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

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

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

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

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

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

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

Net worth, annual expenses, and volatility

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

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

The Australian federal election, climate change, and solar power

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

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

The ASFA Retirement Standard

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

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

ASFA Retirement Standard March 2022

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

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

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

How to Prepare for Upcoming Stagflation

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

the beginning of an xjo crash september 2018
Source: Bloomberg

How may the stock market crash?

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

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

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

What can be done to protect against a downturn?

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

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

~Jack Bogle, Vanguard Group Founder

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

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

Which ETFs perform best in a bear market?

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

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

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

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

Gold miners and bonds vs stocks
Source: Bloomberg

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