.44%
US Equities (IVV)-14.93%
Government Bonds (BOND)-10.32%
Australian Equities (XJO)-8.67%
Gold (PMGOLD)3.48%
Oil (OOO)48.56%
Returns of various assets from 1 Jan 2022 to 12 June 2022

The weakness of bonds has been surprising. Government bonds have usually been considered safe havens, but during the recent downturn they have under-performed oil, gold, and Australian equities. The safe haven status of Australian equities seems to be related to exposure to mining and energy, a sector that would clearly do well with high inflation.

Net worth, annual expenses, and volatility

Something that I have been thinking about is how important it is to reduce the volatility of your investments as you get older and closer to retirement. Vanguard founder Jack Bogle recommended the “age in bonds” rule where you own a percentage of your net worth in bonds equal to your age e.g. if you are 40 then you own 40% of your net worth in government bonds.

Even though I own no property, I can now appreciate one of the benefits of owning your own home outright, which is that there is no or little volatility in relation to the cost of shelter. The two main necessities for humans are food and shelter. If you have a fully paid home, you cover the cost of shelter (ignoring council rates, maintenance, etc) and only need to worry about the cost of food. If you own a $500k home that is fully paid off, you have a place you can live and not worry about this cost, but if that $500k is in ETFs and you rent a place to live, you need to match the returns of the ETF to the rent.

The Australian federal election, climate change, and solar power

Recently there has been a federal election in Australia where the conservative party was defeated after nine years in power. One of the main issues in this election campaign was climate change. One way of reducing carbon emissions involves installing solar panels on your home. Not only can this reduce carbon emissions but it can also reduce electricity bills. In fact, when I think about it, installing solar panels on your home vs paying electricity bills every month is very similar to the buy vs rent dilemma in relation to housing. If you own a fully paid house, you lock in the cost of shelter whereas if you rent you are exposed to market rent. Rent can go up or down but usually it goes up. The same applies with energy. If you own fully paid off solar panels, you lock in the cost of energy for as long as the solar panels are operational, and you are not exposed to the cost of energy. Right now when energy prices are going up, having solar panels seems smart.

Nevertheless, even though you can go into debt and buy a home and install solar panels and batteries on your house, and this can cover your shelter and energy costs when the debt is fully paid off, another option is to simply invest and live off the investment earnings, which is the option to which I have committed myself.

The ASFA Retirement Standard

For a long time now I have been wondering how much do I need to retire, and thankfully there has been many studies on this.

According to the Association of Superannuation Funds of Australia’s Retirement Standard, a single person will need $27,582 per year to live a “modest lifestyle” and $43,638 per year to live a “comfortable lifestyle.”

ASFA Retirement Standard March 2022

One important detail about the ASFA Retirement Standard is that it assumes that you own your own home outright. However, if I assume that, when I retire early, I will live in a one-bedroom apartment in Melbourne, Australia, then according to Numbeo, this will cost $1,687.42 per month or $20249.04 per year. Therefore, the adjusted ASFA numbers are $47831.04 per year for a simple lifestyle and $63887.04 per year for a comfortable lifestyle. Assuming a 3% safe withdrawal rate, this means you will need $1.6 million for a simple lifestyle or $2.1 million for a comfortable lifestyle.

To give myself some wriggle room, I should aim for a comfortable lifestyle i.e., have a net worth over $2.1 million, and by the time I retire early, my net worth should not be too volatile.

I am using a 3% safe withdrawal rate because withdrawing 4% per year is only tested for 30 years, so if I am retiring at age 60, I would withdraw 4% per year, but if I retired before that, I would want to withdraw 3% per year to be sure that my money does not run out. I remember reading somewhere that for every decade earlier you retire, you should subtract 0.5 percentage points e.g. if you plan to withdraw 4% per year retiring at 60 but end up retiring at age 50 instead, you’d withdraw 3.5% per year, and if you retire at age 40 you’d withdraw 3% per year, 2.5% per year if you retire at age 30, and so on.

How to Live off Crypto by Staking

I primarily invest in the stock market and aim to live off dividends mostly from ETFs. However, the cryptocurrency market is hard to ignore. When you compare the total crypto market to the S&P500 (see chart below) you will notice that crypto makes holding stocks feel like holding cash. In the last five years, the S&P500 has gone up by 109 percent which is almost double. However, the total crypto market cap has gone up 18,942 percent.

Total crypto market cap (blue) vs VOO ETF, which tracks S&P500 (orange) over the past five years.

Institutions are starting to look into crypto. For example, Tesla invests in bitcoin, and the Commonwealth Bank has announced it will soon allow crypto to be used within its app. All this shows that crypto is going mainstream.

Recently ETF provider Betashares has released its Crypto Innovators ETF (CRYP). For those who are interested in exposure to crypto, I highly recommend this ETF, which doesn’t invest in crypto itself but in crypto companies (e.g. crypto miners, crypto exchanges, and companies that hold a lot of crypto). It is analogous to investing in a gold mining ETF rather than holding physical gold itself. What is reassuring about this ETF is that it roughly tracks the price of bitcoin and ether, the two largest cryptos.

The CRYP ETF (blue) is roughly correlated to bitcoin (orange) and ether (aqua) prices.

The benefit of buying CRYP rather than holding the actual cryptos itself is safety and security. ETFs are regulated by government, which is reassuring. The alternative way to securely hold crypto is via a paper wallet, which I do not recommend to beginners as it is complex. If you do not know what you are doing, one small error can cause all your crypto to be lost.

When buying and holding crypto investments such as bitcoin, ether or CRYP, you mainly profit from capital gains made when prices go up. Usually there is little income to be made from crypto. The CRYP ETF pays dividends, but it is likely to be very low. However, a recent innovation in the crypto market that has changed all that is staking, which allows you to earn income on crypto.

What is staking?

According to Binance, the term “staking” is defined as “holding funds in a cryptocurrency wallet to support the security and operations of a blockchain network. Simply put, staking is the act of locking cryptocurrencies to receive rewards.”

To put it simply, when you stake crypto, you are locking it up and allowing it to be used to earn more. The passive income earned via staking is termed “staking rewards.”

Why stake?

What is the purpose of staking? Why not just buy and hold the crypto or invest in dividend-paying stocks? Quite simply, the returns via staking are huge. My favourite place to stake crypto is the PancakeSwap Syrup Pools, and as of November 2021, the average APR from staking is about 60 to 70 percent. Earning 70% from crypto staking is far higher than what you’d earn from dividends. Furthermore, if you buy and hold crypto or CRYP, you are earning either zero or very little passive income.

The huge risks of staking crypto

Of course, if returns from staking are 70% or more, why not just go all in? The answer is that staking is very risky, so I do not recommend putting in too much, and any amount you put in should be an amount you are prepared to lose. When staking crypto, you are giving up control of your crypto and handing it to a protocol. Protocols are merely code, and code can have flaws that hackers can attack. There have been many hacks recently e.g. billionaire Mark Cuban lost a lot of money following the hack of Iron Finance. Other examples of major hacks of decentralised finance networks include PancakeHunny and Poly Network.

So then if crypto staking is so risky, what is the point of staking? Basically you will need to consider whether the high gains are greater than the risks. Everyone has different risk tolerance. Thankfully there are many ways you can reduce the risk of crypto staking. The first is to stake on more reputable networks e.g. PancakeSwap and ApeSwap are examples. Research whether these networks have been audited by reputable crypto audit organisations (e.g. Certik). Furthermore, it is always a good idea to spread your money across different networks just in case one gets hacked. I currently stake crypto on PancakeSwap, ApeSwap and BiSwap.

How exactly do you stake?

In terms of the nuts and bolts of how to stake, more detail can be found on YouTube. In terms of how I stake crypto on PancakeSwap, I deposit Australian dollars into Binance and then convert it into BNB (Binance Coin). Then I withdraw the BNB into a crypto address generated using the Trust Wallet app. Using the Trust Wallet browser, I go to PancakeSwap and convert the BNB into CAKE. I then go to the syrup pool and stake the CAKE. When the staking pool generates a reasonable amount of staking rewards, I harvest the staking rewards, convert it back to BNB, send it to Binance, and then convert it back to Australian dollars before withdrawing it into my bank account.

Conclusion

As mentioned, staking is very risky, so I am relying on both staking rewards from crypto and dividends from ETFs to fund my living expenses. The staking rewards provide high returns whereas the ETFs provide safety and lower risk. Indeed the staking rewards are taxed in full. There are no franking credits on staking rewards. Regardless, for argument’s sake, even if you pay 50% in tax, staking reward of 70% means you have 35% after tax. Dividend yields are about 5% and assuming franking credits completely offset income tax, 35% is higher than 5%, so it is better to simply pay the tax. Often investors are focused too much on tax or other aspects of an investment (such as how much leverage you can achieve). What matters is total return.

Returning to Living Off Dividends

There is a large body of personal finance advice that states that investing for dividends is unwise and tax inefficient. The argument is that when a company pays a dividend, the stock price must decline by the amount of the dividend to reflect the declining assets on the balance sheet. Hence receiving dividends is no different to simply selling shares except the difference is that the company makes the decision to sell rather than you. The argument goes that while you are working and earning a relatively high income, it is better to not receive dividends, which will be taxed heavily (because of your high income). It is better instead to let the earning accumulate as capital gains and then realise those gains after you retire when your income (and hence the tax bracket you’re in) drops.

About two or three years ago, I was strongly persuaded by these views (known as the dividend irrelevant theory). In a 2019 post titled My Changing Views, I said the following:

I believed that financial independence depended on dividends alone. If you generate high dividends, you will have enough to live off the dividends and become financially independent quickly. When I read back on my earlier posts (e.g. Dividends vs Capital Gains and 4% SWR vs Living off Dividends), I now notice that I seem quite cultish and stubborn in my views that dividends from Australian equities with franking credits was the only legitimate route to freedom and that anyone who does anything contrary to this is a slave! When I was in my twenties, I would dream of a life in my thirties, forties, and beyond flying around the world, relaxing on beaches, and living off dividends drinking coconut by the beach as I read books. Perhaps I am becoming more mature as I head into my mid-thirties. I have since relaxed my views on a pure Australian dividend focus. Even though I did invest in some foreign equities, I had the bulk of my investments in Australian equities, and one of the consequences of that is that capital gains were not as high. Had I invested in foreign equities, my net worth today would be much higher. Things may change in the future. I will not tinker too much with my portfolio. For all I know, the Australian stock market may perform very well, but what this illustrates is the importance of global diversification. Australia only makes up 2% of global equities, which is almost nothing, and you never know what policies may be implemented within a country that impacts on every single company in that country.

My scepticism of dividend investing and growing belief in the dividend irrelevance theory didn’t start in 2019. I had been thinking about it for a while. When I think about it today, I may have been strongly influenced by FOMO after seeing the performance of Australian equities (high dividends) relative to foreign equities (high growth). As a result, I did divert more money into foreign equities and even cryptocurrency. I also used my margin loan to leverage more into foreign equities.

Indeed, in the past few years, foreign equity and crypto (especially crypto) has outperformed Australian equity. In the past five years, Australian equity as represented by VAS went up 32% whereas foreign equity as represented by IWLD went up 58%. However, the total crypto market cap has gone up 20525% in the last five years.

Returning to living off dividends

Recently I have decided to shift my focus back to dividend investing. I have learned that going into debt and focusing on capital gains has some negative side effect.

I will not be selling my high growth and low yield investments (mostly foreign equity ETFs and crypto), but new money from my salary will now be invested into investments that pay high passive income e.g. Australian equity. (I am also looking into crypto staking as a way to earn passive income, but I am very new to this and that is a topic for another blog post.)

Sometimes it’s worth paying extra for professional service

According to the dividend irrelevance theory, receiving dividends is no different to selling shares except the company sells for you. In other words, the board of a company, a group of professionals, make the decision on how much earning to distribute to shareholders as dividends. Because professionals are making this decision, I like to use the term “professional dividends” as it contrasts with the term “homemade dividends.”

Homemade dividends refer to a form of investment income that investors generate from the sale of a percentage of their equity portfolio. The investor fulfills his cash flow objectives by selling a portion of shares in his portfolio instead of waiting for the traditional dividends. Usually, if a shareholder needs some cash inflow, but it is not yet time for a dividend payout, he can sell part of the shares in his portfolio to generate the required cash inflow.

Corporate Finance Institute

In my opinion, there is a benefit to relying on professionals to decide how much to spend and how much to reinvest. The 4% rule is a rule of thumb and is not perfect. It takes historic stock market performance in the US and assumes that what has happened in the past will likely happen in the future, but we don’t know if what has happened in the past can be extrapolated into the future. The high stock market returns of the past may have been fuelled by an abundance of natural resources, high fertility rate, and central bankers continually dropping interest rates. What happens now that natural resources are more scarce and the world faces climate change risk, low fertility rate, and interest rates dropping to near zero?

One of the principles of index investing is that you let the market decide rather than engage in “active investing.” The idea of letting an index weight companies by market capitalisation is that you have a higher exposure to companies that the market deems as better. In my opinion, the same idea applies to dividends. Generating homemade dividends seems like active investing. You are making very bold predictions about the sustainability of your wealth when using rules of thumb such as the 4% rule. By relying on the boards of multiple companies to decide the dividend payout ratio, you are crowd-sourcing what professionals and the market believe is an optimal amount of earnings to distribute as dividends. When boards make this decision, they are considering many factors such as risks they foresee in the future. When COVID-19 hit, many companies decided to reduce dividend payouts based on their judgements. Even if the judgment of these boards are not great, if a company pays out too much in dividends then the market should be able to detect this and reduce the share price, which, assuming you’re investing in a market cap weighted dividend ETF, means that your exposure to these types of companies is reduced.

We rely on professionals for many things in our lives e.g. accountants, lawyers, doctors, and even personal trainers. Often it is better to relying on professionals rather than do it yourself. The same idea applies to dividends.

Investing is emotional

One of the benefits of letting boards and professionals decide how much to distribute as dividends is that it takes out emotion. If you are generating your own homemade dividends by selling down stock, you will likely be overcome with emotions. If you sell too much, you might deplete your wealth before you die. If you sell too little, you will deprive yourself right now, and a stock market correction in the near future may wipe out all those gains anyway.

If you try to take away this emotion by relying on rules of thumb such as the 4% rule then you run the risk of being overly simplistic and extrapolating historical performance into the future. By outsourcing this decision to professionals and the market, you reduce emotion significantly.

When saving money, it is often advised that you should “pay yourself first” or “set and forget.” You should ideally automate everything so that you don’t need to think too much about it. Those who try to time the market tend to mess things up. The same logic applies to homemade dividends vs professional dividends. Living off dividends is automatic. Everything occurs in the background and you only see the dividends hitting your bank account.

A bird in hand is worth two in the bush

Another argument for dividend investing is that we do not know if a catastrophic market crash will hit us in the future. If we live off dividends rather than let those earnings compound on a company’s balance sheet, then certainly the growth of our net worth may be lower, but we spend more today, which can help address feelings of deprivation associated with aggressive frugality. If we focus entirely on capital gains, who is to say that just before we retire or during our retirement, an enormous market crash won’t wipe away everything? At least if we invest in high dividends and spend all our dividends, even if everything collapses near the end, we can look back and be happy that we lived off dividends.

Thoughts about the 2021 Crypto Crash

The cryptocurrency market has crashed. It peaked sometime in May 2021 but has gone down since. Major cryptos like bitcoin and ether have gone down about 50% while dogecoin has gone down about 70%.

What I find amazing is how negative people get when prices come down. Based on historical price movements in the stock, property and crypto makets, the downturns are usually great times to buy.

Reaffirming the cake and icing analogy

Of course, as I mention in my previous post about cake and icing, crypto is highly volatile, so it should be considered the “icing on the cake,” the extra returns above and beyond the core necessary “cake” portion of your net worth. Suppose you can live off $40k per year comfortably and you had $1 million invested in a balanced ETF that generates about $40k per year. Then any investments beyond that can be as risky as you wish and it will not affect your lifestyle. Because you have created a solid safety net, you are able to tolerate higher risk, and taking on higher risk allows you to potentially have higher returns.

Of course, you need to be sure that you are comfortable living off $40k per year. If you lifestyle inflates, you will need a bigger “cake” which means you won’t be able to take on as much risk, which means your opportunities for larger gains become more limited.

Anchoring bias

One of the most common biases I’ve noticed coming out of the recent crypto crash is the anchoring bias, which Wikipedia defines as “a cognitive bias whereby an individual’s decisions are influenced by a particular reference point or ‘anchor’.” 

A great example of this is seen in Pro The Doge, a 33-year-old man who put in US$180k into dogecoin, which was everything he owned. At the time, the price of dogecoin was 4 cents. Dogecoin went up to around 75 cents, which resulted in his net worth ballooning to about US$2.8 million. However, he did not sell, and dogecoin went back down to 19 cents, and his net worth now is approximately US$800k, which means he is no longer a US dollar millionaire.

Pro The Doge went from $180k net worth to $3 million and back down to $800k

Of course, what should Pro The Doge have done? Clearly he should have sold all his dogecoin when it peaked at about $2.8 million, and many people have criticised him for holding onto his crypto as it went down.

However, market timing is very difficult. There is a lot of evidence that most of us are terrible at timing the market. Pro The Doge could have sold everything at $2.8 million, but it is easy to criticise him in hindsight, and if any of us had the ability to pick the tops and the bottoms perfectly, we would become the first trillionaire on earth.

So I don’t blame Pro The Doge for not selling. My point is that those who criticise him are suffering from anchoring bias. There is no reason why the all time high of $2.8 million is the “anchor” and that his current net worth of $800k must be compared to the all time high, which results in a loss of about $2 million. If you change the anchor to his initial $180k, then suddenly he has increased his net worth from $180k to $800k, which is more than a 400% return.

This practice of comparing the current price to when you got in or what your average entry price is (if you dollar cost average into the asset) leads to strategies such as “playing with house money.” The idea behind the “playing with house money” strategy is that Pro The Doge should take out his initial $180k and convert it into cash. This way it is impossible for him to make a loss.

However, this too is anchoring bias. In the same way that the all time high is an arbitrary anchor, so too the price you got in at is also an arbitrary anchor. It is useful for taxation when calculating capital gains tax, but it is not useful for your personal finances.

To understand why this it the case, consider that Pro The Doge is still dollar cost averaging (or buying the dip) into dogecoin. If he were to sell $180k worth of doge and covert it into cash, he would crystallise capital gains tax, and then when he continues to dollar cost average into doge, he would covert cash back into doge. Why covert doge into cash and then right after convert cash back into doge again? You are just adding more transactions and triggering capital gains tax when you don’t need to.

According to the “house money” strategy, this is what he should do, but as I have shown, this is self-defeating because he would be selling and then buying back into doge when he continues to dollar cost average into it.

I recall watching a video of Pro The Doge buying about US$30k worth of doge after it crashed because he wanted to “buy the dip.” If he were to sell $180k worth of doge and convert it into cash (as per the “house money” idea) and then go on to buy $30k of doge afterward, he would have been better off only selling $150k worth of doge and incurring less capital gains.

What this example shows is that when you get in is irrelevant. What matters is the volatility of your overall net worth and whether you can tolerate that volatility. For example, suppose your net worth is made up of 99% cash and 1% dogecoin. Suppose dogecoin went up 5x and suddenly you have 95% cash and 5% dogecoin. According to the “house money” idea, you should sell 20% of your dogecoin such that you are only playing with house money. This would bring your portfolio to 96% cash and 4% dogecoin. So you have gone from 5% dogecoin to 4% dogecoin and the rest is in cash. In other words, this will have almost no impact at all on the volatility of your net worth.

What this example shows is that the “house money” idea is just another form of anchoring bias. What you should do instead, in my opinion, is look at the overall volatility of your net worth and see if you are able to tolerate that volatility. To know if you are able to stomach the level of volatility of your portfolio, you need to look at your necessary spending vs non-necessary spending and then work out what portion of your net worth is the “cake” and what portion is the “icing.” The “cake” portion should be made up of low or medium volaility assets so that you can reliably and comfortably draw down on it or generate passive income from it to cover your necessary expenses.

For Pro The Doge, it is hard to know how big his cake fund is. It is a personal matter that depends on not just your current obligations but also what your future needs are. For example, Pro The Doge currently lives in a studio apartment. However, if he feels that in the future he must live in a large house (e.g. if he plans on raising a family), he will need more money in his “cake” fund. However, if he is happy living in a studio apartment because it is lower maintenance and if he doesn’t want kids in the future, then he will be able to take on more risk.

Pro The Doge going all in on doge seems very risky to me, but it may be justified if he is comfortable living on little and keeping his obligations low.

How we understand risk tolerance

I remember when I booked in an appointment with a financial advisor to discuss my superannuation. It was a free meeting set up by my super fund, so I figured I’d book in time. At the session, I was given a questionnaire that set out to determine my risk tolerance. It asked me questions such as “are you willing to take on more risk if it leads to potentially higher returns?” Of course, I answered yes for that. Most people just want higher returns, so when they learn that you need to take on more risk in order to get higher returns, they will take on higher risk.

As a result of this meeting with the advisor, my super fund was set to a “high growth” strategy that was almost all in equities. Then the GFC happened and I have to admit that I was shaken watching money I saved disappear so rapidly. I experienced FONGO (“fear of not getting out”), and as a result I dialed down the risk in my super fund slightly to the “growth” strategy instead. However, once the markets went back up again, I suddenly felt FOMO (“fear of missing out”) and quickly scrambled to invest in equity ETFs and even to get a margin loan (which I still have today).

My point is that risk tolerance is something we need to experience to understand. It is normal, in my opinion, to think we can tolerate risk in order to gain higher returns, and this is why so many talk about tracking stock indices like S&P500 or the ASX200 but rarely talk about bond indices like the Vanguard Global Aggregate Bond Index.

In my opinion, we gain a better understanding of our true risk tolerance when we personally experience both FOMO and FONGO that comes from price volatilty. The problem with most people is recency bias. When prices shoot up, they feel FOMO and their risk tolerance is too high, but when prices collapse, they feel intense FONGO and their risk toleraence is too low. You need to remember how you felt when prices spiked and crashed and adjust your asset allocation accordingly such that you minimise both FOMO and FONGO.

I am also concerned about complacency due to constantly rising prices. Cryptocurrency has been rising for the past decade even when you consider the wild swings, but it is no guarantee that it will continue to go up. An asset class can keep going up even in the long run until it does not. However, this applies not just to cryptocurrency but also to e.g. the stock market. The stock markets of the US has gone up historically for the last century or so, which may lead many to think that it is inevitable that it will continue to go up. However, what if it doesn’t? This is why it is important to reduce risk and volatility up to the point where you are financially independent.

Conclusion about crypto

I do personally own cryptocurrency, but it makes up about 25% of my net worth, which is a level of risk and volatility with which I am comfortable. Most of my crypto is concentrated in bitcoin, ether and dogecoin.

If I had to advise on whether someone should invest in crypto or not, I am hesitant to advise them that they should because one of the biggest downsides of crypto is how difficult it is to secure. If you keep your money in a bank account, if you suddenly forget the password needed to log into your internet banking account, you can simply go through the password reset process or just walk into the bank and talk to somoene who can verify your identity and unlock your cash. There is a human element to the traditional banking system, but with crypto there is no human element, which is by design. If you lose your crypto mnemonic passphrase, your funds are gone forever. If you merely expose this passphrase to someone, they can sweep all your funds and it is impossible to reverse the transaction.

The future of crypto is uncertain, but I think over time crypto will become less volatile as the crypto world will integrate with the traditional financial system. We are seeing today bitcoin ETFs and large companies like Tesla investing in bitcoin, and conversely it is possible to buy tokenised stocks. All this shows that the two worlds are merging, and I speculate that this merging will continue into the long term. If these two worlds do merge, I speculate that the crypto world will be the main beneficiary as net value will flow from the much larger traditional system into the much smaller crypto system. As such, it is a good idea, in my opinion, to allocate a portion of your portfolio to crypto, but it should be considered the icing on the cake rather than the actual cake itself.

Is Investing in Crypto Irresponsible? A Cake and Icing Analogy for Investing

“He is richest who is content with the least” ~ Socrates

Recently I have been thinking about Tesla’s decision to invest $1.5 billion in bitcoin and accept payment for Teslas in bitcoin (although later Tesla stopped accepting payment in bitcoin due to environmental concerns).

This decision by Tesla as well as many other companies to invest in bitcoin made me think about the decision. Bitcoin is considered a very volatile asset and so it made me wonder about the merits of companies buying bitcoin. Many businesses are also considering pricing their goods or services in cryptocurrency, but this presents challenges due to the aforementioned volatility of crypto.

After much research, it seems many companies were buying bitcoin as a replacement for idle cash on their balance sheet. All companies have a bunch of assets on their balance sheet related to the normal operations of their business e.g. Tesla would have factories as well as patents on their balance sheet as assets, but companies also need to hold liquid assets such as cash in order to meet expenses. For example, Tesla needs to pay taxes, and taxes are denominated in currency like USD, and so Tesla needs to have USD on hand to be able to pay for these expenses.

Through research, I found that the $1.5 billion in BTC that Tesla had only represented about 8% of its cash. This means that Tesla had about $19 billion in cash and it has converted a small amount of that into BTC.

How does this relate to individuals and early retirement?

Individuals are similar to organisations. In the same way that Tesla holds cash to be able to meet expenses, so too I hold a small amount of cash as well. In the same way that Tesla keeps most of its assets in its business e.g. factories, so too I keep most of my assets outside of cash. The reason why I don’t want to hold too much cash is because cash does not earn much. In fact, given that savings accounts provide virtually no interest, cash does not really earn anything, especially when you factor in inflation. It makes sense to keep most of your net worth in higher returning assets while only keeping a small amount of your net worth in cash in order to meet expenses.

We need to take on more risk to beat inflation

We don’t keep all our net worth in cash because we need to beat inflation. Everyone has expenses and these expenses are denominated in the local fiat currency. For example, for someone living in Australia, they’d need to pay taxes, which are denominated in Australian dollars (AUD). The necessities of life such as food and shelter are also denominated in AUD. According to Numbeo.com, as at May 2021, the cost of living in Melbourne, Australia for a single person is $1322 per month not including rent. The cost of rent is $1715 for a one-bedroom apartment in the city. This adds up to $3037 per month or $36444 per year. If we round this up to $40k and then apply the 4% rule, this means you will need $1 million in net worth to be able to retire in Melbourne.

The 4% rule assumes a rough mixture of stocks and bonds, approximately 50% in stocks and 50% in bonds, which can be acheived with a balance ETF. An example of a balanced ETF with 50% bonds and 50% stocks is the Vanguard Diversified Balanced Index ETF (VDBA).

Basically if you have $1 million and put it into VDBA, you’d be able to live a comfortable life in Melbourne, Australia.

Icing on the cake

But what if you have more than $1 million? Suppose you have $2 million in net worth and you have $1 million in VDBA from which you are drawing $40k per year to meet basic expenses. Because the other $1 million is not necessary for covering basic expenses, why not invest it in higher risk investments e.g. a high growth ETF such as VDHG or even in a diversified basket of cryptos? You can divide this $2 million wealth into two parts: VDBA, which represents moderately volatile investments needed to meet basic necessities denominated in local fiat currency (i.e. the cake); and crypto (or VDHG), which represents more volatile investments that provide extra income (i.e. the icing on the cake).

Volatility is relative depending on the base asset

No asset is inherently volatile. One of the main criticisms of cryptocurrency is that it is too volatile. Let’s take a crypto such as ether (ETH). ETH is volatile if priced in USD. However, if you price USD in ETH, suddeny USD looks volatile.

When most people thinking about volatility, they think about volatility relative to the local fiat currency, and the reason why they think this is because most good, services, and taxes are denominated in that local fiat currency. If I am living in Australia, I need to pay for rent, food and taxes with AUD, so I need to make sure that the $1 million I hold in my “cake” fund is not too volatile relative to AUD, which is why you would hold it in VDBA or similar. However, if I can meet rent, food and taxes with $1 million in VDBA and I have more, why do I need to worry about volatility priced in AUD? Why not increase volatility to the maximum level once you can cover your basic expenses?

Age-based vs wealth-based bond tent

A very interesting idea proposed by Michael Kitces is the idea of creating a “bond tent” to mitigate sequence of return risk.

Sequence of return risk is basically the risk of a severe market crash occuring right after you retire. So imagine you have 100% in equities and it is 2008. You finally amass $1 million in wealth and decide to retire. Then suddenly the GFC happens and the stock market falls 50% thereby reducing your net worth to only $500k.

Dampening The Volatility Of The Portfolio Size Effect Using A Bond Tent
Figure 1: Michael Kitces’s Bond Tent

The bond tent addresses this risk. Basically, in order to create a bond tent, before you retire, you gradually increase the proportion of your net worth in bonds. Then when you retire, you reduce it. The reason why you reduce your bond allocation after you retire is because, according to the theory, you need equities for long term growth. Bonds provide stability but not growth. The risk with holding too much in bonds when you are retired is that you have stability at the expense of not enough growth, which increases the risk you deplete your wealth before you die.

However, I think there is a problem with the bond tent. If you look at the horizontal axis above in figure 1, you’ll notice it is based on age. You retire at 65. At that age, the bond allocation is at its peak. Why should this be based on age? Why not make it based on wealth?

As I’ve described previously, you need about $1 million in about 50% stocks and 50% bonds to retire and live a modest life. Why not change the bond tent chart above by replacing the horizontal axis with net worth? The peak of the bond tent should instead occur when net worth is $1 million. This means that when you are young, you should take on more risk because, even if the market goes down, you are still young and have time to earn money to replace money lost. However, as you gain more wealth, the risk grows because you have more money exposed to riskier assets and you are close to the net worth required to cover your necessary expenses. Imagine you are 25 and have $100k in net worth and suddenly the GFC occurs. Then you’d lose $50k. However, you would be able to replace this loss with one or two years of work and savings. However, imagine you are 35 and have a net worth of $1 million and a GFC happens. Then you’ve lost $500k. This loss could take about 15 to 20 years to replace, which sets back your early retirement considerably.

The importance of minimalism

The wealth-based bond tent illustrates to us the importance of minimalism and how it can help you build more wealth. The $40k per month expense is based on Numbeo’s estimate of expenses of a typical person. However, suppose someone is able to live on less. Suppose hypothetically someone can live off $20k per year e.g. rather than retire in Melbourne, Australia they are happy to retire in an area with a lower cost of living. Perhaps they are willing to live in a one-bedroom apartment on the outskirts of the city rather than in the city itself. Regardless of how someone saves money, if you are able to get by on $20k per year, then the bond tent shifts to the left. You only need $500k in VDBA in order to create the “cake” needed to cover your living expenses, and once you hit this $500k net worth, you can quickly put any new money into the “icing” fund, which goes into high risk assets, which provide opportunity for higher returns (and losses).

Imagine two people who earn $100k per year. One is a minimalist who spends only $20k per year vs a normal person who spends $40k per year. The person who spends $20k per year is able to invest $80k per year (assuming no taxes) and is able to accumulate $500k within 6.25 years (for simplicity, assuming no investment growth). However, the normal person spending $40k per year is only able to invest $60k per year which means they will need 16.66 years in order to accumulate $1 million.

By being a minimalist, you are able to overtake the bond tent more quickly and transition your wealth into higher risk assets at no risk to your retirement because you have already built a solid foundation i.e. you have fully developed your “cake” fund and are now simply putting the icing on the cake.

A minimalist who can live off $20k per year is able to provide themselves with financial independence within 6 years and in their seventh years they can invest in higher risk assets such as more speculative tech stocks or ETFs or cryptocurrency. However, a normal person who lives off $40k per year needs to wait 16 years before they can do this.

Lifestyle inflation destroys the icing

A normal person living off $40k needs to invest for 16 years before they can be financially secure or independent, but imagine if that normal person, after 16 years of hard saving, suddenly inflates their lifestyle such that they spend $60k per year. If after you have $1 million you suddenly have $60k worth of spending, then this means $1 million is not enough. According to the 4% rule, you now need $1.5 million, which means you need to save up $500k more, which means you need to work 8 more years in order to build up your “cake” fund.

By inflating your lifestyle, the cake needs to grow, which means you spend more time investing in VDBA or similar assets. Your opportunities for higher growth are impaired because you’re forced to invest in safer assets for longer in order to fund your lifestyle inflation.

Cake spending vs icing spending

What does lifestyle inflation mean? In my opinion, lifestyle inflation occurs only when your necessary ongoing expenses goes up. Suppose you have $1 million in VDBA generating $40k and this goes into food, shelter and taxes. This is the “cake” and your spending on food, shelter and taxes are what I call “cake spending” because these are necessary ongoing expenses. You cannot avoid food, shelter or taxes otherwise you will die or be put in prison.

Let’s suppose you have another $1 million in crypto and you draw out 4% from this for spending. This is the “icing” but you need to spend it on what I call “icing spend” which are unnecessary once-off or reversible expenses.

So a person with $1 million in VDBA and $1 million in crypto draws $80k. $40k goes into food, rent and taxes, but the other $40k can go into a lavish holiday. A holiday is not necessary, once-off and not ongoing. This is important because the icing fund is high risk. Crypto is highly volatile and could drop by 90% within a year. Suppose this did happen and the $1 million in crypto suddenly turns to $100k. Then rather than within $40k in icing expenses you are withdrawing only $4k in icing expenses. This is not a problem because you simply take a cheaper holiday or don’t go on holiday at all. The icing is optional. You don’t have to eat a cake with icing.

An example of ongoing necessary expense beyond food, shelter or taxes is, for example, if you decide to have a family. Paying for a family means added ongoing and necessary expenses e.g. food, shelter, childcare, etc. If crypto prices suddenly fall and you can only draw out $4k per year rather than $40k per year, this is not going to be good if food, shelter and childcare prices are higher than $4k per year. However, a holiday is not necessary and can be scaled back if required.

Rentvesting with NAB Equity Builder

Rentvesting (a mix of renting and investing) involves renting a place to live while investing. When many people talk about rentvesting, they refer to renting and investing in property at the same time. However, another way to rentvest is to rent while investing in the stock market via ETFs.

When rentvesting into the stock market, it is better to leverage into the stock market i.e. borrow money to buy ETFs. An EY study into rentvesting into the stock market found that renting while leveraging into the ASX 200 index using a margin loan with 50% LVR was approximately equivalent to buying a place to live in. However, this study found that without leverage, it is better to buy a home. More leverage provides higher returns (and higher losses as well should the market go down).

Rather that using a margin loan, I recommend using NAB Equity Builder (NAB EB) instead because the interest rate on a NAB EB loan is much lower. As at the time of writing this, the NAB EB interest rate is 3.9 percent vs the CommSec margin loan interest rate of 5.5 percent. Many people criticise margin loans because of the dreaded “margin call” but if margin loan interest rates were equal to NAB EB interest rates, I would prefer a margin loan because it provides more flexibility on when to make repayments vs NAB EB which requires monthly repayments. A margin call is not as bad as many claim it is because it provides you with more flexibility on when you make repayments whereas regular monthly repayments do not provide as much flexibility because you are forced to pay monthly. However, this added flexibility has a cost i.e. a higher interest rate.

Another major disadvantage with NAB EB is that it is not an interest only loan and you are required to make principal repayments which are quite high considering the loan term is only 10 years. Property loans are typically for 30 years, which spreads out the principal repayments. Some property loans are also interest only. Margin loans provide the most flexibility by requiring no interest or principal repayments so long as the LVR is below a certain level. The consequence of these higher NAB EB principal payments is that the level of leverage achieved via NAB EB is lower compared to what could be achieved via a property loan or a margin loan.

An example

I have created a spreadsheet that details a typical example of someone who saves $130k deposit to buy a home and compared it to someone who instead puts that $130k into the VDHG ETF using NAB EB. After ten years, the person who uses that $130k deposit to buy a home has a net worth of $760k whereas the person who uses that $130k to leverage into VDHG has a net worth of $790k. What this shows is that by renting you are not throwing money down the drain. In fact, both option yield fairly similar net worth.

Renting and investing in VDHG via NAB Equity Builder is a good alternative to buying and living in a home

Let’s imagine you’re thinking of buying a $500k apartment, which means that you’d typically need a 20% deposit of $100k. Add in the stamp duty and it is about $130k deposit you would need in order to buy this property.

The alternative option is to put this $130k into NAB EB as a 35% deposit and buy $371k worth of VDHG. You might be wondering why the deposit amount is 35% and why VDHG is purchased. Basically you cannot achieve as much leverage with NAB EB as you can buying a property. When you buy a property, you have lower interest rates (2.69% compared to 3.90%) and you can borrow for 30 years vs NAB EB which only allows you to borrow for 10 years. The 35% deposit for NAB EB results in lower leverage (65% LVR vs 80% LVR for the property owner) but has similar cashflow. In other words, the property owner is paying $32k per year made up of $26k in mortage repayments, $5k in maintenance and $500 in council rates whereas the person renting also pays $32k per year made up of $38k in monthly debt repayments, $15k rent, -$15k in VDHG dividends (after PAYG tax), and -$5k in interest deductions.

What these numbers show is that the NAB EB disadvantage of high principal repayment is offset by the advantages that rentvesting provides i.e. you recieve dividend income and the ability to deduct interest expenses. The dividend income of $15k is after PAYG tax, which is assumed to be 37%. This dividend income covers the rent.

After ten years, the property owner sees his or her property worth $500k grow in price to about $1.06 million and has debt of $300k (calculated using a CBA mortgage calculator), which results in net worth of $760k. The renter sees his $371k of VDHG grow to $813k and has zero debt (as NAB EB loans are for 10 years). The renter has a higher net worth of $813k vs $760k for the property owner, but we need to consider the capital gains tax exemption that the property owner has, which means that the ETF owner pays $22k in CGT. The $22k in CGT takes into account the 50% CGT discount. The calculations also assume that the renter realises capital gains when he or she retires and therefore faces a lower marginal tax rate and draws down $40k per year in retirement. Because ETFs are more divisible than property, $40k per year can be sold, which reduces capital gains tax by spreading it across multiple years. After capital gains tax is considered, the renter has a net worth after 10 years of $790k vs the property owner’s $760k.

It is important to note that although renting comes out on top by a small margin, this analysis does not include measures that government often implement to entice first home buyers into the market e.g. recently there was an announcement by the Victorian government to reduce stamp duty by 50% for a limited time. These various incentives are not included in the analysis because they differ from state to state and typically do not last long. If these government incentives are included, the advantage for renters is likely to narrow or even disappear, but the main point of this analysis is that renting is not “dead money” and that you are not considerably disadvantaged by renting.

VDHG vs one property is not comparing apples to apples

One criticism of this anaysis is that the renter invests in VDHG, which is a broad and diversified high growth ETF provided by Vanguard that invests mostly in global equities whereas the property buyer buys one house. The property is not diversified and the price is estimated based on the price history of one Melbourne property on the BrickX platform (BRW01) that provided the highest returns (7.8% per year). In my opinion, this is more realistic as the property owner is buying one house to live in, and so the price history of one house should be used to estimate future returns.

However, comparing diversified stocks (VDHG) to undiversified property (BRW01) is arguably flawed. If we are to use undiversified property (BRW01) for our analysis, we have higher risk and therefore higher returns whereas the high diversification of VDHG reduces the risk and returns thereby putting the rentvester at a disadvantage. To compare apples to apples, we’d need to compare undiversified property (BRW01) to undiversified stocks, but then the question is which stock? If we choose Tesla stock then this returns 62% annualised. A renter who invests in Tesla stock undiversified would have achieved much higher returns compared to the home owner simply because his capital exposed to a very high growth asset. However, even though the renter is able to select good stocks, he or she may choose a bad stock that performs poorly. It makes sense then that we use VDHG, which diversifies across almost all stocks globally. However, we need to apply the same approach to property to compare apples to apples. If we remove the advantage of stock picking for the renter then we need to remove the advantage of property picking for the home owner. A home owner may pick a great property through research of public transport, schools, etc but the home owner may pick a bad property as well. In order to compare apples to apples, we need to diversify across all property across multiple countries. However, by doing this, the returns of property start to look very bad.

PWL Capital has considered this issue and looked at global diversified property vs global diversified shares: “To estimate this cost, we need to determine expected returns for both real estate and stocks. A good place to start is the historical data. The Credit Suisse Global Investment Returns Yearbook 2018 offers us data going back to 1900. From 1900–2017 the global real return for real estate (net of inflation) was 1.3%, while stocks returned 5.2% after inflation. If we assume 1.7% inflation, then we would be thinking about a 3% nominal return for real estate, and a 6.9% nominal return for global stocks.”

In other words, global property returns only 1.3% after inflation whereas global shares return 5.3% after inflation. This shows that the returns of property are very poor compared to shares. A property owner may argue that he is able to select good property in certain suburbs or cities, but the renter who invests in stocks could also make that argument that he is able to select stocks like Tesla, Amazon, or Afterpay.

Arguably, if you pick stocks e.g. Tesla or Afterpay (or even crypto such as bitcoin or ether), you are speculating whereas if you buy a diversified index fund such as VDHG or DHHF then you are investing. However, the same logic applies to property. If you select specific properties, which you must if you are looking for a place to live in, then you are speculating and not investing.

If you buy VDHG rather than select stocks, you reduce risk. You could have purchased APT but you also may have purchased a dud like Flight Centre (FLT). By investing in VDHG, you diversify and reduce risk. With the property you live in, there is no ability to mitigate risk. There is no VDHG equivalent for the property you live in because you are only buying one property in one location (unless you’re a billionaire who has multiple properties across multiple countries). As such, you don’t know if you will select a property in a suburb that does poorly due to e.g. zoning or if the property you buy may have existing cladding, termite or mould problems.

Once we compare apples to apples and compare diversified property to diversified shares, the renter is much better off than the buyer.

If you have higher income, consider more leverage with NAB EB

NAB allows LVR on VDHG of 75%, so leveraging with 65% LVR is well below the 75% limit. However, if a renter has high income, he or she is able to increase LVR. The table below shows ETFs where approved LVR is 80% which is the highest level of leverage. The highest LVR of 80% is allowed on global ethical ETFs (ETHI and HETH) and “old-style” Australian LICs (AFI and ARG). NAB EB also allows 80% LVR on a bond ETF (RGB) which in my opinion seems pointless.

NAB Equity Builder approved ETFs and associated LVR as of 21 November 2020 (Source: NAB website)

The age pension

One argument for owning a property you live in is that it is not considered as part of your assets in the asset test for eligibility for the Australian age pension.

However, if you own a liquid asset like ETFs then it is easy to simply sell that and buy a property in your own age if it is advantageous to do so. However, capital in the property you live in has an opportunity cost that may be greater than the pension you receive. Imagine you have a $1 million house and you get $24k pension per year from the government (which is the age pension payment for a single person as of January 2021).

Now let’s imagine instead that you put that $1 million in a high dividend ETF such as IHD and get $60k per year (IHD has a dividend yield as of January 2021 of about 6%). You’d pay income tax on this but that is offset with franking credits. You’d be able to rent that house for about $30k (rental yield is about 3% in Melbourne) and have 30k per year in spending money.

In both these cases, the home owner and renter are living in a $1 million house but the home owner gets $24k per year in age pension to live on whereas the renter is getting $30k in dividend income (after rent) to live on. The renter is slightly better off in this case.

Psychological considerations

The misconception that “rent money is dead money”comes from not perceiving opportunity cost. When you rent, there is a clear cost you are paying in the form of the rental payment made to the landlord. However, when you buy a home, there is an opportunity cost that is incurred because the capital locked up in the home could have earned a higher return. This capital could have earned an income if you don’t live in the property and instead rent it out and collect rental income, but the capital could also earn dividend income if invested in stocks. Furthermore, because there is no ability to diversify the property you live in, another cost is higher risk. Opportunity cost and risk are harder to perceive compared to cold hard rental payments.

There are also many psychological arguments home owners make in favour of home ownership which I think are valid. For example, a renter needs to move if the landlord forces him or her to do so whereas a home owner does not need to move because he or she owns the property. Furthermore, a home owner can do whatever they want to the property whereas the renter may need to ask permission before they e.g. put up solar panels. That being said, renters express control by selecting the property they want. If they want a property with solar panels, they can look for a property with solar panels and rent it. Furthermore, the renter, in selecting a property to rent, controls both the property and the neighbourhood surrounding the property. For example, if a renter lives in a neighbourhood they think has low crime, over time this neighbourhood may start to have high crime. A renter is able to move out to a better neighbourhood whereas a home owner will face $30k in real estate commissions to sell the property and another $30k in stamp duty to buy another property in a better neighbourhood. Chances are they will just stay in the neighbourhood and put up with the higher crime. This lack of control that owner occupiers have over the neighbourhood in which they live is the reason why we have the NIMBY phenomenon. The flexibility provided to renters to simply move if anything goes wrong arguably provides more control over both the property they live in and the neighbourhood in which they live, which is a psychological argument in favour of renting.

Further research

Ben Felix (PWL Capital) compares renting to buying. Note this video is geared towards Canadians rather than Australians.

Note: As of 21 November 2020, new applications for NAB Equity Builder are not being accepted due to high demand. You are able to fill in an expression of interest on their website if you’d like to be notified when applications are open.

The Downsides of Working from Home

I’ve done reasonably well out of COVID-19. Even though my net worth dropped back in March by about $120k, it has since recovered and grown much more rapidly than normal.

Working from home has saved me a lot of money e.g. I used to buy coffee and lunch every day when I was in the office, in addition to spending money on public transport, petrol, etc.

Even though I am saving and making a lot of money, I am somewhat keen to get back to the office. Working from home is mostly terrible.

My first gripe with working from home is OHS. My back is hurting. Ever since I started working from home, I have purchased a new desk, footrest and chair, but my back still hurts. Back in the office, someone else sets up my desk and made sure that it was ergonomic. With all the work I am doing at home, my back is really starting to hurt.

Another issue I have with working from home is that it is lonely and isolating. I miss socialising with people at work. I had a Zoom catch up with some coworkers about a week ago and we reminisced about some of the fun moments in the office, but when I thought about the last eight months working from home, nothing came to mind. It’s like I did nothing in the last eight months except work and sleep. There are no good memories. The thought that a person does nothing but stay in a small room all day by himself working, eating, watch Netflix, sleeping etc seems sad and dystopian.

Another problem with working from home is the drop in productivity. A lot of work gets done much slower when people are working from home. Simple work like writing a report or emailing can be done remotely very easily, but work that requires collaboration or quick exchange of ideas is difficult to pull off in a remote environment. Remote meetings are also really bad. When you are in the office and in a meeting, people are engaged, and I think this is because they know they are being watched, so they chip in and add value. However, in a remote meeting, the person who sets up the meeting really has to drive the meeting. Most people just turn off their video, mute themselves, and do something else e.g. check their e-mail. Workers seem to be more disengaged when working remotely.

Another reason why working from home is difficult is because the home can be a distracting place. I am somewhat lucky in that I don’t have children, so I am not interrupted much when I work, but many people do have children, and it definitely affects their productivity. Now that childcares have reopened, many parents are putting their children in childcare, but many parents do not, and due to their drop in productivity, a lot of work falls on other people.

Looking for Yield in Emerging Market Bonds (ASX: EBND)

I have finally sold HVST! For many years I have been holding onto this ETF, which has steadily gone down over many years (see The Problem with HVST). The reason why I was so reluctant to sell HVST was because it provided big juicy franked dividends paid monthly. As of today, HVST’s dividend yield is approximately 8 percent. Even though I enjoyed the high dividends, I was disgusted by the capital decline, so I made the decision to sell all my HVST.

Having sold HVST, I had spare cash which I was keen to reinvest. I decided to reinvest a portion of the cash into VanEck Emerging Income Opportunities Active ETF (EBND), an active ETF from Van Eck that invests in emerging market bonds.

What exactly are emerging market bonds? Basically you are lending money to the governments of poor countries. The average person might think this is financially reckless because of the credit risk of these government, but higher credit risk means higher yield. Investing in bonds of developed countries unfortunately means accepting very low yield (sometimes even negative yield). However, because these EM bonds are packaged in an ETF, you get significant diversification. You are not putting all your money into one country. In my opinion, investing in emerging market bonds is no more risky than investing in high dividend Australian equities.

Why invest in EBND?

The main reason I invested in EBND is because I wanted reliable and high monthly passive income. I was getting monthly passive income from HVST of about 8 percent. EBND provides monthly income as well, but its yield is approximately half that of HVST at about 5 percent. This might seem low, but the main benefit of EBND over HVST are capital gains or capital preservation.

EBND (blue) has outperformed HVST (red) during COVID-19

The chart above shows EBND (in blue) outperforming HVST (in red) during the COVID-19 crisis. I sold HVST in July 2020, so I wasn’t able to insulate myself from the COVID-19 crash of March 2020, but EBND would have provided no protection against this downturn anyway. In fact, as the chart above shows, EBND went down even more than HVST did. However, what EBND has been able to do was recover rapidly as central bankers around the world embarked on agressive money printing. In contrast, HVST has languished during the pandemic and continues to go down to this day.

What is surprising from the chart above is is how similar EM bonds are to global equities. The chart below compares EBND (blue) to global equities represented by VDHG (red) compared to DM bonds represented by VBND (green).

EBND (blue) is not a defenstive asset like VBND (green) is. In fact, EBND’s price chart somewhat resembles global equities as represented by VDHG (red).

The chart shows that EM bonds have a somewhat similar risk profile to global equities (with a beta of approximately 0.8). The chart also clearly shows that DM bonds are a much better defensive asset. The March 2020 COVID-19 crash resulted in large declines for EBND and VDHG of about 15 percent to 25 percent respectively but for VBND there were declines of only about 7 percent.

However, because I am still in my thirties and still consider myself somewhat young, I am comfortable taking more risk. Investing in EM bonds exposes me to equity-like risks while still providing high monthly income.

Another reason why I have invested in EBND is to diversify my sources of passive income away from Australian equities. A big problem with relying on Australian equities for income is concentration risk. The ASX 200 is dominated by a handful of banks and miners. If anything happens that significantly affects these businesses, your dividends are under threat. We are seeing this today as Australian banks cut dividends due to the impact of COVID-19. While I still hold a reasonable amount of high dividend Australian equity ETFs (e.g. through IHD and SYI), I am keen to spread my passive income sources to other areas in order to reduce risk. Having sold a large amount of HVST, I am keen not to reinvest the proceeds back into Australian equities which would only exacerbate my concentration risk.

EBND vs IHEB

Those who keenly follow the ASX ETF scene may understand that EBND is not the only EM bond ETF on the ASX. In fact, an investor can invest in EM bonds through the iShares J.P. Morgan USD Emerging Markets Bond (AUD Hedged) ETF (IHEB).

The benefit of IHEB over EBND is that is has a much lower management fee of 0.51% rather than EBND’s pricey 0.95 percent. This is due to the fact that IHEB is a passive index fund vs EBND which is actively managed.

While EBND pays monthly income, IHEB pays income tri-annually. Both seem to have roughly similar yields of about 5 percent, although EBND’s distributions seem more consistent and smooth.

Another major difference between EBND and IHEB comes from currency and particularly the US dollar. IHEB invests only in US dollar denominated bonds. This means it invests in debt from countries that borrow in US dollars. What this means is that if the US dollar goes up in value, the debt of these governments rise. This makes IHEB highly sensitive to the US dollar. IHEB will perform better the weaker the US dollar is. Add to that the fact that IHEB is AUD hedged, which means that as the US dollar weakens, IHEB will go up even more. In contrast, all currency considerations in EBND are at the discretion of the fund managers. The fund manager could invest in US dollar denominated EM bonds, but they can also invest in EM bonds denominated in the country’s local currency.

EBND (blue) vs IHEB (orange) vs DXY (purple)

The chart above shows EBND (blue) vs IHEB (orange) vs the US dollar index DXY (purple). About half of all debt in the world is denominated in US dollars. A considerable amount of investors borrow in US dollars (low yield) and invest in emerging markets where yields and risk are higher. However, borrowing to invest is extremely risky. You amplify your gains but also amplify any losses, which is why many investors who leverage are keen to sell during times of crisis. For example, during e.g. the March 2020 COVID-19 crash, when asset prices were collapsing, many investors sold down assets. They do this either because they wish to sell assets themselves before prices go down even further or perhaps they are forced to sell by their banks as margin calls are triggered. Regardless, because they borrowed in US dollars, when they sell assets, they get US dollars in return, which increases the demand for US dollars. This explains the spike in DXY in purple during the March COVID-19 crash.

As the chart shows, IHEB collapsed as DXY spiked, which makes sense. However, during the COVID-19 recovery, IHEB recovered rapidly as central banks aggressively printed money and devalued the US dollar. EBND is much less senstive to USD currency fluctuations.

The tables below also show that the countries that IHEB invests in (right) seem different to those that EBND (left) invest in. Generally speaking, resource rich countries (e.g. Saudi Arabia, Qatar, UAE, Russia, and Brazil) seem to have more US dollar denominated debt.

Problems with EBND

As mentioned above, high management fees of 0.95% are a big problem with EBND. Over time, these fees will compound, eating away into returns. Another downside for EBND is active management, although some argue that active management is beneficial in emerging markets where human discretion matters more.

The opportunity of emerging markets in general

I am investing in EM bonds for income, but I am also investing more and more into EM equities as well (via IEM). Global macro investor Raoul Pal has recently tweeted a chart of the EM equities to S&P 500 ratio, which suggests that EM equities are highly undervalued and may turn any moment now to the upside.

I also think that many people overestimate the risk of emerging market bonds and emerging markets in general. Most people think of EM countries as backwards and corrupt, places where money cannot be made. But this is simply not true, and the fact that people believe this I think means that EM is undervalued relative to DM, which is bullish for EM.

EM countries have very favourable demographics i.e. higher population growth and a much younger population. They also have a strong appetite for economic growth and development. As a world traveller, I’ve been to many of the “megacities” (urban population > 20 million) of the world today (e.g. Shanghai, Chongqing, Mumbai, Delhi, Sao Paulo, Jakarta, Dhaka, and even Lagos), and when I explore these cities, I get a strong sense of how dynamic these places are and how much pent-up economic growth they hold.

In my opinion, the only downside to emerging market investments are ethical concerns. If you lend to e.g. the Chinese or Indian governments, are you contributing to the oppression of Uighurs in China or Kashmiris in India? There is a question mark on the ESG credentials of these investments. On one hand, developed markets tend to have more political freedoms and e.g. greener policies, but on the other hand, if you don’t invest in emerging markets, they will remain poor, which is not ethical.

Living off Dividends vs the Four Percent Rule – Part 2

According to Wikipedia, financial independence is defined as “the status of having enough income to pay for one’s reasonable living expenses for the rest of one’s life without having to rely on formal employment.”

Financial independence does not mean you have e.g. a late-model luxury car, an expensive house, a nice watch, or even a paid-off house. If you have to work, you’re not financially independent because you are dependent on your job.

So how do you live off your investments forever? There are two main ways to achieve this: (1) live off dividends and (2) sell assets according to the “four percent rule.”

In a post I made back in 2018 titled 4% Safe Withdrawal Rate vs Living off Dividends, I claim that it is better to live off dividends because it is easier:

 [It] is better in my opinion to simply live off your investment income (dividends, rent, interest, etc) as there is no calculation involved and no work. Everything is on autopilot. That being said when living off dividends there is a trade off between income and growth (see The Problem with HVST) and this is where I think the four percent rule can be used as a guide. If your dividend income is more than 4% of your net worth, invest more in growth assets whereas if your dividend income is less than 4% of your net worth, invest in income-producing assets.

Living off dividends is indeed simple. Suppose you have $1 million. You invest it in a high dividend ETF (e.g. IHD, SYI or VHY) and that is it. The dividends will be paid to your bank account, which you live off.

However, there are many problems with relying on dividends. Typically Australian investors have relied on blue chip Australian stocks for dividends because of favourable tax treatment (due to franking credits). The problem is that these stocks tend to be concentrated among a handful of companies and historically Australian high dividend payers have performed poorly. It makes sense that high dividend paying stocks underperform because each dollar paid out in dividends is a dollar not reinvested in the company. Because the company pays out the profit as dividends, it is not able to use that money to further grow the company. The chart below demonstrates the underperformance of high dividend paying stocks by comparing an Australian high dividend ETF (black) with the broader Australian equity market (orange). For the sake of comparison, the Nasdaq 100 is represented in blue, which is the NDQ ETF tracking an index that consists mostly of technology companies that historically pay low dividends but instead reinvest profits for growth. Major companies in NDQ are Amazon, Microsoft, Apple, Google, Facebook, etc.

High dividend ETF IHD (in black) underperforms the broader Australian stock market (represented by STW in orange) and significantly underperforms the tech-heavy Nasdaq 100 index (represented by NDQ in blue). Source: Bloomberg

In contrast to the simplicity of dividends, implementing the four percent rule is more difficult, but there is considerable evidence that this approach is better, not only due to it being more tax efficient but also because the assets you invest in tend to earn more (as demonstrated in the above chart comparing the Nasdaq 100 ETF vs an Australian high dividend index ETF). Suppose you have $1 million. Rather than invest this in high dividend stocks or ETFs, you invest it in high growth stocks or ETFs that focus more on capital gains rather than dividends. You can choose NDQ, a Nasdaq 100 ETF, but if you want more diversification across countries and sectors, a good high growth ETF is VDHG, which invests in 90% global equities and 10% bonds. (Another ETF similar to VDHG but with slightly lower fees is DHHF.)

How to implement the 4% rule

When you retire, rather than rely on dividends, you simply sell off 4% of the value of the investments each year, so if you have $1 million you sell off $40k and then live off that for the first year. The expectation is that after you sell $40k then you will have $960k, but if we assume 7% annual growth then the next year your net worth will grow to $1.027 million and then you withdraw 4% of this, which is $41,088. This higher withdrawal in the next year accounts for inflation. (Note there is some uncertainty about whether, in this example of retiring with $1 million, you simply withdraw $40k each year or if you withdraw 4% of the new balance each year. I believe the latter option is safer because it explicitly accounts for inflation.)

The “four percent rule” is controversial with many arguing that it is only designed to last you thirty years. However, a simple fix to this problem is to withdraw 3% of your portfolio each year rather than 4% and, in my opinion, anything below 3% is far too conservative. Based on FireCalc.com, although the 4% rule fails with 95% probability after 30 years, the 3% rule is highly likely to last you forever. Basically if you are retiring in your 60s or 70s, you should be able to get away with the 4% rule, but if you retire any earlier, you should use the 3% rule instead.

The chart below made using FireCalc.com provides a simulation of historic stock market returns using the 4% rule and shows that over 70 years there is a good change you will not run out of money after 70 years but there is approximately a 10% probaility that you will (represented by lines going down below the horizontal red line).

Simulation showing the 4% withdrawal rate has an approximately 10% probability of failure over 70 years. Source: FireCalc.com

However, using the 3% rule, there are no probability where you lose your money (based on historic stock market performance), even under the assumption that you retire in your 30s and live for 70 years.

Simulation showing a 3% withdrawl rate being highly likely to last you forever. Source: FireCalc.com

The reason why selling off assets is more tax efficient is because capital gains are not realised until you sell the assets, which means you can sell them when you retire. By selling off assets when you retire, you do so when your income is low, which exposes more of your capital gains to low (or zero) income tax brackets. However, dividends are taxed once they are paid, which means that while you are working and accumulating assets, you’ll pay taxes on dividend income while your income is relatively high.

Capital gains are subject to Australian income tax rates once the capital gains are realised.

What will I do?

Early in my journey towards financial independence, I focused mainly on accumulating high dividend ETFs e.g. IHD and even HVST (see The Problem with HVST). When investing in purely Australian equities, I discovered that not only did my investments underperform but I also needed to pay taxes every year. To address this problem, I used a margin loan to borrow against my ETFs and diversify into international and emerging market equities more (e.g. I made some good bets on technology ETFs). Having a margin loan has its pros and cons, but one of the pros is that the interest on the margin loan is tax deductible, which helps to offset the tax paid on the dividends from Australian equities. Today Australian equities make up approximately half of my equities with the other half in international equities and a small amount of emerging market equities. Although I have a margin loan, I have started dabbling in NAB Equity Builder. NAB EB allows you to borrow at a lower rate compared to a margin loan.

While I am moving towards growth rather than dividends, I am still holding onto my high dividend ETFs. My plan is, rather than choose between dividends or growth, I will simply aim for both. There are many benefits of dividend investing e.g. franking credits. Furhermore, even though Australian high dividend stocks have underperformed in the last decade, there may be hope in the future as these companies enter the post-COVID future. If I sell Australian dividend stocks and use the proceeds to purchase global tech stocks, there is a very real risk that I will sell low and buy high, so rather than sell, I prefer to simply leave my Australian dividend stocks and ETFs. It should also be noted that there are other ETFs on the ASX that pay high dividends but do not invest in Australian equities e.g. UMAX uses options against the S&P500 to generate income; EBND invests in emerging market bonds and pays approximately 5% monthly; and TECH focuses on global tech stocks that have strong moats, and surprisingly this ETF has a dividend yield of approximately 9% paid yearly. I will discuss these non-Australian high-yield ETFs in a separate future blog post.

Property vs shares

Although it is clear that I have a bias towards shares over property, the strategy of selling down high growth ETFs exposes yet another benefit of shares vs property, which is the ability of ETFs to be sold in small chunks. If you have a $1 million property, you cannot sell half of it because no one will want half a property. You must sell it all in one go. Suppose you make $500k capital gains. Then $18200 of that will be exempt from tax while the rest of it is subject to tax, so you’ve managed to avoid tax on $18200. Now suppose you have $1 million in ETFs, which we will assume is $1 million all in VDHG. Rather then being forced to sell all of it in one go, you sell half of it in one year and the other half the next year. By doing this you realise $250k in each year. This exposes $36400 to the tax free threshold. By being able to sell smaller portions, you make the most of the tax free threshold.

Thanks to ETFs being highly divisible, I can sell off small amounts of ETFs each year thereby spreading capital gains across multiple years and exposing more capital gains to low tax brackets. Furthermore, any capital gains on assets held over one year receive a 50% CGT discount.

Another benefit of investing in ETFs rather than property is that you can sell ETFs cheaply e.g. selling one property will cost you about $20k to $30k in real estate agent commissions, but with ETFs you will pay about $20 or $30 to sell (or even $9.50 for discount online broker SelfWealth).

Other benefits of ETFs vs property is you avoid stamp duty and land tax. You also have access to franking credits.

Of course, in all fairness, there are some downsides of ETFs vs property e.g. the interest rate on NAB EB and margin loans are higher than those on mortgages, and although you can achieve leverage of about 70% using NAB EB or margin loans, you are able to achieve leverage of 80% up to 95% with property. In my opinion, even if you are able to achieve more leverage against property, it doesn’t necessarily mean you should. Leverage can magnify gains but also magnifies losses should the market go through a downturn. When leveraging into ETFs, you are able to diversify within the portfolio defensive assets such as bond ETFs (e.g. VDCO), hybrid ETFs (e.g. HBRD) or even gold mining ETFs (e.g. GDX), which reduces volatility. When you leverage into a property, you are all in one property in one place, exposed to an universified asset in one location. Many believe that property is safe compared to the volatility of the stock market, but if you invest in a highly diversified ETF, it is safer than investing in one property. The lack of volatility in property is actually the result of poor price discovery mechanisms rather than because property is inherently safer than shares. Once property is listed and exposed to the same price discovery mechanism of shares, property is highly volatile as evidenced by the price charts of residential REITs.

Disclosure: I own IHD, SYI, HVST, NDQ, UMAX, EBND, TECH, HBRD, and GDX.