Merry Christmas 2018! Thoughts about Socialising, Conformity and the Recent Market Turmoil

This post will go over some of my thoughts that have been on my mind over the Christmas holiday. In true minimalist style, I have not purchased a Christmas tree nor have I purchased any gifts for anyone, and I will not be attending any Christmas parties. I have caught up with some friends and family over the holiday period but little else. Although it is cliche to say this, Christmas is highly commercialised these days, and personally I don’t celebrate Christmas too heavily, but many other people do, and I think my lack of engagement in Christmas activities puts a distance between me and others.

Ultimately the main issue is that often the cost of human connection and intimacy is conformity, but conformity is often costly.

Socialising and conformity

As I have discussed, an idea that has been on my mind recently is the cost of socialising. Many of us like to think that we are independent, that we do what we want regardless of what others think, but going against the grain and being very different is harder than you may think. It is natural and normal to conform. In fact, I would argue that we are hard-wired to conform. It is something that we evolved to do. There is a famous psychology experiment (the Asch conformity experiments) that shows just how powerful conformity is and how susceptible we all are.

Even though I like to think of myself as independent, I do conform to a degree, and conformity is sometimes important because it allows you to fit in to a certain culture with which others are familiar. Taking the example of Christmas, if you do not give gifts or engage in any Christmas activities, this will clearly put a barrier between you and others.

There have been moments in my life when I have been too independent, too much of a freethinker, and this has isolated me from society, which leads to misanthropic feelings, and this can have very negative mental health outcomes and can lead to depression. It is important to find the right balance between independence and conformity. As a man who enjoys independence and freedom as well as systematically minimising all forms of obligations (debt, social norms, customs, tradition, etc) this has been one of the realisations I have come to this year, that there is some value in conforming, but it needs to be controlled and I need to practice conformity in a way that still allows me to be myself and to be authentic. Most importantly, conformity needs to be practiced from a position of independence and freedom. This reminds me of the concept of exit, voice and loyalty. You can be loyal i.e. you can conform to something or someone’s values, but you need to have the freedom to be able to voice your own views or values, and if your values or views conflict too much with those with whom you are loyal, then you need the ability to exit. This is where having huge passive income and minimal obligations helps. For example, if you have a huge mortgage and three children to support, and you work a job you hate, you are trapped in this job. You are forced to conform or be loyal in this arrangement without the freedom to voice or exit. However, if you suddenly hate your job but you live off passive income, have no debt, no children, no mortgage, and no obligation or commitments, then there is nothing stopping you from voicing your displeasure or exiting entirely.

Although I do believe there is some value in conformity, I should say that everyone is different and that I do believe there are many who value nonconformity. We are typically more comfortable when we are in environments that are familiar, that fit in with our own culture. When someone is noncomformist, e.g. to take an extreme example, if someone comes to work wearing clothes that are inappropriate (e.g. wearing underwear), then this creates discomfort. Something just doesn’t seem right. However, conformity can go too far. Too much conformity creates a fakeness that many find unappealing. Although familiarity can put people at ease and build human connection, you can go too far to the point where you are fake and this also creates unease. There is value therefore in conforming in moderation but it is also important to have the courage to be yourself, to reveal your true thoughts, and to be authentic. Usually the ability to be your true self and to be authentic comes when you are financially secure and when you have few obligations.

I should also add that conformity is not just about whether you give gifts or wear certain clothes to work. Most of us conform but aren’t really aware that we conform simply because we feel that what we do is what we are supposed to do. For example, most people drive cars, get married and have children without even thinking about it because this is seen as normal. If you’re a cycling, if you’re single, and if you’re childfree, this is seen as unusual, but I think society nowadays tolerates individual freedom, so even if you are a single childfree cyclist, you will be considered different but you will not necessarily be socially ostricised. In my opinion, it is very important to be aware of how much culture affects you because when individuals conform to most cultures, they usually impose upon themselves large obligations. Among most cultures there is an expectation that a person’s youth is a period of freedom. However, the expectation is that once someone has enjoyed his or her youthful freedom, they need to become adults, they need to accept adult responsibilities, and they need to “settle down.” I argue that you don’t need to ever settle down, that you don’t need to accept large obligations. You can be free forever.

The recent market turmoil

I will change topics now and talk about the markets. The markets have done very poorly over the last few months. In my opinion, we have gone through an eight-year-old bull market without a major correction, which is the longest in history, so we are due for a crash soon. This recent turmoil in stocks may be the start of the next financial crisis but there are many credible institutions (e.g. JP Morgan) predicting the next financial crisis will occur in 2020.

Donald Trump’s policies do not help, especially the tariffs between the US and China. Importers will need to pay the tariff and pass it on to customers, which creates inflation as the cost of living rises. Furthermore, corporate tax cuts and higher government spending increases money supply in the economy. All these factors increase inflation, which necessitates the central bank increasing interest rates. Higher interest rates means corporate profits fall as companies need to pay higher interest to service their debt. Furthermore, tariffs don’t just mean importing products into America become more expensive. Once tariffs are applied to Chinese goods coming into America, the Chinese will apply retailiatory tariffs, which block American exports going to China, which in turn hurt sales. Because Chinese companies cannot export to the US as much, this impacts on Australia as we export a significant amount of raw material to Chinese companies who then transform these raw materials into consumer goods to be exported to the US. History has shown that protectionism benefits no one. Both parties lose out.

In my opinion, throughout a market collapse it is important to stick with your investment plan rather than sell in a panic. In an earlier post I spoke about “age in bonds” or owning your age in government bonds e.g. if you are 30, own 30% bonds. This rule is a guide and can be modified to fit your risk appetite e.g. if you can tolerate more risk then consider putting 50% of your age in bonds (e.g. if you are 30, you own 15% bonds).

The problem most people have is they cannot predict their risk appetite. When markets are going up, they think they can tolerate high levels of risk, but once markets actually collapse and they are confronted with large and sudden declines in wealth, they realise that they cannot stomach volatility, and they panic sell and crystallise their losses. Therefore, in my opinion, if the recent bull market has lulled you into complacency and now you are feeling nervous, it is a good idea to reflect on what your true risk appetite is, and in the future you can buy more (or less) defensive safe-haven assets (such as bonds, gold or cash) in order to align the asset allocation in your investment portfolio to your actual risk appetite. Over time, as you live through more market crashes, you start to get a feel for what your actual risk appetite is. It is not something that is easy to predict. It is something you need to adjust as you experience it in real life. One of the biggest mistakes in financial planning is when the financial planner hands you a form and you fill how much risk you are willing to take. In my opinion, no one really knows how much volatility they are able to withstand until they actually expereince it in person. Until someone feels $100k of their wealth being wiped out in one day can they truly appreciate how much volatility they can stomach.

It is also important to keep in mind why you are investing. For me, investing in stocks is mostly about generating dividends, passive income, and thereby providing freedom. Therefore capital gains do not matter much because my intention is to hold these stocks or ETFs forever. The recent market correction therefore can be seen as an opportunity to load up on more high-dividend ETFs. For example, with the market collapse, the iShares S&P/ASX Dividend Opportunities ETF (ASX: IHD) currently has a dividend yield of 13% according to Bloomberg. Of course, even if you are a dividend investor, there are benefits in diversifying into bond or hybrid ETFs. Although high-dividend ETFs such as IHD currently have a yield of 13% whereas government bond ETFs such as BOND have yield of 2.3% and HBRD, a bank hybrid ETF, has yield of 3.7% it is important to remember that although dividend yields are higher than bond yields, dividends can be cut.

If the market correction we are currently experiencing gets really bad, I will not be surprised if companies start announcing dividend cuts. It happened after the GFC, and it can happen again. This is where bonds can be useful because bonds are more likely to be paid to investors. If a company faces distress, bondholders by law are paid before stockholders. Bonds or hybrids then can be useful for income investors seeking passive income because they provide not only stability in price but also stability in income. Even though yields are lower for bonds or hybrids, this reflects the lower risk, the fact that these payments are less likely to be cut in the event of economic distress.

Disclosure: I own IHD and HBRD.

ETFs (and other ASX-listed Products) that Pay Monthly Distributions

“If we have food and covering, with these we shall be content.” ~1 Timothy 6:8

Some time ago I wrote about the Betashares Australian Dividend Harvestor Fund (HVST), which as of now has a very high dividend yield (about 9%) and pays monthly distributions. Monthly distributions are very convenient if you are living off passive income because, for day-to-day expenses such as food, it is more convenient to receive your payment more frequently. Most ETFs pay distributions every quarter, which is quite a long time to wait.

That being said, quarterly or even yearly distributions may be convenient for spending on things you spend less frequently on e.g. a holiday. Suppose you had $100k invested returning 4% dividends. This is $4k per year but paid monthly this would be $333 per month, which means if you wanted to save up for a holiday you’d need to take that $333 per month and put it in a savings account and wait for it to accumulate to $4k before you take an annual holiday. However, if you put that $100k into an ETF that pays yearly distributions, then you’d get $4k once a year, and when you get your $4k, you can go ahead and book your flights and hotels online. The fact that the ETF pays yearly rather than monthly distributions acts to force you to save for those expenses that occur yearly (typically a holiday).

Therefore, I think it is useful to have a mixture of distribution payment frequencies to match what you spend your money on. However, when it comes to financial independence, you shouldn’t focus on holidays first. You should focus on the necessities, and even though I am an atheist, I like to quote 1 Timothy 6:8 in this instance: “If we have food and covering, with these we shall be content.” In many translations of the bible, it claims that you should be content with “food and raiment,” and the word “raiment” is often translated as referring to clothing, but really raiment refers to covering, i.e. not only clothing but also shelter i.e. four walls and a roof over your head. Why am I talking about food and coverings? Because generally food and rent consist of payments we make frequently. For most people, food spending consists of going to the local supermarket to buy e.g. bread. Rent or mortgage payments are usually monthly payments to the landlord or bank. As such, it is better to have monthly passive income if you’re living off passive income while covering the necessities of life.

In my greed to secure monthly passive income to cover the cost of necessities such as bread and almond milk, I invested a reasonable amount of money into HVST, which at the time was paying about 12% dividend yield. However, the problem with high yield funds is that they are high risk funds as well. In fact, most ASX-listed products that pay high monthly passive income perform quite badly in terms of capital preservation. This may be due to the rising interest rate environment. Many high-yield ETFs and LICs that have managed to achieve reasonable capital preservation have been those that pay quarterly distributions e.g. VHY, IHD, STW, and BKI. The reason I believe this is the case is that stocks provides higher yield than e.g. bonds, but there is greater risk in stocks. Unless we are talking about variable-rate bonds, most bonds are fixed-income products, e.g. a government bond pays you a fixed coupon amount. You can therefore rely on this coupon always being paid. There is little uncertainty. Dividends from stocks, however, may vary depending on market volatility and business activity. For example, recently BHP announced it was buying back shares and paying a special dividend thanks to the sale of a US shale asset to BP. If a fund manager holds BHP, it may receive a huge dividend one day and then the next month may receive little dividends. If economic conditions are challenging, dividends may be cut. As such, if a fund manager were relying on stock dividends to pay monthly distributions, there may be times when dividends are low, which means that in order to maintain the high monthly payout, the fund needs to eat into original capital.

When focusing on financial independence, it make sense to focus on the necessities first, i.e. food and raiment rather than holidays, and given that it is more helpful to have monthly passive income to fund these expenses, I believe it is necessary to look instead at medium-yield (not high-yield) exchange-traded products that pay monthly distributions. Assuming food costs $300 per month and rent costs $700 per month then this means you need $1000 per month for necessities, which means $12k per year. You only need $150k invested earning 8% to get this. This is the allure of high-yield funds. However, with high yield comes high risk, so a medium-yield fund may provide a good compromise.

Remembering that investing has a risk-return tradeoff, and remembering that food and raiment are necessities (you cannot live without food and covering), we should not rely on high-yield high-risk investment to fund necessities. We should at least rely on medium-yield medium-risk investments to fund necessities.

I make these comments because recently I have purchased Betashares’s hybrid ETF (HBRD), which pays about 4% monthly. I have found that HBRD pays very reliable income, almost the same every month whereas virtually all other investments pay variable passive income. Looking at the Bloomberg price chart of HBRD below, you can see that HBRD (in black) is somewhat correlated to the XJO (represented in orange by the STW ETF) but with a lower volatility (or lower beta). This makes sense because hybrids are lower risk than stocks but are riskier than bonds. (Hence they are hybrids as they have bond-like and stock-like characteristics.)

HBRD (in black) has lower volatility than XJO (in orange)
Source: Bloomberg

In fact, Betashares seems to have learned its lesson from HVST and have introduced a slew of other medium-risk ETFs (e.g. CRED and now BNDS) that pay monthly distirbutions to complement their existing inventory of low-risk income ETFs (e.g. AAA and QPON) and high-risk income ETFs (HVST, YMAX, EINC, and RINC).

Below is a table of ASX-listed products (mostly ETFs, LICs, and LITs) that pay monthly distributions. The products below are sorted by risk/yield. I have used my judgement to classify these are high, medium or low yield. Generally high-yield investments derive income from stocks and pay around 5% to 10% yield, medium-risk investments derive income from hybrids and corporate bonds and pay around 3% to 5% yield whereas low-risk investments derive income from cash deposits and government bonds and pay around 1% to 3% yield. Some of these products invest in highly risky areas e.g. QRI will invest in commercial real estate debt. Note that some of these investments have not been released yet and that this is a personal list that I keep that may not include all ASX-listed investments that pay monthly passive income. If I have missed any, please notify me in the comments section.

ASX TickerNameYield
HVSTBetaShares Australian Dividend Harvester FundHigh
PL8Plato Income Maximiser LimitedHigh
QRIQualitas Real Estate Income FundHigh
AODAurora Dividend Income Trust High
EIGAEinvest Income Generator Fund High
GCIGryphon Capital Income TrustHigh
MXTMCP Master Income TrustHigh
HBRDBetaShares Active Australian Hybrids FundMedium
CREDBetaShares Australian Investment Grade Corporate Bond ETFMedium
BNDSBetaShares Legg Mason Australian Bond Fund Medium
QPONBetaShares Australian Bank Senior Floating Rate Bond ETFLow
AAABetaShares Australian High Interest Cash ETFLow
BILLiShares Core Cash ETFLow

Disclosure: My investments include BHP, IHD, HVST, AOD, HBRD, and AAA.

Buy a House vs Invest in ETFs

This is a common dilemma. You are saying up money and want to know if it is better to buy a house and live in it or invest in ETFs and rent (also known as rentvesting).  Personally I would invest in ETFs. The reason why is because the key difference between the two options is you pay far higher taxes when you buy a house.

For example, if you buy a house then you’re need to pay stamp duty. On a $1 million house that is roughly $57k in stamp duty, which will reduce your net worth. Assuming you save up a $200k deposit, then right after you buy your house your net worth will be $143k whereas if you simply keep your money in ETFs you’d still be at 200k.

However, an argument can be made that if you buy a house, because you have borrowed money to buy $1m worth of asset then you have leveraged exposure, which moves you up the risk-reward curve (also known as the efficient frontier). If you save $200k and invest it in ETFs, if there is a 10% increase, you have made $20k. However, if you have purchased a $1m house and it goes up 10% then you have made $200k. However, what is misleading about this comparison is that it compares apples with oranges, that is, it is comparing leveraged real estate vs unleveraged ETFs. To compare apples with apples, you need to compare leveraged real estate vs leveraged ETFs. Leverage does not increase returns without any consequences. Leverage increases risk, which may result in higher returns.

You can move up the risk-reward curve with ETFs simply by reallocating a portion of your ETFs into internally leveraged ETFs e.g. GEAR or GGUS. Another option is to invest in higher risk niche ETFs (e.g. ROBO or TECH) to move up the risk-reward curve. The benefit of buying higher risk ETFs is that there are no mandatory monthly mortgage payments or, if you take out a margin loan, margin calls. The effect of leverage is handled by the fund itself and there is no obligation for you to pay anything.

Gearing into equities is expensive before tax but cheap after tax

Another way to move up the risk-reward curve is to take out a margin loan and buy ETFs with it. The downside to taking out a margin loan is higher interest rate compared to home loans. According to Canstar, the cheapest margin loan rate is 5.20% from Westpac whereas the cheapest home loan it is 3.49% from Reduce Home Loans. However, if you buy a home to live in, the mortgage debt is not tax deductible, but the margin loan debt is tax deductible, i.e. you can negatively gear into ETFs by taking out a margin loan, which effectively lowers your interest rate by your margin tax rate. Assuming you earn between $87k and $180k and face a 37% margin tax rate then rather than pay 5.20% interest rate you are effectively paying 3.27% which is in fact lower than the home loan. If you have chosen to leverage using internally geared ETFs, because the fund manager has high bargaining power, he or she is able to get low interest rates anyway. According to the GEAR and GGUS brochure from Betashares, “the fund uses its capacity as a wholesale investor to borrow at significantly lower interest rates than those available directly to individual investors.”

Another advantage of investing shares or ETFs is that Australian shares often pay dividends with attached franking credits (e.g FDIV pays 100% franked dividends), which lowers you tax burden even further.

Capital gains tax has little impact

Even though living in a home does not make you eligible for negative gearing, you are eligible for capital gains tax exemption. However, capital gains tax is easy to avoid if you buy a hold shares or ETFs. Because capital gains tax is triggered with you sell and because capital gains tax is charged at your marginal tax rate, simply buy and hold and wait until you are retired. When you are retired, you will earn no salary, so your income will drop and your salary will likely face lower income tax, perhaps even being within the tax free threshold. You then sell off shares or ETFs bit by bit when you’re retired, ensuring that you pay little or no CGT.

Low rental yields vs high dividend yields

Now that we have established that ETFs have lower borrwing costs than real estate due to the impact of negative gearing, stamp duty avoidance, and franking credits, a huge argument for investing in ETFs rather than real estate is the huge difference between rental yields and dividend yields. As of right now, a three-bedroom unit in Brunswick East costs $1.3m and has rental yield of 1.42% i.e. around $18.5k in rent per year. However, as of right now, Commonwealth Bank shares are paying gross dividend yield of 8.6%. This means that if you have $1.3m, then rather than buying the Brunswick East unit and living in it, you can simply take out a margin loan, invest $1.3m all in CBA, and then receive $110k in dividend income per year. After income tax and franking credits, this will be around $90k. After paying rent of $18.5k you have roughly $70k per year extra simply by using ETFs.

Not only do you get $70k per year extra thanks to the extreme spread between rental and dividend yields, but the benefits for ETFs are magnified even further because of lower post-tax borrowing costs.

Using one Brunswick East unit vs one high dividend paying stock (CBA) is an extreme example. Not all stocks are the same and not all residential real estate is the same. However, the general trend is indeed that rental yields in Australia are low and dividend yields on Australian stock are high. If you bring up a list of all properties on the BrickX fractional property platform and sort by rental yield, the highest yield property, a one-bedroom unit in Enmore NSW only delivers a rental yield of 2.76% with the average rental yield about 1.5%. However, a broad ASX200 ETF such as STW provides gross dividend yield of 5%.