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.

Image
EM equities to S&P 500 ratio. Source: Raoul Pal

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.

More Thoughts on Remote Working during the COVID-19 Crisis

It has been a few months since the COVID-19 crisis has hit, and as a result of this crisis, I have settled into working from home. I’d like to describe my experience working from home from my parents’ home for the last few months.

Disadvantages of remote work

First of all, I find I have been quite busy. I would often either wake up early or work into the night in order to get work done. It seems there is more work to do when working from home. There are definitely advantages of working from home, but there are definitely disadvantages, the main disadvantage being that it is more difficult to work with others. For example, when you’re in an office, you can walk to someone’s desk and talk to them about something, but in a remote environment, you need to e-mail or call them, and they may not respond to your e-mails or calls. Furthermore, when I am in the office, I can walk to someone’s desk. If they are on the phone, it is clear they are busy, so I can walk away and come back at another time. However, when working remotely, I am more reluctant to ring someone because I have no idea what they are doing. They might be in the toilet or they might be changing their baby’s nappies, so there is this fear that I may intrude on their private lives whereas at work the expectation is that you work at work so you have no private life at work. Working from home does not seem to work well for “fast-paced” work where quick communication is necessary, especially when there is a deadline looming.

Advantages of remote work

There are advantages of remote work. In my opinion, there are more advantages than disadvantages. If I had to choose between working at home or working at the office, I’d prefer working at home, but ideally I’d prefer to have both options. There are some tasks I’d prefer to ask colleagues to come into the office to do, and there is also better socialisation in the office. For those who do live by themselves or who do not have too many friends outside of work, the office becomes the source of friend and family.

For me, the key benefit of working from home is I save a considerable amount of time not commuting. You don’t need to drive or take a train to work, which benefits me greatly because it takes one hour for me to get to work, which means I get two extra hours per day to sleep, exercise, read or watch Netflix. Another benefit is that you don’t need to worry about what you wear. When you go into the office, you need to dress correctly. However, when you work from home, you can wear anything. You can just put on sweatpants and a hoodie or you can stay in your pajamas. Even if you are on a Zoom call, you can turn off the video or you can position the camera so your clothes are off the screen.

Another benefit of working from home is that you don’t need to concentrate in meetings. This might sounds bad, but there are many meetings where you can safely turn off video and audio and do your other work. You can dedicate half your attention listening to the meeting (in case you need to speak) and the other half doing your other work.

Something I have noticed ever since working from home is that I am signing up to many webinars. Back in the office there are plenty of optional training sessions that I do not sign up for because I simply don’t have time. If I needed to get off my desk to go to one hour of training, that is one hour I would not be working. I only go to those training sessions that are mandatory. However, since all these training sessions are now online, they are quick and easy to sign up for, you can listen to them while doing your other work, and if something urgent comes up at work, you can simply and easily leave the webinar without any embarrassment or shame. As a result, I have gone to many webinars and feel I have learned a considerable amount about many different topics, from HR all the way to finance, retirement planning, etc.

Another benefit of the COVID-19 crisis is the amount of money I have saved. I don’t drive much, but in the last three months I have not driven at all, so I have saved a lot of money on petrol. Even when I have the option to drive short distances, I prefer to walk instead because I spend so much time indoors that I want to walk more to be outdoors. (When you drive, you are indoors.) I also never eat out, go to cafes, etc. Any socialising needs to be online, so it is free. I watch Netflix rather than go to the cinemas. Basically everything is done at home or online, which is much cheaper than “going out.”

I am still working from home and I have no idea when I will be going back to the office. I have heard that many organisations have asked their workers to come back whereas others are providing staff with the option to work from home or not. In my opinion, the best approach is to permanently give staff freedom to work from home or come into the office, which is what Twitter has done.

Impact on the property market

The impact of COVID-19 on the property market is very unclear. There is a considerable amount of stimulus being applied to prop up not just the property market but also the stock market. That being said, if remote working becomes the norm, there is no advantage of working near the city anymore. This means I can live in the outer suburbs without worrying. Even if it takes me two hours to commute into the city, if I do so rarely, it’s not a problem. This means the cost of putting a roof over your head goes down considerably. It costs about $1600 per month to rent a one-bedroom apartment in the city, but in the outskirts of the city it costs about $1000 per month, so automatically you save $600 per month. Using the 4% rule, this means you only need to save $300k to pay rent forever (rather than $480k).

The frugal non-consumerist post-COVID lifestyle

Based on quick calculations for a single childfree person living in an Australian city, COVID-19 has reduced the cost of living by about one-third, from $3500 per month to about $2111 per month. Once again, using the 4% rule, this means you only need about $633k to retire rather than $1 million.

How is this possible? Because you no longer need to live near work, you can minimise costs by moving to the outskirts of the city, which should halve your rent. I am assuming the cost of a one-bedroom apartment in Melbourne CBD vs a one-bedroom unit in the outskirts of Melbourne (e.g. Frankston). Because you are not going out at all but eating at home all the time, this should halve your food costs. You also don’t need a car because you can walk, bike or take public transport everywhere. Assuming all other expenses stay the same, this cuts costs by about one-third.

Expense ItemMonthly Post-COVID CostMonthly Pre-COVID Cost
Rent$1000 $2000
Food$311 $600
Car$100
Other$800 $800
Total$2111 $3500
Estimated monthly cost of living pre-COVID and post-COVID. “Other” includes electricity, internet, streaming services, etc.

In my opinion, one of the benefits of the COVID crisis is that it has forced people to live a non-consumerist lifestyle, which may result in many people realising that they are able to retire early if they want to. You don’t necessarily need $1 million to retire because living in isolation has taught you that you only need about $650k to retire.

In my opinion, a post-COVID lifestyle presents an opportunity to live more environmentally sustainably. A lifestyle with less car use, less overseas travel, less “going out” and more bike riding, walking, having meetings online, etc are better for the environment. I also think that caring for the environment can help you save more money because it provides extra motivation. For example, I am driving less today not only because I save money driving less but also because I am starting to feel very guilty driving a car. This extra guilt helps to discourage me from driving or travelling or going out to restaurants.

What about the economy and personal finances?

There is a considerable amount of uncertainty about the future of the economy. Some believe there will be a V-shaped recovery whereas others are expecting a W-shape or even an L-shape. Regardless of what letter of the alphabet the stock market resembles, I am not too concerned because I have diversified my portfolio to include not just equities but also bonds, gold and even cryptocurrency.

Another benefit of the COVID crisis is that interest rates have fallen. The interest rates on my CommSec margin loan as well as NAB Equity Builder have both fallen (5.6% and 3.9% respectively). As I have explained in other posts, debt can be positive because you are able to deduct interest expenses. Many people invest with debt when buying a property, and they deduct interest expenses. It is possible to do the same with ETFs, but in my opinion the main benefit of holding debt to buy shares rather than property is that stocks or ETFs can quickly and cheaply be sold to extinguish the debt whereas a property is very expensive to sell. For example, if I borrowed money to buy ETFs and suddenly wanted to retire early, I can sell ETFs and with the proceeds I can pay off all my debt. However, if I borrowed to buy a property and suddenly wanted to retire, selling a property to extinguish the debt would cost me about $30k in real estate agent commission.

Another benefit of ETFs vs property is that you can avoid or minimise capital gains tax. If you own an investment property with debt on it and you suddenly retire, you need to sell it to pay off the debt. Selling it will trigger capital gains tax. For example, suppose you buy a property for $500k and it increases in price to $1 million. Then you sell it but need to pay CGT on the $500k price rise. However, the benefit of ETFs is that you don’t have to sell all ETFs at once. Suppose you purchase $500k in ETFs and it rises to $1 million in price. Rather than sell all the ETFs, you only sell half thereby realising only $250k in capital gains. Then you sell the other half the next year thereby maximising the amount of capital gains subject to lower income tax rates. This works in Australia because capital gains tax is based on the progressive income tax rates. Under the Australian income tax system, income (including triggered capital gains) under $18200 in the financial year is exempt from any tax whereas any amount above that is subject to tax. So if you sell a property and realise $500k capital gains, then only $18.2k of that is exempt from tax with the rest being subject to tax. But if you sell half your ETFs in one year and the other half the next year, then $36.4k is exempt from tax. ETFs are highly divisible, which allows this, but property is not. You cannot sell half the house and then the other half the next year.

Because I have invested in a range of different ETFs, if I needed to retire quickly and needed to extinguish the debt, I would simply sell an ETF that has made large gains and then offset these gains by selling off a different ETF that has made losses. The losses and the gains would roughly cancel each other out, which means there is little capital gains tax to pay. Any existing capital gains can be left untriggered. ETFs allow you to control your capital gains and therefore your capital gains tax.

Some people say that an easy way to avoid CGT is to put your money into your principal property of residence (PPOR), which is exempt from CGT. However, this does not work. When people buy an property, there is a reason why investors prefer to put a tenant into it even if doing so removes CGT exemption. It is because putting a tenant into a property provides the landlord with rental income as well as the ability to deduct expenses. The gains from the rental income and interest deductions is greater than the loss of CGT exemption. If this were not the case, there would be no investment properties because landlord would put any extra money into their main residence rather than invest it in a rental property. This means it would be impossible to rent because no landlord would put money into rental properties because the tax advantages would be greater for main residence. The government must provide rental property investors greater tax benefits for rental property compared to main residences otherwise the rental market would not exist. That rental income and tax deduction on expenses from owning investments is greater than CGT exemption on a PPOR is the key factor that justifies “rentvesting” but that is a topic for a separate future post.

Am I close to retirement?

There are two main reasons why I would feel uncomfortable retiring today. One is that I have quite a bit of debt. Of course, I can sell assets to pay off the debt, and some of my investment income can be used to meet the debt repayments. However, I feel reluctant to do this. Part of me feels that I should pay off more debt or at least generate more dividend income to meet all debt obligations.

Another reason why I am reluctant to retire is because a substantial amount of my personal wealth is in my superannuation fund, which I don’t have access to until I am 60. This means that if I retire now, I will need to implement the “two bucket system” and run down my non-super bucket that will tide me over until I have access to my super, which will help me pay off my debts. If I implement the “two bucket system” right now, I’d be living a very frugal lifestyle with a pre-super safe withdrawal rate of about 2 per cent rather than 4 per cent. I want to build up more wealth in my non-super bucket that will tide me over until 60.

New podcasts and website

While under lockdown, I have been listening to many podcasts. A recent podcast that I highly recommend is FIRE and Chill which discusses personal finance in Australia.

Another website that I find useful is the Nomadlist FIRE calculator, which helps you determine which countries you are able to retire in based on your net worth. The most expensive city to live in is New York, so if you have enough net worth to be able to retire in New York (about US$1.1 million), in my opinion you are effectively financially independent. However, what this site teaches you is that even if you have low net worth, there are many countries all around the world where the cost of living is low, which means you will be able to retire very quickly. Many people assume that they need to live in expensive cities e.g. Sydney, Melbourne, New York, London, etc. However, the world is enormous and there are so many places where it is cheap to live. For example, in Liverpool, UK you can live off US$500k. In Davao, Phillipines you can live off US$250k. Looking at sites like this is a strong motivator because as my net worth grows, I am able to tick off cities around the world where I am able to live. The ultimate achievement is ticking off on New York because then you’d have the safety and security of knowing you can retire early in the world’s most expensive city.

The Impact of Coronavirus on Financial Independence

The stock market crash caused by the Coronavirus (COVID-19) has hit hard. Top to bottom, the ASX 200 has fallen about 30% and we don’t know if it will continue to fall. What I found incredible about this downturn is how fast it was. The GFC back in 2008 was a much more staggered downturn whereas the COVID-19 crash looks like a straight line down.

The only way to prevent the spread of this virus is to restrict movement. However, restricting movement hurts the economy. If people cannot commute to work, travel to another country to do a business deal, go to a shop to buy something, etc then trade doesn’t happen. If trade doesn’t happen, businesses collapse. This may lead to businesses firing staff, which reduces spending, which leads to more business collapse.

Diversification

This whole incident demonstrates the importance of diversification. Even though I am heavily invested in high-dividend Australian equities, the risk with focusing on a narrow asset class is a lack of diversification, so my focus on high-dividend Australian equities has definitely not helped me during this market crash.

The video above (with overly dramatic music) demonstrates how widely different countries’ stock markets have performed during the virus outbreak and illustrates the importance of diversification. Chinese equities have held up very well compared to the stock indices of other countries. Other assets that have held up well are gold, government bonds, and the US dollar.

All this demonstrates the importance of diversifying across a range of different assets. Because a significant amount of my wealth is in high-dividend paying Australian equities (e.g. IHD), I have made significant six-digit losses. Investing with leverage doesn’t help either. Nevertheless, I am relatively young and feel hopeful that there will be a recovery. As I get older, I will definitely reduce risk by diversifying into a variety of safe haven assets, but while I am young I do feel an obligation to invest in riskier and more volatile assets.

Mass job losses as a result of COVID-19

Something else that the COVID-19 crash demonstrates is the importance of financial independence. Being able to live off your investments forever is important because your job is not certain. Many people have an optimism bias and think they will be employed forever, and they structure their life around the assumption that they will always be employed. However, even what is perceived to be a safe job can be unsafe. For example, a pilot may think their job is bulletproof. They may think that air travel will always happen, so their job is safe. Black swan events do happen.

In my opinion, you should aim to be financially independent as fast as possible, as soon as you leave school or university. This involves a combination of high savings as well as cutting costs of living. If you are able to live off $10k per year, you only need to save $250k in order to retire (according to the four percent rule). If, when you are young, you inflate your lifestyle to $40k per year in expenses, you will need to save $1 million. The better you are at being content with living on little, the quicker it will be for you to be financially independent.

Surviving self-isolation

As a result of Covid-19, I am now working at home. I find there are pros and cons to working from home, but I am getting used to it. The biggest pro is being able to wake up about one to two hours later because I no longer need to get dressed or take the train into the city. Although not essential, I feel it is good to start the day by having a shower, wearing reasonably nice clothes (so you look okay when video-conferencing), and having a coffee. Not only is being clean, neat, and caffeinated important in itself, but the ritual of these activities helps to put your mind into “work mode.”

I have been to the supermarket in these new times, but it is not a pleasant experience. Everyone seems nervous and anxious. They stare at you as if you are going to grab the last pack of toilet paper. There are many stories of shoppers fighting over toilet paper, which I think is disappointing. To avoid crazy people and to avoid being infected, as much as possible, I am trying to avoid going to the supermarkets by buying essentials online. Many essentials can be purchased online, from food to toilet paper. Hoarding toilet paper, in my opinion, is not a good idea because toilet paper prices are high now, so you should only buy what you need and put any excess cash into the stock market.

The key to surviving Covid-19 is to have good respiratory health and a strong immune system, which is why exercise is important. Even though the government has imposed restrictions, exercise is still allowed where I live, so I make sure I ride my bike around the neighbourhood regularly. Riding a bike is not just a form of exercise but is also a cheap way to commute. Surprisingly, the park trails are filled with people walking their dogs, so I find that it is safer to ride on the roads where there are almost no cars.

While the global community deals with Covid-19, what is becoming clear is that many of those who contract the virus have no symptoms or mild symptoms and are able to make a strong recovery thanks to a strong immune system. As such, I have been trying to eat as much fruit and vegetables as possible.

Now is the time to dollar cost average into the stock market

I have heard of many people selling shares or converting their superannuation into 100% cash. The Australian government will soon allow those who are affected by Covid-19 to access $10k from their superannuation. This is a bad idea. Now is the time to be buying stocks, not selling.

“The best time to buy is when there is blood on the streets, even if the blood is your own.” Baron Rothschild

Will Australian property prices go down?

It makes sense that property prices are not immune from Covid-19. If enough people are unemployed from Covid-19, they will not be able to meet their mortgage obligations nor will they be able to save for a deposit on a property. Property investors typically rely on tenants to pay them rent so they can meet their own mortgage obligations, so if tenants lose their jobs, landlords may be required to sell their properties. Falling demand and rising supply push prices down.

However, there are a number of policies put in place that can prop up property prices e.g. lower interest rates and six-month mortgage holidays. These measures put in place to stimulate the property market, in my opinion, are good reasons why you should not buy a property now. Because the stock market has fallen so violently, the prices for these assets are very attractive relative to historical earnings (and dividends) whereas if property prices are propped up, you are not getting any discount on your purchases relative to rental income. The cheaper you buy your investments relative to income, the more they will go up when there is a recovery.

The silver lining

Although the Covid-19 outbreak has caused considerable wealth destuction and job losses, there is a silver lining. One benefit is that carbon emissions are falling sharply across the world, but unfortunately when the recovery happens, all this may be reversed. Another benefit of Covid-19 is that remote working systems across the world will be strengthened, which means over time more and more workers can work either fully remote or partially remote. This means I may be able to pursue my dream of becoming a “digital nomad” while still doing the 9-5 job I am familiar with. Usually those who work remotely are people with families, tech workers, graphic designers, etc, but the Covid-19 outbreak will normalise remote work for everyone because it has forced everyone to work from home (unless the job cannot be done at home). This is good not just because it means you don’t need to commute but it also means you can potentially travel while you work or work from low-cost-of-living countries. A world of remote work could look very different to the sort of world we live in today which is build upon the idea that you live in the suburbs, commute into the city every day, and take an overseas holiday two weeks per year. If more and more work is remote, we may see permanent digital nomads i.e. rather than commute for hours each day on the freeway or a train and get two weeks per year of travel, you can travel permanently, be on “permanent vacation,” hopping from one country to another and living and working in co-living spaces. This is all very utopian but it may be a reality, and even if it is not a lifestyle most people embrace in the future, it is certainly a lifestyle you can design for yourself once you are financially independent.

Commitment Phobia and Early Retirement as an Escape from Responsibilities

We are well into 2020 now. It is a new year and a new decade. Something that has been on my mind a lot is early retirement. Do I really want to retire early? Once you start earning more, it becomes harder to give up the salary. That being said, work has been hard lately, and whenever work gets hard, I begin to think about early retirement. 

Something that happened in 2019 was that I was in a brief relationship for about three months, but that ended. It was nice while it lasted but it definitely is over, which is a pity because I do want a girlfriend, but I think I do have a severe case of commitment phobia. I am fairly certain I don’t want children, and I could go on forever about the reasons for that, but I am also worried about marriage, which to me seems very risky. I have also witnessed many bad marriages. Many people say that conflict and argument are a normal part of marriage and you need to just work through it, but this seems to be an unsatisfactory answer. For 2020 and beyond, my plan for relationships is the same as always, which is to stay single but be open to meeting new women. 

At this point in time, I am probably as lonely as ever. I don’t think I have any friends. I don’t have a girlfriend either. I pretty much have nothing. Most of my interaction with people is work-related and there are a few people I catch up with every now and then. This is a bit depressing, but at the same time, I do like the solitude. I also like the freedom that comes from just being by myself. It is not like I am completely alone. People do contact me to have lunch or coffee with them, and sometimes I contact others to catch up with them, but mostly these catch ups are not that great. Whenever I catch up with others, I feel like I am just engaging in polite conversation. I cannot really express who I am or what I am thinking. Maybe I haven’t fully built up the courage to say what I want to say.

When I started my financial independence journey, my plan was to retire early in Southeast Asia, and I still want to do this. Whenever times are tough, I’d imagine myself living on a beach on an island in Southeast Asia. I’d sleep in a beach bungalow, wake up late, walk along the sands to a beachside cafe or coworking space, and spend my days reading books or writing books on a laptop, which I would self-publish on Kindle. I’d drink coffee and coconut by the beach while I read or write books. In the afternoon, when the sun sets on the horizon, I could go for a swim, and the water would be very warm.

Part of the reason why I’m hesitant to have children or to marry is because of the threat that children or marriage pose to my early retirement dream. There is something about children or marriage that seems so final. The commitment is so large, and it is a heavy burden. 

When you live differently, people naturally challenge you, and when I tell people about my dreams to retire to Southeast Asia, they inevitably talk about how terrible these places are, how they have poor healthcare, how the traffic is bad, and so forth. All these points miss the bigger picture, which is that the reason why I want to go to Southeast Asia is not beause I necessarily want to go to Southeast Asia but rather it is because I want to have the ability to go somewhere else. Even if I don’t like Southeast Asia, I could always move back or move elsewhere. It is the movement and the flexibility that matters. I want to have no major obligations and I want to be completely free. I don’t want to be shackled to a job I initally liked but have grown to hate as I try to pay off a huge mortgage and car loan. There seems to be a tendency for people to push you to decide on something, commit to it, and then settle down, but I want to keep my options open. I never want to commit and I never want to settle.

How Debt Can be Good

If you simply stand where you are and do nothing, will everything collapse? If so, you need to fix this. If not, you are a free man.

For a long time I have been uncomfortable with debt (see Why You Don’t Need Debt and The Borrower is Slave to the Lender). However, over time, I have borrowed more and more, and I think it is because I have become comfortable with debt. I used a CommSec margin loan to borrow to buy equities, which I now do not recommend to readers because interest rates on a margin loan are approximately 6 percent. I have recently started to use NAB Equity Builder, which allows borrowing to invest in ETFs or LICs for 4.3 percent which is quite low.

One of the problems with debt is that the return on investment needs to outweigh the cost of borrowing. The interest rate on the margin loan is approximately 6 per cent, which means you need to find an investment that beats 6 percent otherwise you will make a loss. However, central banks around the world are lowering interest rates and new products are emerging that allow you to gear into shares with low interest rates (e.g. NAB Equity Builder). Another argument in favour of leverage is that the interest expense is tax deductible. Currently in Australia if you are on a six figure salary, each additional dollar you earn is taxed at 37 percent, so if you are borrowing at 4.3 percent from NAB Equity Builder then after tax you are effectively borrowing at 2.7 percent. In my opinion, 2.7 percent should be easy to beat. As of right now, an ASX200 ETF such as STW is providing 5.66 percent in dividend yield, which after tax is 3.5 percent. Once you add in franking credits and capital gains, you are well ahead.

What about freedom?

One of the arguments used against debt is that debt reduces freedom because you are obligated to pay it. If you have an obligation, this reduces your freedom. However, just as in personal finance we look at both expenses and income so too when considering personal freedom we should look at both obligations to us and obligations from us. While personal finance is about cashflow and net worth, personal freedom is about obligation and specifically whether all your obligations are offset by obligations others have to you. Being free means having as little net obligation as possible.

In a previous post I discussed how freedom ultimately depends not only on cash flow but on “obligation flow.” We all have obligations e.g. the obligation to eat to survive as well as the obligation to put a roof over our head to shelter ourselves. However, if we have enough passive income e.g. from dividend ETFs to cover these costs, we are free, and we are free because our obligations to us (from the companies paying dividends to us) is greater than the obligations from us (to eat and sleep). Basically if your passive income is greater than your living expenses, you are free. It is net obligations that matter.

The same concept applies to debt. Suppose you have an obligation to pay interest. That may not be a problem if you own enough dividend ETFs to cover the cost of the interest. In the example above, the STW ETF’s dividend yield (or a similar ETF e.g. A200, VAS, or IOZ) is enough to cover the interest cost, even after (or especially after) tax.

It is important to keep in mind that dividends are strictly speaking not obligations that companies have. Technically companies do not need to pay any dividends. However, in reality, companies that have historically paid high dividends continue to pay high dividends because of shareholder expectation, and if shareholder expectation does not meet reality, share prices will go down, and the executives deciding how much of company profits to distribute as divdends are usually remunerated with shares, so it is in their interest to ensure the company is both profitable and continues to pay high dividends. Something else to consider is that dividends are not the only form of obligation. A company may use debt to raise capital from bond investors. In this case, there is a real obligation that the borrower has to pay bond investors. Furthermore, going back to shares, companies don’t need to pay dividends to provide value to shareholders. Simply retaining and reinvesting profits back into the business helps the business grow, which increases stock prices. Once the shareholder sells the stocks, there is an obligation to the shareholder to receive the proceeds of the sale. Outside Australia where there is often no franking credits, building wealth through capital gains is much more popular due to tax efficiency.

In summary, holding debt can be consistent with the idea that it is important to minimise obligation because you can have obligation from debt but have it offset with other people’s obligation to you. However, what I should emphasise is that offsetting obligations in this way increases risk. You may have debt to the bank and rely on dividends to pay back the debt, but there is no guarantee dividends will not be cut in the future, and so by playing the middleman game effectively you are taking on risk. The reason why middlemen exist in the world is because of risk transfer. Those on either side of the middleman have transferred risk to the middleman. The same concept applies at work. Middlemen are middle managers who also have obligations from them (to deliver for their manager) but need to match this with obligations to them (from their subordinates). In many areas of life, there is greater risk in aligning these two sides (obligations from you and obligations to you). The key is in if you are able to stomach and manage these risks.

Why financial capital is better than human capital

Obligation needs to be seen not just in terms of money (e.g. debt) but also non-monetary obligation needs to be considered as well e.g. something that takes away your time such as work. Most people go into debt but don’t think about what they need to do to service that debt and so they end up working for the rest of their lives. When I speak about balancing obligations from you and obligations to you, I speak mostly about your financial capital providing income (e.g. dividends) that cover your expenses. However, this ignores human capital. When banks lend you money, they not only look at your financial capital e.g. how much shares or property you have, but they also look at your human capital e.g. your income, job stability, etc.

However, relying on human capital to offset obligation is much more risky than relying on financial capital because income from human capital (i.e. a salary) is active rather than passive. If you borrow to invest and the cashflow is greater than the repayments, there is no obligation from you to do anything. However, if you borrow to invest and you have an obligation to make repayments and if your investments pay low income (e.g. it is a high growth asset) then you top up the difference with your salary which comes from human capital (e.g. your work skills). The problem with relying on human capital is that you are obligated to work in order to derive income from human capital, which reduces your freedom.

In order to take into account non-monetary obligation and to also keep a check on whether you are relying too much on human capital rather than financial capital, I recommend what I call the “do nothing” test. Basically if you do nothing e.g. don’t go to work, don’t take care of the children, etc. If you simply stand where you are and do nothing, will everything collapse? If so, you need to fix this. If not, you are a free man. Even if you have debt, if that debt is being paid for by passive income, it is as if you have no debt. Looking at non-monetary obligations e.g. childrearing, suppose you have children but they are taken care of by a childcare or nanny whose expenses are covered by passive income. You are also free. I have described the “do nothing” test in more detail in a separate post called My Changing Views:

Another key principle I feel I have not let go of is the idea that freedom depends ultimately on the absence of obligation. An obligation is something that compels you to do something in the future e.g. debt compels you to work to pay the debt. Obligation can be non-financial e.g. if you feel you must follow a particular social custom. Obligation is everywhere, and many obligations give people meaning and satisfaction in their lives e.g. obligation to their family or children. However, obligation is indeed the enemy of freedom, so if you want more freedom, you need to minimise obligation. I am a big believer in what I call the “do nothing” test, which is the idea that you are truly financially free when you can do nothing and everything is fine. If you must work to pay the bills, you are not free. There must be automated income coming into your bank account to cover all your obligations.

Can you retire with debt?

Yes, you can retire with debt, but it is harder. For one, you are no longer deriving income from human capital, so you are relying purely on financial capital to pay for debt, which is higher risk not because financial capital is riskier than human capital but because you are drawing down on one type of capital rather than two. It is much harder to get into a job than to get out of a job, so if you need a job suddenly because your financial capital is failing you, there is more effort you need to put in.

A key benefit of borrowing to invest is deducting interest expenses, which is likely to not be necessary or less necessary when you retire because your income will drop.

It all depends on how much risk you are willing to take. The good news is that it is often simple to sell down assets in order to pay off debt. Personally, when I retire, I would not want to keep debt and will simply sell assets in order to pay off debt completely.

Shares vs property

I’d like to end by discussing shares vs property. Most people think borrowing to invest is someting only property investors do. In fact, most people think stock market investors are cocaine-snorting men in suits who perform thousands of trades every day in order to capitalise on small price movements in stocks. In my opinion, shares and property are much more similar than the stereotype suggests. Shares or at least ETFs are safer investments than property because they can hold many different types of assets in them and can provide instant diversification. You can negatively gear into property and you can negatively gear into shares as well. It used to be the case that property allowed you to leverage more because you can borrow to buy property at lower interest rates than with shares (e.g. interest rates for property is around 3% or 4% but a margin loan has interest rates of 6%). However, banks are now starting to understand how similar shares and property are and new products like NAB Equity Builder allow you to borrow at 4.3% which is higher than the interest rate for most property investors (approximately 3.8% as of now) but only slightly higher. Furthermore, banks allow a property to be geared at 80% to 90% LVR whereas NAB Equity Builder allows gearing at up to 75% LVR. Even though LVR is slightly lower and interest rates are slightly higher, stock market investors are not exposed to many of the costs that property investors are exposed to e.g. stamp duty, land tax, and council rates. You also need to factor in franking credits as well as the peace of mind that comes from having a truly passive investment. For a property to be passive, you need a property manager, which eats into your rental income. Furthermore, property is not cheap. The cheapest property you can find in an Australian capital city will likely be about $400k. With ETFs, you can put in $4000 deposit to buy $15k worth of ETFs or you can scale it up. You can dollar cost average with shares but you cannot with property. You are in more control with shares, and when you sell, it can be done within days rather than months and for a much lower cost. Weighing all this up, I think shares are better than property. I would even go so far as to say that you don’t need to buy property at all, even property to live in. Rent is not dead money. If you rent and invest at the same time by leveraging into ETFs (also known as “rentvesting”) you can be better off than if you had purchased a place to live in, and you have much more flexibility to live where you want to live. But that is a post for another day.

Photo by Jamison McAndie on Unsplash

My Changing Views

One of my favourite financial independence bloggers is Pat the Shuffler who has done very well for himself investing purely in Australian ETFs and LICs. He currently has close to half a million in net worth. From what I know, Pat rents a place with his girlfriend, has a high-paying construction job, and manages to save a huge amount of money into Australian equity ETFs and LICs (e.g. VAS and AFI).

However, recently he wrote a post regarding his changing views. Over time, he has realised the importance of global diversification. He will be transitioning away from Australian equities and diversifying into foreign equities using VGS, which invests mostly in the stocks of the US, Europe, and Japan. In my opinion, this is a great move, and it reminds me of my own evolving views, and it has also inspired me to admit some of my own backflips and mistakes.

My views with regards to investing were very similar to Pat’s in that 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 as 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.

Another area where my views are changing is in regards to debt and property. I am not a fan of debt, but I do have debt in a margin loan, and if you read my old posts, you’ll notice many posts that are anti-property. Property, in my opinion, is neither better or worse than shares. It is different but also somewhat similar, and there are some benefits of investing in property instead of shares. The key benefit of property is that interest rates on property are typically lower than interest rates for borrowing to invest in shares. Property is easy to leverage and great for capital gains and growth as opposed to Australian shares, which are great for cashflow but historically are lacking in capital gains. Whether now is the right time to be buying property is uncertain. Property prices have been going down for the past two years but the rate of decline has been slowing recently, leading many to believe the market may be bottoming out.

So what do I believe? If I have moderated on everything I have believed in, is there anything here of value? In my opinion, Pat the Shuffler explains it best when he says the following:

“Despite my many stumbles, poor decisions, changing of strategies and general non observance to much of the best advice when it comes to investment, I am still here and still kicking goals. So what gives? Thankfully for me…and everyone else…getting things perfect from the beginning isn’t nearly as important as getting things mostly right and just starting.”

Pat the Shuffler

Basically, it is important to not let perfection get in the way of progress. Most people spend so much time trying to get everything perfect that they don’t start at all. You need to start saving and investing right away, and in my opinion there are three fundamental principles: (1) lower expenses, (2) diversify, and (3) minimise obligation.

Saving a lot of money relies on lowering expenses. Rather than focus on small expenses, we should focus on the big expenses e.g. accommodation and transport. Regarding accommodation, if you live with flatmates or with your parents, you will save far more. Regarding transportion, if you ride a bike or take public transport more, you will save far more. Do you need frequent international travel? Perhaps ride your bike around bike trails in your city.

Another key principle is diversification. Every investment or asset class has pros and cons. Property has cheap leverage and potentially high growth, but poor cashflow; dividend stocks may have less capital growth but good cashflow; tech stocks have low dividends but potentially high growth; gold generates no income and questionable capital gains but may perform very well during a market crash or a period of prolonged economic uncertainty. Rather than feel that you must invest in or feel attached to one asset, it is best to simply diversify across everything. Where there is uncertainty, diversify, and where you feel certain in any asset, it is important ot test that certainty by exposing yourself to the opposite viewpoints. Getting into the habit of challenging our views and diversifying accordingly is a check against our natural psychological biases.

Another key principle I feel I have not let go of is the idea that freedom depends ultimately on the absence of obligation. An obligation is something that compels you to do something in the future e.g. debt compels you to work to pay the debt. Obligation can be non-financial e.g. if you feel you must follow a particular social custom. Obligation is everywhere, and many obligations give people meaning and satisfaction in their lives e.g. obligation to their family or children. However, obligation is indeed the enemy of freedom, so if you want more freedom, you need to minimise obligation. I am a big believer in what I call the “do nothing” test, which is the idea that you are truly financially free when you can do nothing and everything is fine. If you must work to pay the bills, you are not free. There must be automated income coming into your bank account to cover all your obligations.

Reaching Financial Independence under Australia’s Superannuation System and the “Two Bucket” Method

There is a controversy within the Australian financial independence and retire early (FIRE) community about whether to salary sacrifice into superannuation while you are young to get the tax benefits. (For international readers, “superannuation” or “super” is the Australian version of the American 401(k) or IRA, basically a retirement fund.)

When you salary sacrifice into your super fund, the money going in is taxed at 15% rather than your marginal tax rate. For example, if you are earning $100k per year, your marginal income tax rate is 37% so there are large tax savings to be made if you salary sacrifice into super.

However, there is a downside because you do not have access to this money in your super fund until you are 60. For many young people, this is too far away, so they’d rather take the money now.

In my opinion, if you earn under $37k, there are insufficient tax benefits to warrant salary sacrificing into super, but once you earn over $37k, additional income will be taxed at at 32% and 37% so you should be salary sacrificing.

The table below shows that once you earn over about $18k, additional income is taxed at 19% so the reduction to 15% is hardly worth it, but once you start earning over $37k, there is quite a large gain from salary sacrificing.

Australian income tax rates for 2018/2019 and 2019/2020 (residents)

Income thresholdsRateTax payable on this income
$0 – $18,2000%Nil
$18,201 – $37,00019%19c for each $1 over $18,200
$37,001 – $90,00032.5%$3,572 plus 32.5% of amounts over $37,000
$90,001 – $180,00037%$20,797 plus 37% of amounts over $90,000

There are many arguments made not to salary sacrifice into super, and the most common arguments are provided below.

You may need the money while you are young e.g. to raise children, so you should not lock your money up in super

It is important to realise that there is a limit to how much you can salary sacrifice into superannuation. The amount your employer contributes plus the amount you salary sacrifice cannot exceed $25k, so even if you are salary sacrificing into super, there is still money you are not investing in super, so you are likely to have money outside of super to cover any unforeseen expenses.

Futhermore, when most people invest outside of super, they lock the money up anyway, e.g. they buy and hold ETFs or invest in property. It is true that ETFs and property can be sold to be used for necessary expenses, but there is a hassle involved, especially with property. There are large transaction costs involved in unwinding these investments including but not limited to capital gains tax. The only truly liquid asset is cash, and most people hold small amounts of cash to meet day-to-day expenses because they are aware that they can get better returns elsewhere, so why not apply the same principle to supernanuation and lock it up for the tax benefits?

Another consideration is that money locked up in super is still accessible in dire situations e.g. if you are bankrupt and living on the streets, you are able to access money in super via “hardship provisions.”

Another perspective is to look at money locked up in super as an argument for it rather than against it. Many people recommend getting an investment property as an investment because the compulsory monthly mortgage repayment provides “forced savings.” Since property is difficult and costly to unwind, this prevents the average person from raiding the piggy bank to pay for frivolous costs. Super can be seen as the ultimate form of “forced savings” because you cannot access it unless you are 60. Good money management is mostly psychological. Cash in your wallet is as good as gone because there is very little preventing you from spending it at the shops, but money in super is the other end of the extreme, and buying and holding shares or property are in the middle.

Forcing yourself to save money via a mortgage or superannuation is very useful for those who lack self-discipline, and while it is easy to think of yourself as being self-disciplined, most people are not.

Money outside of super can earn more than money inside super. Super is invested in shares and is therefore risky so you should leave money outside super and invest it in safer investments e.g. property.

This is a common argument given, that money in super is invested in shares, and most people perceive shares to be risky, so it is better to not invest in super and invest in property, which is perceived to be safe.

There is so much wrong with this idea. Firstly, most super funds invest not only in shares but also e.g. bonds and listed property. Furthermore, anyone can use a self-managed super fund (SMSF) to invest in almost anything, including Australian residential property (e.g. via BrickX).

Using an SMSF, it is possible to e.g. invest in residential property and even to leverage investments e.g. via internally geared ETFs. There are even margin loans designed for leveraging into super e.g. Nab Super Lever.

Another false assumption is that property performs better than shares. Many equity indexes perform just as well as property if not better. For example, looking at the historical performance of properties on BrickX, the best performing properties average 8% per annum capital gains, but the net rental yield of these properties is about 1.5% per annum. Historical performance of the STW ETF, which tracks the ASX200 index, as of July 2019, according to Bloomberg, also shows 8% per annum capital gains over five years, but the STW ETF also provides 5.93% dividend yield as at writing this, and that is not counting franking credits. If we look at equity indexes such as the S&P500, then performance is even better for shares. One could argue that other equity indexes have not performed well or that particular shares may not have performed well, but the same argument can be levelled at property. The 8% performance for property was plucked from the best performing properties in BrickX. Had you invested in other property, you would not have achieved these results. Furthermore, investing in shares allows you to easily diversify via index funds, and many super funds use either index funds or their active management policies require them to diversify globally, so you are getting instant diversification, but if you buy one house, you are not getting any diversification at all, which is a huge risk.

Furthermore, the argument that shares are riskier because they are more volatile is also false. The reason why stock prices move up and down quickly is because shares or ETFs are listed on the stock exchange. The price is disclosed whenever the market is open, which is every weekday. However, we only learn about the price of property when we buy or sell it or when we have an auction, and this happens very infrequently, e.g. every ten years. If there is an auction for a particular house every single day, there will be price volatility. Because there is not an auction every single day, this hides the volatility, but it doesn’t mean it doesn’t actually exist.

The fact that house price volatility is hidden also hides losses very well. For example, one of my friends had a mere $10k in his superannuation fund, and during the GFC his balance went down by $4k. He was so freaked out seeing the balance in his fund reduce so much so quickly that he withdrew all the money. He is an old man, so he is able to do this. However, this friend also owns a property that is valued at about $1 million, and in the recent 2017 and 2018 property price declines in Australia, the valuation of his property using CoreLogic data shows that his property went down in value to $800k, so basically $200k was wiped out, and he didn’t seem fussed at all. When my friend saw $4k wiped out from his super fund, he saw the balance go down instantly. He saw the market gyrations on the financial media and the stock market charts in free-fall. A mere $4k loss was enough to freak him out. However, when $200k is wiped out from his property, he doesn’t bat an eyelid. He knew in general that property prices were going down, but there is no dramatic price charts, and it is often uncertain to really know how much your property is worth. Most people have no idea. This story illustrates how irrational most people are with regards to property vs shares.

The government may change the rules and start taxing your super heavily.

This is another common argument against superannuation, that if you put your money in super, it is at the whims of government legislation. Supposedly if your money is locked in super, there is temptation for the government to increase taxes on super or increase the age at which you have access to it.

However, the problem with this argument is that even if you don’t put your money in super e.g. you put it into property or shares outside of super, it is also at the whims of government legislation changes e.g. if there are changes in income tax, capital gains tax, or franking credit legislation. Government can change anything, not just legislation that impacts on superannuation but also legislation that impacts on funds held outside of superannuation.

The only way you can avoid the risk of rising taxation imposed by the Australian government is to move your money into offshore havens or to e.g. cryptocurrency such as bitcoin, ether, or monero. However, offshore havens are not immune from the risk of legislation change. If your money is held in e.g. Bermuda, who is to say the Bermuda government can’t change its legislation? Cryptocurrency is also not a foolproof tax avoidance mechanism since crypto is still subject to capital gains tax by the ATO. There are other risks with crypto as well because even if you avoid countries and government, arguably the country or government in a crypto investment is the community of investors or the miners and the legislation is the protocol that governs how the crypto operates, and this is subject to change by developers. A whole book can be written about this, but basically there is no way to avoid risk of changes in legislation negatively impacting investments unless you diversify.

Contributing to super prevents you from retiring early

This argument is somewhat true but not as bad as you may think. Basically if you salary sacrifice into super, you don’t get access to the funds until 60, so if you are putting a huge amount into super, you may have enough to retire early but you don’t have access to it, which means that effectively your early retirement is deferred. To take an extreme example, suppose you need $1 million to retire, and you salary sacrifice so much that you have $1 million in super but nothing outside of super (because you use all your cash outside super to spend on expenses). Then you cannot retire until you reach 60 even if you managed to amass $1 million in super by e.g. age of 40.

However, as I stated before, there is a limit to how much you can salary sacrifice into super. The employer contribution plus amounts salary sacrificed cannot exceed $25k per year, so more realistically the amount you save outside of super should roughly equal the amount going into super. Rather than reach the age of 40 with $1 million only in super, chances are you will have $500k in super and $500k outside super. The amount outside super will likely be in e.g. ETFs, shares, and property.

Early retirement according to the FIRE community relies on the “four percent rule” i.e. your annual expenses should equal 4% of your net worth. If you reach age 40 with $1 million in your super, you cannot retire early and spend $40k per year because you don’t have access to the funds, but if you reach age 40 with $500k in super and $500k outside super, you probably can. Simply take the age at which you can access your super and subtract it by your age. In our example of someone retiring early at 40, this means there is 20 years left before he or she has access to super at age 60, so the money outside of super of $500k needs to last for 20 years. The simplest way to make sure you don’t spend over $500k in 20 years is to apply a simple straight line calculation and divide $500k by the years left, so in this case $500k divide by 20 is $25k per year you should spend before you have access to your super fund. By the time you have access to your super fund, that $500k in 20 years should be about $2 million assuming 8% per annum growth, and this means by the time you reach 60 you can apply the four percent rule and draw down $80k from your super per year. This is what I call the “two bucket system” and it is briefly explained by Aussie Firebug in his Australian Financial Independence Calculator as well as Mister Money Moustache in his article How to Retire Forever on a Fixed Chunk of Money.

Of course, retiring early on $25k and then suddenly reverting to $80k after 60 is a very weird way of implementing the two bucket method because I use a straight line method to draw down funds before access to super and then after access to super I use the four percent rule. Ideally you should use the four percent rule both before and after age 60 and arrange it such that you run out of pre-super funds just as you hit 60. This requires a much more complicated formula that Aussie Firebug has worked out in his spreadsheets above, but I believe that using the straight line method before access to super is much easier. The straight line method ignores growth in the pre-super funds, and so it is very conservative.

If you salary sacrifice heavily and use the straight line method to draw down funds before access to super, you will likely push early retirement out a little. If you are not willing to do this eg if you are absolutely determined to retire at age 40, then one way to still retire early while also salary sacrificing into super is to temporarily retire in a low-cost-of-living (LCOL) area e.g. Southeast Asia and then come back to Australia when you are 60 to access your super and retire here. The benefit of this approach is to use geoarbitrage to get the most bang from your buck in a LCOL area while you are young but then come back to a welfare state to access generous healthcare systems when you are older. However, this will be the subject of another post where I speak in more detail about retiring in LCOL areas as well as the “two bucket” system.

Thoughts about the 2019 Australian Federal Election

In my previous post (How to Adapt to the Labor Party’s Reforms to Franking Credits) I spoke about how to adjust your portfolio if Labor won the 2019 Australian federal election. The polls and the betting odds were showing a Labor win, but remarkably the Coalition won, so everything is business as usual. I will admit the result came as a huge surprise for me and although I did not vote for the Coalition, I accept the will of the people as this is a democracy.
I have mixed feelings because personally I imagine I will benefit from the Coalition’s policies e.g. cash refunds from franking credits as well as capital gains discounts and reductions in the top tax rates down to 30%. A large portion of my wealth (maybe 70%) is in Australian shares. The focus of the election was on the property market and in particularly on negative gearing, but negative gearing does not impact me because I positively gear into stocks. Leveraging into high dividend shares to get franking credits usually results in a positive gearing position because the dividend income typically exceeds the interest expense.
Something that bothers me and makes me feel some sense of guilt is that I understand that more money in my hands to live off dividends means there is less money for others. Some may flippantly say that if I want to fund these programs, I should do so with my own money, but welfare is not sustainable without taxation. Medicare, for example, would never work if it relied on private donations.

Labor proposed a number of policies that would have helped the poor, the sick, and the environment e.g. subsidised dental care, subsidised treatment for cancer patients, subsidised childcare, and funding for climate change action. That many people would vote for money to be given to investors to leverage or gear into the property and stock markets and live off dividends rather than fund these other worthwhile causes is, in my opinion, quite disappointing because it reveals something quite negative about human nature. It is yet further evidence that human nature is darker than I imagine. I am not naive, but I do wrestle between wanting to belive that humans are inherent good vs inherently bad, and it seems that every day there is a stream of evidence that points towards the the idea that humans are innately bad.

Many people think I am lame for thinking this way. My father tells me I should forget about others and think about myself. He constantly tells me I need to “man up” and get married, have children, etc. However, when I think about human nature, it makes me think about whether I should have children or whether I should start a family. With childcare costs rising and with climate change presenting an existential risk for the next generation, does it make sense to have children? If people are truly bad, what sort of world would my child inherit? What sort of social ills would my child be faced with?
I am still childfree and single but haven’t ruled out a relationship, marriage or children, but I am not the sort of person who would just jump into something big without careful consideration.
The way I see it, there are two options. One is believing in the goodness of humanity and instilling these positive values in my child so they grow up and contribute to a positive society and world. Financial independence becomes a means of funding procreation, and procreation is pursued for the sake of perpetuating the human species because the human species is good.
The other option is to believe that humans are inherent bad, and in this case financial independence plays a defensive role with passive income used to retire early and to shield myself from society.

How to Adapt to the Labor Party’s Reforms to Franking Credits

According to the Sportsbet odds, there is a very good chance that the Australian Labor Party will win the next election, and there are a number of proposed policies that will have a large impact on investors.

Sportsbet odds as of 6 April 2019 have Labor winning the next Australian federal election

I don’t want to focus too much on my personal political views as I feel I should only discuss personal finance here, but personally, even if I benefit economically by voting for the Liberals, there are many other non-economic issues that bother me about the Liberals e.g. it is highly likely that there is a Nazi faction within the Liberal party. This raises the likelihood that the Liberals will engage in Trump-style divisive politics based on racism and sexism. Furthermore, something I care about more than money is the environment, and the Liberals are filled with climate change skeptics.

Back to the topic of personal finance, one proposed Labor policy is banning refundable franking credits. This has mislead many people who think that franking credits will be banned. In order to understand what this policy is, it is important to understand what franking credits are.

Australian companies pay a corporate tax rate of 30% on their profits. A portion of the profits is then distributed to to shareholders as dividends. However, when shareholders receive dividends, they pay tax on their dividends. As a result, there is “double taxation” i.e. the company pays taxes on profits and then the shareholder pays income tax. To fix this problem, when companies pay dividends, they can attach franking credits to it, which allows the tax paid by companies to be refunded back to the shareholder.

Companies pay 30% corporate tax, but shareholders pay income tax, and given that there is progressive taxation is Australia, shareholders may pay anywhere from zero tax to 45% tax depending on their income. The higher your income, the higher your income tax rate. If you are on the highest income tax rate of 45% then the franking credits that refund the 30% corporate tax back to you will not cover all your taxes and you will still need to pay money to the government. However, there are many people who retired who have low income and live off dividends. Because they earn little, they may pay zero income tax, but because dividends have franking credits, they are in a position to receive money from the government. It is these cash refunds that Labor is targeting, not franking credits in general.

How to adapt to the new policy

Franking credits do not apply to all investment income. For example, income from property has no franking credits e.g. REITs. Furthermore, income from outside of Australia e.g. US equity ETFs such as IVV pay dividends with no franking credits.

In order to adapt to the new policy, simply increase the amount of unfranked investment income you receive. Once the amount of unfranked investment income increases, the income tax you pay will rise. Remember you only get a cash refund when your personal income tax is below 30% so if you increase how much unfranked investment income you receive such that your personal tax rate is at or above 30% then any franking credits you receive will simply offset the taxes you pay on the unfranked income you receive, so you don’t need to worry about receiving a cash refund.

As I said, the easiest way to achieve this is to invest not just in Australia but to go overseas and invest outside of Australia. Examples of ETFs that achieve this are VGE (as well as the ethical equivalent VESG) as well as INCM, which is globally focused equity income ETF. Another option is to invest in AREITs e.g. SLF, which invests mostly in Australian commercial property and pay quite high rental yields.