Calvin Hague

Covered Call ETFs on the ASX

Global X has recently issued three covered call ETFs on the ASX:

S&P/ASX 200 Covered Call ETF (AYLD)
S&P 500 Covered Call ETF (UYLD)
Nasdaq 100 Covered Call ETF (QYLD)

The US has for a long time been spoilt with choice when it comes to ETFs and especially income-focused ETFs. To appreciate how much choice Americans have on covered call ETFs, you only need to look at the Global X US website to see they provide 12 different covered call ETFs to Americans:

What is a covered call ETF?

A covered call ETF uses a “covered call” strategy which involves the fund manager not only holding stocks and collecting dividends but also making additional income by selling call options against those stocks. The catch is that the call option gives the buyer the right to buy the stock from the fund manager if it goes up in value. This effectively means that the upside growth of a covered call ETF is curtailed because stock price increases allow the buyer of the call option to take the stock away from the fund manager. On the other hand, the covered call ETFs in theory provide downside protection because, if the stock prices goes down, the buyer of the call option cannot buy the stock and the fund manager pockets the income from selling the call option.

Betashares already provides covered call ETFs

Although Global X has recently issued AYLD, UYLD, and QYLD on the ASX, Australia’s own Betashares has already had covered call ETFs listed on the ASX. YMAX, which is a covered call ETF that invests in the top 20 Australian companies, has been around since 2012 whereas UMAX, which is an S&P500 covered call ETF, has been around since 2014. Betashares recently issued QMAX, which is a Nasdaq 100 covered call ETF, was recently issued in October 2022.

Something that definitely jumps out about covered call ETFs from Betashares is their high management fees. YMAX as a MER of 0.69%, UMAX’s MER is 0.79%, and QMAX’s MER is 0.68%. However, all of Global X’s ETFs have a MER of 0.60% making them slightly cheaper.

	Betashares ETF, MER	Global X ETF, MER
Australian equity covered call ETF	YMAX, 0.69%	AYLD, 0.60%
S&P 500 covered call ETF	UMAX, 0.79%	UYLD, 0.60%
Nasdaq 100 covered call ETF	QMAX, 0.68%	QYLD, 0.60%

Given that YMAX and UMAX has had such a long track record, we can look at their performance over time.

As the chart above shows, YMAX (in blue) has been on a steady decline since it was issued in 2012 whereas UMAX has been increasing. In fact, one seems to be a mirror image of the other, with UMAX rising about 30% since inception whereas YMAX has declined about 30% which means that if you invested half in YMAX and half in YMAX, you’d effectively be holding cash.

Of course, investors do not invest in covered call ETFs for price alone. They are focused on dividends. According to Market Index, YMAX has a dividend yield of 8.92% so far whereas UMAX has a dividend yield of 7.18% which means if you invest half in YMAX and half in UMAX, you’d effectively be invested in cash but in a high interest savings account that pays about 8% with franking credits.

It is curious why YMAX has underperformed UMAX so substantially, but I suspect the explanation comes from the volatility of investing in the top 20 ASX stocks. Because investing in only 20 stocks on the ASX means much of the money is concentrated in Australia’s miners and big bankers, this increases volatility compared to the broader, more diversified and more stable S&P500. As such, to compensate for the higher volatility, the buyer of the call option will pay less, which results in a lower options premium for the fund manager who is the issuer of the call option.

This volatility explanation for why YMAX underperforms UMAX can also be seen in covered call ETFs on the US markets. For example, QYLD, Global X’s Nasdaq 100 covered call ETF QYLD (of which there is a Reddit community called r/qyldgang), has underperformed XYLD, which is Global X’s S&P 500 covered call ETF.

In the chart above, QYLD (in blue) has underperformed XYLD (in orange) over a long period of time. Whereas the top companies in Australia are dominated by bankers and miners, in the US the top companies are dominated by tech firms such as Google, Apple, Microsoft, and Amazon. Given that the Nasdaq 100 index is concentrated mostly in tech and internet companies, there is more volatility, which may mean lower options premiums for the fund manager, which results in under-performance.

However, a quick Google search shows that the dividend yield of QYLD is about 11% compared to 7% for XYLD. This is also analogous to YMAX vs UMAX where YMAX underperformed YMAX on price but made up for it with higher dividend yield.

Buying multiple covered call ETFs to balance income and price

What this suggests is that blending different covered call ETFs can be used as a strategy during early retirement to draw down income but also preserving capital so that you do not run out of money. For example, if you retire at 50 with $2 million in net worth, you may wish to put it all in an Australian equity or Nasdaq 100 covered call ETF because you don’t have long to live but you have a lot of net worth, so you can afford some capital depletion. However, if you retire at 35 with $750k and want to live overseas in developing countries, you may wish to put it all into S&P500 covered call ETFs which hopefully will provide more capital preservation at the expense of lower dividend yield. If you retire at 45 with $1 million, it may be a blend of all S&P500, Nasdaq 100, or ASX covered call ETFs e.g. half in YMAX and half in UMAX. You can mix and blend to balance capital preservation and dividend yield.

Selling off high growth investments (such as crypto or property) during retirement and putting it into covered call ETFs is an alternative approach rather than selling off 3% or 4% at a time. When selling off assets, for many people there is psychological stress that they may run out of money. Putting everything in high dividend ETFs (including covered call ETFs) is a much simpler way to generate income for retirement.

Disclosure: Image made using Stable Diffusion. I hold YMAX and UMAX.

Is Now the Time to Buy Crypto?

To be fully transparent, my crypto portfolio is down 83% from all time highs. My overall net worth is down 40% from all time highs. However, I started seriously investing in crypto in 2018 and my crypto portfolio is up about 700% from then.

Now that 2022 is coming to an end, I have found that this year is the first year when my net worth has declined. In fact, from the start of this year to today, my net worth has declined by 23%, but the peak of my net worth was back in November 2021 and from then my net worth, as mentioned, has declined by 40%.

Focusing on how much your net worth has declined against the all time high is an example of the achoring bias. There are many ways to measure how much you have made or lost from an investment. For example, if you purchased dogecoin for $0.007 back in 2018 and held it until today when it is $0.07, it seems like you have made 10x off your investment. However, dogecoin reached a peak of around $0.70 back in November 2021. If you had sold all the dogecoin back when it was $0.70, you would have made 100x, but because you waited, you only made 10x. Or did you lose 10x because you could have sold back in November 2021 but did not? Did you make 10x or lose 10x? I have thought about this and my view now, after listening to Dave Ramsey, is that it doesn’t matter. According to Dave Ramsey, when you have purchased an asset in the past is a sunk cost. What matters is when you sell it and if you’re comfortable with the volatility when you sell the asset.

Although 2022 has been a hard year, it is important to remember that downturns happen, especially in the stock and crypto markets. In fact, looking at history, none of this is new. The crypto market especially has seen a spectacular decline, especially with the collapse of crypto exchange FTX. However, in my opinion, the collapse of FTX is not as bad as many make it out to be. FTX is merely an exchange, and staff in this exchange stole funds. It doesn’t necessarily mean that there is anything wrong with the actual crypto. To use an analogy, if a bank is corrupt and the staff siphon off money for themselves, it doesn’t mean that there is anything wrong with the currency they stole. If a robber breaks into a vault and steals gold, it doesn’t mean there is anything wrong with gold as an investment.

I have recently started allocated more of my salary into to dollar cost averaging into various cryptos. In my view, there is a real use case for crypto. It is not just imaginary money. The use case for crypto is much clearer in developing countries. For example, if I were an expat or migrant working in Zimbabwe, I would convert my pay into crypto rather than deal with having to send it back to Australia or convert it into Australian Dollars. Look at the recent war in Ukraine. Crypto has been used by many Ukrainians and even Russian who have had to use crypto because their banking system does not work as well during war. Crypto has been used to send money to help the Ukrainian war effort. Crypto is useful when there are problems with the banking system in your country. According to Bitcoin Cash (BCH) user Roger Ver, there is a Russian man who now lives in Saint Kitts and Nevis and spends in Bitcoin Cash because his bank accounts have been frozen.

Although the use case of crypto is clear in developing countries, what about developed countries? Quite simply, there is no telling when a developed country may become a developing country due to a collapse of civilisation. In fact, due to political polarisation and extremism, I think it is becoming more and more likely that developing countries could collapse. And although I currently support the sanctions and asset seizures of Russian oligarchs currently, who is to say that another political party may get into power later and rather than target Russian oligarchs they come after me? Or you?

As such, I view crypto as a safe haven similar to gold. Some people argue that if there is a collapse of civilisation then the internet will not work and therefore crypto will not work. However, just because there is a collapse of civilisation it doesn’t mean that the internet everywhere will stop working. Crypto is useful when there is a situation where there is a collapse where you are but not in other areas. A good example, as I mentioned, is Ukraine.

Which cryptos as best?

After the recent crypto downturn, I have learned again that it is best to diversify across multiple cryptos and to stick to the ones that have been around for a long time. In my opinion, bitcoin, ethereum, and dogecoin are all good cryptos and make up the majority of my crypto portfolio. If you invest in some of the newer cryptos, I recommend investing only a small amount (e.g. PancakeSwap has not done well). If in doubt, diversify. Also I do not recommend staking or investing in stablecoins. If you want exposure to USD, just get actual USD.

As I said, if in doubt, diversify. All good investors are humble enough to understand they don’t know everything, and diversification is the antidote to ignorance. With that being said, I don’t recommend going all in crypto. It is important to not only diversify your crypto but also to diversify into other asset classes such as equities or bonds using ETFs.

How do you hold crypto in a safe way?

As the FTX collapse has shown us (and the Mt Gox collapse before that), holding crypto on any exchange is dangerous. It is much better to hold crypto yourself (self-custody) rather than let an exchange hold it for you. This is one of the reasons why I do not recommend staking crypto anymore because you typically give up self-custody when you stake crypto.

Of course, when you say “self-custody” to the average person, it is very difficult to explain the concept to them, and self-custody is very hard to do correctly. This I think is one of the main barriers to mass crypto adoption. To make self-custody easier, many in the crypto community recommend buying a Ledger hardware wallet directly from the official Ledger website (do not buy a Ledger via eBay).

An alternative to buying a Ledger, in my opinion, is to buy an ETF that invests in crypto companies. An example of one on the ASX is the CRYP ETF from Betashares. For those who are familiar with ETFs but unfamilar with crypto and self-custody, CRYP is a good way to gain exposure to crypto without any of the issues with self-custody. Many people who look at the CRYP price will be stocked to see that has been trending down since inception. However, CRYP was introduced right at the peak of the crypto market, so it makes sense that it will go down with the market. In fact, if we compare CRYP to the prices of bitcoin and ether then we notice that CRYP roughly tracks these major crypto (see below).

CRYP ETF (blue) vs BTC (orange) vs ETH (cyan) throughout 2022

It s worth noting that although CRYP gives you exposure to crypto, it doesn’t actually invest in crypto. Rather, it invests in companies that work in crypto such as exchanges like Coinbase or bitcoin miners. This is analogous to holding a gold mining ETF such as GDX or MNRS rather than a physical gold ETF itself such as PMGOLD. It is like buying Woodside Energy (WDS) rather than storing coal and natural gas in your garage. Exposure to companies rather than commodities means that there is risk associated with company scandals, corruption etc but the advantage is that you don’t need to worry about self-custody of gas, coal, gold, or crypto.

Which crypto am I most bullish about?

Of all the cryptos I invest in, I believe ethereum is the most promising. I would not be surprised if, in the future, companies and even governments are run on the ethereum blockchain. Below is a recent video I watched that captures the many achievements of ethereum in 2022 including the monumental transition from proof of work to proof of stake. Of all the cryptos, ethereum seems to be the most open to innovation.

Are Discounts and Sales Worth It?

During the Christmas and New Year holiday period, there would be many retailers offering discounts, and on the surface it makes sense to buy something when it is discounted. However, there are many times when I go into the shop with the intention to buy something and end up buying something else as well because it is discounted. Discounts create a sense of urgency and exploit FOMO.

This is purely anecdotal, but based on my observation, those who tend to buy products on discount also tend to end up buying a lot, which makes sense because sales are used as a marketing tool to attract customers and boost sales.

Avoiding FOMO using deliberate ignorance

At the train station, there is a display that provides the times when certain trains would come. This display details which train comes at what time, when the next train comes, and which platform to go to. I have seen many people look at this display, notice that their train is coming in a few minutes, and then proceed to run to the platform because they feel stressed that they may miss their train. Even if they miss their train, the next one will likely come in ten minutes, so is it even that harmful if they miss the train? Clearly FOMO is impacting them and creating a sense of stress and anxiety.

After realising this phenomenon, my technique now when I go to the train station is to never look at the display. I’d rather not know when the next train is coming. I’ll go to the train and catch whichever train comes next. If I end up at the train station and miss a train that came a few minutes beforehand, because I never knew that train came, I don’t feel any worse off, and even if I am ten minutes late, it doesn’t really matter.

The same anti-FOMO concept can be applied to discounts and sales. Rather than shop around for the best discounts and sales, it is better to just ignore everything and only buy when you really need to buy.

Buy discount and stock up vs buy only when necessary

I have a friend who is obsessive about sales and discounts. He would collect petrol coupons and bulk buy goods when they are discounted. He has two children and needs to cook for them. Once when I went over to his house, he showed me his stash of vegetable oil. When vegetable oil was on sale, he bought an enormous amount and stockpiled it in the garage.

From experience, I know that when you have a huge amount of a certain product at home, you tend to use it up more. For example, if you see food on sale and buy it and leave it at home, the food is likely to be eaten very quickly. So stocking up on more will just make you consume more. It is like keeping cash in your wallet. The cash will just end up being spent because it is so easy to access. Money that is harder to access, e.g. because it is locked up in an illiquid asset such as your home or your retirement account, is harder to spend. The same concept applies to consumer goods. If you need to get dressed and go to the grocery store in order to buy something, it adds layers of friction, which means you are less likely to consume it. Food in the supermarket is less likely to be consumed than food in your refrigerator.

As such, rather than hunt for discounts on food, bulk buy them, and then leave them at home where you overeat them, I believe it is better to leave as little food as possible at home and just consume what you have. Once you run out, then you buy a small amount and do a quick search to see where it is cheapest.

In other words, frugality is about reducing quantity by suppressing desire rather than bulk buying in order to get a discount only to encourage overconsumption.

Avoiding commitment

When you think about it, buying something on discount is a form of commitment. You are committed to consuming that product. For example, if you purchase ten bottles of vegetable oil, you have committed yourself to consuming all that vegetable oil before the expiry date. However, over time you may get sick of the vegetable oil. The problem with commitment is that you cannot reduce consumption once your desire wanes. If you purchased vegetable oil as you need it, if you suddenly get sick of vegetable oil, you can just stop buying it.

The Formula for Working Out if You Should Buy an Electric Car

I have created what I think is a formula for working out if it makes economic sense to buy an electric vehicle. You can find it below:

$r_E = \dfrac{k}{100p} \left( f_I e_I - f_E e_E - \tau - \beta \right)$

$r_E = return \; on \; EV \\ k= kilometres \; travelled \; per \; year\; (km) \\ p= EV \;premium \; (\$) \\ f_I= ICE \;fuel \;cost \;(\$ \;per \;L) \\ e_I = ICE \;fuel \;efficiency\; (L \;per\; 100km) \\ f_E = EV \;energy \;cost \;(\$\; per\; KWh) \\ e_E = EV \;energy \;efficiency \;(KWh \;per \;100km) \\ \tau = EV \;tax \;(\$ \;per \;100km) \\ \beta= \;battery \;depreciation \;(\$ \;per \;100km)$

Explanation of the formula

The way to think about whether an EV is worth it or not is to consider the EV premium, which is the difference between the higher cost of the EV and the cheaper internal combustion engine (ICE) car. So for example, as of December 2023, the MG ZS EV costs $42,990 whereas the petrol version MG ZS is $21,990, so there is an EV premium of p = $21,000. When you pay for this EV premium, you are effectively putting this $21k into an investment that has a return ( $r_E$ ) which needs to be compared to the return of other investments. For example, suppose you buy an EV and spend and extra $21k and from the fuel savings etc you make 3% per annum returns ( $r_E = 0.03$ ). If you believe that an alternative investment such as DHHF or VDHG has an after-tax return of over 3% then you would be better off buying the petrol MG ZS and putting the EV premium of $21k into DHHF or VDHG.

Another key consideration is battery depreciation. The EV premium is mostly a battery premium. The investment you are making is mostly in the battery. This battery has a return that you get from having access to energy in the form of electricity. Energy in the form of electricity is much cheaper than from petroleum. However, the EV tax and battery depreciation needs to be considered as well.

Looking at the MG ZS vs the MG ZS EV, the fuel economy of the MG ZS is 7.1 L per 100km and the petrol price is assumed to be $1.75 per litre. This means that every 100km you drive you are spending $12.43 in petrol.

However, for the MG ZS EV, the energy efficiency is 17.1 KWh per 100km and the cost of electricity under the Powershop EV Plan is $0.18 per KWh, which means that every 100km you only pay $3.11 in electricity costs. However, add in the EV tax of $2.50 per 100km (only applies in Victoria, Australia) and battery depreciation of $4.29 per 100km assuming battery life of 350,000 km and battery replacement cost of $15,000 and the EV cost is $9.89 per 100km, which is still cheaper than the $12.43 per 100km from the petrol car.

Because costs depend on the distance you drive, whether it makes sense economically to drive an EV strongly depends on how much you drive. The more you drive (especially over 25,000 km per year) the more it makes sense to get an EV whereas if you drive under 25,000 per year, it starts to make more sense to drive a petrol car.

Something else to consider is that when you pay for petrol, you pay for it using after-tax money whereas if you put the EV premium into getting an electric car, the lower cost per 100km you get is tax free. You need to compare the return from paying the EV premium against the after-tax returns from an alternative investment e.g. the after-tax returns of DHHF or VDHG.

If we assume that you drive 25,000 km per year then the MG ZS EV costs $2,473 per year whereas the MG ZS costs $3,106 per year. Given the EV premium of $21k this means the return on the EV premium $r_E = 0.0301 \; or \; 3.01 \%$ .

A major uncertainty is the battery depreciation as it is difficult to know the battery life and battery replacement cost. In fact, most of the costs of driving an electric car seems to come from battery depreciation alone.

Reddit comments

I shared this formula on Reddit and received mixed reviews. Some people raised very good points that I have missed in the formula, but I think overall the formula above is useful to know whether it makes sense financially to purchase an EV or not. Below are some other considerations:

EVs have lower servicing costs.
EVs are heavier and so tire costs are higher.
Charging from solar energy is ignored as this would add extra complication due to the capital costs of installing solar panels and/or home batteries. Charging using solar energy is not necessarily free as some claim as there is opportunity cost associated with locking capital up and not earning returns elsewhere such as DHHF or VDHG.
The EV tax in Australia currently only applies to Victorians. Laws may change in the future amending the EV tax.
A recent FBT exemption provides an incentive to get an EV using salary packaging.
Battery depreciation is considered but the depreciation of the ICE vehicles is not considered because it is assumed that depreciation for the EV and ICE vehicles are the same except for the additional EV battery depreciation. The assumption here is that when you buy an EV, you are buying something similar to an ICE car with a battery, so basically it is assumed that EV = ICE + Battery. However, the EV may depreciate more or less than the ICE vehicle depending on e.g. if governments increase or decrease EV taxes or subsidies. Some suggest that EVs depreciate faster than ICE vehicles, but this may change e.g. if the government introduces an additional carbon tax that applies to petroleum. If government is very aggressive in providing tax benefits for EV use, there is a risk that an ICE vehicle could become a stranded asset.
The formula above ignores power or acceleration differences between cars. The MG ZS EV is supposedly more powerful than the MG ZS. It is claimed that EVs are very quick to accelerate. However, this is ignored in the formula as we only want to focus on cost minimisation.
The formula ignores the environmental benefits of owning an EV as well as national security considerations (e.g. energy supply and price not being at the mercy of Russian or Saudi leaders).
Batteries stored at the bottom of an EV lower the centre of gravity thereby making them safer. Furthermore, because EVs are heavier, they fare better in vehicle collisions.

Other thoughts and considerations

The decision to get an EV or an ICE vehicle is very similar to whether you buy or rent a home. When you buy a home, you lock up a considerable amount of capital into the home. The benefit you get from living in your own home is that you don’t need to pay rent. If you buy your own home and then rent goes up significantly, you are better off. Similarly, when you buy an EV, you lock up capital because of the added cost of the batteries. However, the benefit you get from EV ownership is that you pay significantly lower energy costs. If you buy an EV and petrol prices go up, you are better off.

We also need to think about the future. Currently the break-even point is about 25,000 km. If you drive more than 25,000 km per year, it is highly likely you should buy an EV. However, if battery technology improves, petrol prices go up, and electricity prices go down, the break-even point will go down. There is also huge risk that an ICE vehicle you own may become a stranded asset if government policy aggressively addresses climate change. In my opinion, it is more likely that electricity prices will go down and petrol prices go up rather than the other way around. Electricity comes from multiple sources e.g. solar, wind, nuclear, and even gas, oil and coal. However, petrol only comes from oil. As such the supply of energy sources that can create electricity is much higher than the supply of energy sources than can create petrol, so higher supply should result in lower prices for electricity as an energy source.

Based on these considerations, in my view, even if you only drive 15,000 km to 20,000 km per year, if you’re in the market for a new car, it is better to buy an EV. It is better to drive an ICE vehicle if that is what you currently own and if you don’t drive too much (less than 25,000 km per year).

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.”

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

Update December 2022: I no longer recommend staking crypto. See this post for my more recent views on crypto.

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.