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

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

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

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

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

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

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

Net worth, annual expenses, and volatility

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

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

The Australian federal election, climate change, and solar power

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

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

The ASFA Retirement Standard

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

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

ASFA Retirement Standard March 2022

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

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

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

Why You Don’t Need Debt

I do have debt, but it’s a small amount. For example, I have credit cards, but I always pay it off before there is interest. I also have a margin loan, but I have this so I can buy easily when the opportunity presents itself, and I try to pay off any debt quickly.

Many people talk about how debt is a tool for making money, and theoretically this can be true. For example, if you borrow at 4% from the bank and invest in something an asset, e.g. an investment property that makes 8% then you make a profit. However, if you borrow money from the bank to invest, you need to ask yourself why the bank didn’t invest in that investment itself. The answer is that it is risky.

Banks have a certain level of risk they are willing to take. The property could have gone up 8% but there is no guarantee that it will. If there were a guarantee that the property would go up 8% then the bank would simply invest in it rather than let you borrow money to invest in it. By letting someone else borrow money to invest in the house, the bank effectively transfers risk. If the bank vets the borrower to make sure they e.g. have high enough income, etc and if there were clauses in the contract enabling the bank to seize assets in the event of default, then that 4% the bank makes is almost risk free.

But don’t you need to take on more risk to make more return?

Risk appetite is a very personal topic because everyone has different risk appetite. Generally speaking, it is recommended that young people take on more risk because they have greater ability (and time) to recover should something go wrong. This is the main principle behind the “age in bonds” rule, which states that you own your age in risk-free investments, i.e. government bonds. For example, if you are 25 you should own 25% of your wealth in government bonds.

However, if you’re a 25-year-old who has higher risk appetite, the “age in bonds” rule can be modified to e.g. (age – 25)% in bonds. This slightly more complex rule states that the 25-year-old would have zero in government bonds, which would increases to 1% when he or she is 26 and so forth.

A 25-year-old who has no government bonds and puts all his or her wealth into, say, the stock market, has a high risk appetite, but more risk can be taken if he borrows to invest.

You don’t need to borrow to take on more risk

However, even if someone does no borrow, he can still take on more risk. This can be achieved by investing in internally leveraged ETFs (e.g. GEAR and GGUS) as well as investing in more risky investments, such as emerging markets (e.g. VGE), small caps (e.g. ISO), tech stocks (e.g. TECH and ROBO), and cryptocurrency (e.g. bitcoin, ether, or litecoin).

Right now bitcoin and cryptocurrencies in general are making headlines because of spectacular growth. Had you purchased $10k worth of bitcoin in 2013, you’d be a millionaire today. However, everyone knows that bitcoin and cryptocurrencies in general are risky, and when you hear stories about people borrowing money from their homes and putting it all into cryptocurrencies, most people think this is stupid. It is not that it is stupid but rather than their risk appetite is very high.

However, the example of leveraging into cryptocurrencies shows that you don’t need to borrow in order to gain access to high risk and potentially higher returns. If you simply invest in a riskier asset class, e.g. cryptocurrencies, you already increase risk and the potential for higher returns.

Debt is slavery – the psychological benefits of having no debt

I would argue that there is no need to borrow to increase risk and return because you can simply reallocate your money to risker assets (unless you believe that leveraging into bitcoin is not enough risk).

The benefits of having no debt goes far beyond the lower risk you’re exposed to. Debt is slavery. Happiness is an elusive goal. It is almost impossible for you to know what will make you happy in the future. You may think a particular job, relationship, car, holiday, or house will make you happy, but once you actually have it, you may not be happy. Trying to predict what will make you happy is hard, which is why the best way we humans can be happy to experiment and try out different things. In order to be able to try or experiment with different things that will make us happy, we must have the freedom to do so, and you don’t have that freedom if you’re forced to work in order to pay debt.

Even though freedom does not guarantee happiness, freedom is the best assurance we have of being happy.

Freedom comes from reducing your obligations. Obligations are mostly financial obligations (debt) but can be non-financial as well.

Ultimately it depends on your risk appetite

As I mentioned earlier, everyone has a different risk appetite. I have a fairly high risk appetite myself, but there are limits. For example, I’m happy to put 5% of my net worth into cryptocurrencies. I invest in certain sector ETFs because I estimate that they will outperform in the future (e.g. I am bullish on the tech sector).

Market fluctuations can result in the value of my ETFs and shares to go down by tens of thousands of dollars and I would sleep fine at night. However, there have been many times in my life when I have gotten carried away with buying too using my margin loan account and regretting it. You know you’re taken on too much risk when you worry about it.

Results don’t matter

The outcomes from investing are probabalistic, not deterministic, so results don’t matter. This is a common investing fallacy. Some guy would claim that he is worth $100 million due to borrowing money to generate wealth and that this is proof that you must use debt in order to become rich. However, this is misleading.

The outcomes from investing are probabalistic, not deterministic.

A person may borrow money to invest and be very successful, but another person may replicate the process, borrow to invest, and lose everything. What happens for one person may not necessarily happen for another person. For example, in 2013, there were many people who stripped money from their homes using home equity lines of credit and invested all that money into bitcoin. Just about everyone called these people stupid, but now they are multimillionaires. Does this mean you should borrow to invest in bitcoin right now? No. Just because bitcoin went up from 2013 to 2017 it doesn’t mean the same thing will happen e.g. from 2018 to 2020. Investing is not deterministic. Luck plays a major role.

Do you need debt?

Suppose you put 100% of your investments into risky areas such as cryptocurrencies, frontier market ETFs, mining stocks, etc. If you feel that this is not enough risk, borrowing to invest may be the answer, but I believe that most people do not want to take on this level of risk.

Where debt may be appropriate is if you having little savings and need to borrow money to invest in something that you are fairly certain is greater than the cost of borrowing, e.g. borrowing money for education and training can in most circumstances be a good idea. Even though borrowing money will cost you in interest, you boost your job prospects and your income. If you have savings (or if your parents have savings) then it is better to use those savings to educate or train yourself, but if you don’t have this, you need to go into debt as a necessary evil.

unsplash-logoAlice Pasqual

Dividends vs Capital Gains

There are many people who claim that dividend investing is a bad idea because you end up paying more tax.

Although it depends on country, generally dividends are classified as income, and income is usually heavily taxed whereas capital gains are normally not taxed until you sell the investments. Investors typically sell all their investments when they retire. When investors retire, they are typically earning zero income (because they’ve stopped working), so any tax they pay as a result of capital gains tax is usually minimal.

If you invest in dividend-paying stocks, you are being taxed on those dividends, and in countries with progressive taxation, the tax you pay is usually very high because your salary from work is counted as income as well.

There is also an argument made that companies that pay high dividends sacrifice capital gains because money that the company pays out as dividends could have been reinvested back into the company for expansion.

One in hand is better than two in the bush

While these are all fair arguments, I still believe that investing in dividends is better even if you pay more tax. The reason is due to risk. A bird in the hand is better than two in the bush. When companies pay dividends, you get cold hard cash in your hands. If instead you sacrifice your dividends and instead allow the company to reinvest that money, you don’t know if that reinvestment will work or not. Most people employing a buy-and-hold strategy typically wait multiple decades expecting capital gains to accumulate throughout that time, and when they retire they sell their investments. However, if you wait three or four decades and amass large capital gains, what if, just before retirement, there is a very large global recession that sends asset prices down? Decades of work has been flushed down the drain.

Money printing, negative interest rates, automated trading, and high leverage have made capital gains unreliable

Dividends are simple. A company sells something, they make money, pay their expenses, and a portion of whatever is leftover is given to investors as dividends. Dividend payments therefore depend on the quality of businesses, the quality of their management, products, services, etc.

Capital gains, however, are completely different. In today’s world of constant money printing and stimulus and high leverage products that increase volatility, it’s hard to trust asset prices because asset prices can be instantly manipulated. Asset prices are now so divorced from reality that it’s difficult to know what real or fundamental value is. If a bubble never pops and is continually inflated, is it a bubble?

In my opinion, the lost two decades in Japan following the crash in its asset price bubble in the early ’90s will play out in Western countries. Japan was an economic leader but the crash of the ’90s was its peak, and since then they have simply tried to reinflate their economy with no success, and the economy has gone sideways ever since.

nikkei225-source
The Nikkei 225 since the ’80s

What has played out in Japan will play out in Western countries where peak growth has been realized. We will see a zigzag pattern as stock markets crash and then are reinflated before crashing again, and this continuous forever. The best way to make money in such an economy is to forget about prices and focus on dividends.

Dividends and capital gains are not necessarily a trade-off

Empirically, dividend-paying stocks don’t necessarily perform worse. Below is a chart of the S&P 500 index versus the S&P 500 Dividend Aristocrats index.

Dividend Aristocrats vs S&P500
The S&P 500 Dividend Aristocrats index vs the S&P 500

Source: https://www.indexologyblog.com/2014/12/12/inside-the-sp-500-the-dividend-aristocrats/