Why I Hold Bonds in My Portfolio

I don’t think it’s too controversial to suggest, that at its simplest, a modern portfolio will contain bonds (whether government and/or corporate, domestic and/or international, index linked and/or otherwise) and equities (whether domestic, international developed and/or emerging).  I make this statement as bonds and equities are two asset classes that historically have exhibited different properties that when combined can work together to give some interesting characteristics.  Tim Hale describes the differences well – “Equities have an economic rationale for and history of delivering mid-digit real returns (after inflation) and are considered the engines of portfolio returns, but with considerable and sometimes extremes swings in returns...  High quality domestic bonds on the other hand, tend to have far smoother return patterns at a cost of lower returns, which come in the low single digits, after inflation.”

I probably make it more complicated than it needs to be but at its heart my portfolio is not much more than a 32% bonds/68% equities portfolio which at its conclusion will likely settle at a 40% bonds/60% equities portfolio.  In comparison I’ve recently starting noticing more and more personal finance bloggers who are holding far lower or even no bond allocations in their portfolios.  This has had me thinking:

1. has the significance of bonds in a portfolio disappeared;
2. is it correlated to us now having been in a bull market since 2009;
3. is it because my high savings rate encourages and allows me to live the Warren Buffet quote “Rule No. 1: Never lose money.  Rule No. 2: Never forget rule No. 1” where others might be chasing higher yields; or
4. is it just simply that I’m now nearing the end of my rapid wealth generating journey and others are a little earlier on in theirs.

To make sure it’s not number 1 let’s spend some time going back to fundamentals to understand if bonds combined with equities are still doing their thing.  I’ve been able to source 10 full calendar years (not quite for the bonds as I’ve only been able to go back to 29 March 2004 but close enough) of total return bond and equity performance covering the years 2004 to 2014.  The bonds are the Markit iBoxx GBP Liquid Corporates Large Cap Index and the equities are the FTSE 100.  Armed with this information I can calculate the annual return possible for everything from 100% bonds, through various mixed bond/equity allocations to 100% equities for each year.  I can then calculate the volatility (I’ve used standard deviation to represent volatility) for each allocation for the 10year period.  The 100% Bonds portfolio has volatility of 7.2%, the 40% Bonds/60% Equities has 10.7% while the 100% Equities has 14.8%.  This is all shown in my first table below.

Click to enlarge, Portfolio Annual Return if Bonds/Equities Allocation Rebalanced at Start of each Year

Adding Legal & General to my High Dividend Yield Portfolio (HYP)

On the 29 May 2015 I added Legal & General (LGEN) to my High Yield Portfolio (HYP) at a price of £2.6766 a share.  Since purchase they've fallen a little in Price closing at £2.639 on Friday.  LGEN represents my 13th formal HYP purchase and brings my total HYP portfolio to 15 shares if I include the government gift that was Royal Mail Group (RMG) and the demerger of South32 from BHP Billiton (BLT).

Having unitised my HYP I can accurately tell you that since inception in November 2011 my HYP has seen capital gains of 34.2% compared to the FTSE 100 at 27.7%.  Year to date capital gains performance switches with the HYP up only 0.6% compared with the FTSE 100 at 3.3%.  Dividend yields however, which is why I have the HYP in the first place, are 5.1% (trailing yields) for the HYP vs only 3.6% for the FTSE 100.

So why did I buy Legal & General?  Within my HYP I’m looking to buy solid companies that currently have high yields but which I hope to be able to hold for the very long term, ideally the rest of my life.  Some of the key criteria for me were:

• The Legal & General business model is easy to understand.  They are a large insurance and investment management group with their fingers in defined benefit pensions, annuities, fund management, life insurance and fund wrapper (cofunds for example) pies.
• I prefer large and non-cyclical industries.  Its company number 35 in the FTSE 100 with a market capitalisation of £15.8 billion and generates £1.3 billion in revenues.  It is however not a non-cyclical company.  To demonstrate in 2007 they had an adjusted earnings per share of £0.1188 which by 2008 had turned into -£0.1788.  This then also forced a dividend cut in 2008 and a further cut in 2009 which didn’t recover to 2007 levels until 2011.  So as a retiree living off LGEN dividends your ‘salary’ would have fallen by 1/3 which is not insignificant.
• To minimise risk I'm looking for my HYP shares to be spread over a number of sectors.  LGEN adds a new sector for me – Life Insurance.
• I’m looking for shares with dividend yields somewhere between the current FTSE 100 yield of 3.6% and 1.5 times the FTSE 100 yield or 5.4%.  On a trailing yield of 4.3% LGEN is right in the sweet spot.  Forecast dividend yield is near the top end at 5.0%.
• The company should have an unbroken history of continually increasing dividends plus dividends that increase at a rate equal to or greater than inflation.  As already mentioned they’ve had their transgression but in the 5 years to 2014 LGEN have raised their dividends from £0.0384 per share to £0.1125 or 193% which is a country mile above inflation over the same 5 years at 18%.  Taking away the flattery that the transgression provides and dividends are also up 88% since 2007.  This nicely demonstrates why it might be prudent to carry a couple of years of cash buffer in retirement as the last thing you want to be doing is selling capital to eat when prices are severely depressed.
• A dividend cover of greater than 1.5 for all HYP type shares except utilities where I think that greater than 1.25 is ok.  Here LGEN is right on the limit at 1.5.
• ‘Creative accounting’ can make earnings and hence dividend cover look good.  I therefore also set a greater than or equal to 2 criteria on Operating Cash Flows compared to Dividends.  At 8.3 this is very high but for LGEN this metric moves around a lot.  In 2013 it was 2.4.
• Valuations don’t look cheap with a P/E ratio of 15.8 and a Price/Book ratio of 2.5.
• As I write this post today I have 83.2% of the investment wealth that I believe I need to bring me financial independence.  What I find interesting is that I don’t have a single £ anywhere near a LGEN product.  I'm not sure if this is a good thing or a bad thing though...

My Investment Portfolio Warts and All

Two events have occurred in the past week that prompt this post:

1. My Defined Contribution Company Pension transfer to a Hargreaves Lansdown SIPP has now completed.  The timings ended up being that I sent all the paperwork to Hargreaves Lansdown on the 09 May ’15, received a confirmation letter that it was in progress on the 13 May, the cash landed in my new Hargreaves Lansdown SIPP on the 29 May, I bought all my new low expense investment products (which made this post a little redundant) on the 01 June and the £500 cash back offer landed in my account on the 05 June.  So all in about a month for it all to wash through.  Total Investment Portfolio expenses including SIPP wrapper charges now run to 0.28% per annum.
2. I received a Facebook message from a reader asking if I could do a post with “a really detailed breakdown of my portfolio starting with a rough pie chart with just equities, bond, gold, alternative investments, property etc and then a more detailed breakdown again perhaps an exploded pie chart of the main parts. For example share category American, European shares etc.”  When I read the message I realised that while I've talked ad infinitum about my portfolio over the years I've never given such a detailed breakdown including investment product percentages.

So without further ado here’s my investment portfolio warts and all.

The investment strategy (some might call it an Investment Policy Statement) on which my portfolio is based has now been in place almost since the beginning of my journey.  I first documented it in 2009 but I would suggest reading my 2012 strategy summary (as it included the addition of my High Yield Portfolio (HYP) for a portion of my UK Equities) in parallel to today’s post.  The strategy post will give you the “Why” behind my thinking while today’s post will give you the “What”.  It’s also important to note that nothing I do is original or clever.  It’s predominantly based on work by Tim Hale which is a book that I believe every UK investor should read with tweaks coming from the reading of the following books.

The Top Level Investment Portfolio

Click to enlarge, My Actual Low Charge Investment Portfolio

At a top level the portfolio contains local and International Equities, Commodities, Property, Bonds and Cash.

Insuring Against Sequence of Returns Risk with the State Pension

Anybody who is intending to retire (particularly those taking early retirement) without a healthy Defined Benefit Pension or without knowledge of a guaranteed healthy inheritance should be wary of and maybe even have a healthy fear of sequence of returns risk.  It is the risk of receiving a series of investment returns that are negative (or lower) during a period when you are in portfolio/wealth drawdown which then never allows your wealth to recover even when investment returns normalise.

Blackrock have a couple of charts which demonstrate the phenomena nicely.  Firstly, let’s look at Sequence of Returns during the Wealth Accrual Phase (ie before Retirement).  The chart below shows 3 investors who each make an initial investment of $1,000,000 at age 40 and then never invest again.  Each has an average annual return of 7% but each experiences a different sequence of returns.  25 years later each has the same portfolio value even though valuations varied along the way.

Click to enlarge, Sequence of Returns during Wealth Accrual Phase

Now let’s look at Sequence of Returns during the Wealth Drawdown phase.  Again we have our 3 investors making the same initial $1,000,000 investment, the same average annual return of 7% with annual returns following the same sequences as during the Wealth Accrual Phase.  25 years later each have very different portfolio values with Mr White now forced to beg for food under a bridge.

Valuing the UK Equities Market (FTSE 100) - May 2015

My investment strategy requires me to moderate my equity holdings based upon my view of current equity market values.  I run this valuation monthly for the Australian (currently targeting 15.5% of total portfolio value at current valuation vs 17% at fair value), US (as a proxy for my international equities and currently targeting 10.4% vs 15%) and UK (currently targeting 19.0% vs 20%) Equity markets.  Let’s look at the UK Equity market in more detail.

Firstly nominal values.  Between yesterday and the 1st April 2015 (“month on month”) prices are up 3.3% and since the 1st May 2014 (“year on year”) prices are also up 3.3%.

Chart of the FTSE 100 Price, Click to enlarge

Regular readers will know I’m not a fan of this type of chart as:

• the unit of measure, £’s, is being constantly devalued through inflation (although in the current market one wonders for how much longer); plus
• Pricing should be plotted on a logarithmic scale as opposed to a linear one as by using this scale percentage changes in Price appear the same.  

So let’s correct the chart for the devaluation of the £ through inflation (I use the Consumer Price Index (CPI) here) and convert to a log chart.  This normalised chart shows that Friday’s FTSE 100 Price of 7,031 is actually still 25% below the Real high of 9,331 seen in October 2000.  We’re also still 14% below the last Real cycle high of 8,164 seen in June 2007.

Chart of the Real FTSE100 Price, Click to enlarge

Life’s Great Saving Hard and Investing Wisely for Early Retirement

This week as I was thumping up and down the motorway on my lengthy daily commutes I couldn’t help but take some glimpses of the current and potential future life that this journey to Early Financial Independence is providing.  There are of course negatives but the positives really did override my thoughts.  Let me share a few random musings.

Saving Hard

In a post back in March I shared a little about my personal life which included my ‘9 to 5’.  Today is my 397th post on Retirement Investing Today and that post is right up there when it came to Comments at 51 to date.  Some of them pointed to a punishing work life which prompted me to look around at my colleagues and I do agree that I work much harder than most but this is a little by design as I always want to stay in the top 10% of my peer group.  The rub is that what seems a negative to some is now just normal and on autopilot to me plus on the whole my health and wellbeing is as good as it has ever been.  The positive though is that this approach allows things like earnings increases of 44% in a year and I can already see a door potentially opening that may allow another step change in earnings.  So while I admit to being tired come Friday night I also think my colleagues probably are as well.  The difference is that I have an extra chunk of cash which I can save to power me towards Financial Independence Retire Early (FIRE) which means I’ll be done in the not too distant future and they’ll retire when the government lets them.

On the spending front I've also realised that Living Well Below My Means is now just an autopilot activity.  I no longer crave stuff and get zero satisfaction from consumerism.  I do still track spending religiously just in case I need to correct course but I no longer have any sort of budget and certainly don’t have a £0 one.

These two mind sets currently allow me to save 54% of gross earnings.  Sure it’s not at my target of 55% but do you know what – I really am starting to not care anymore.

Click to enlarge, Gross Savings Rate

Investing Wisely

My investment portfolio which is largely just a set of diversified tracker funds is running pretty close to plan through nothing more than passive portfolio rebalancing and to the end of April 2015 has grown by a Real (after inflation) Compound Annual Growth Rate after expenses of 4% since inception.  It’s also now pretty close to being an autopilot activity.

Click to enlarge, Performance of £10,000 within RIT Portfolio and Benchmark vs Inflation

One active element with my investment portfolio is of course my High Yield Portfolio (HYP).  Trailing dividend yield is a healthy 5.0% when compared to the FTSE100 at 3.5%.  Capital Gain since inception is also a healthy 38% vs 31% for the FTSE100.  Over the shorter term it’s not so rosy with Capital Gain year to date at 3.5% vs 6.0% for the FTSE100.  So this non passive piece is not quite on autopilot but the strategy is well defined and I'm still happy with the results.  The question I'm starting to ask myself though is can I really be bothered with it.  I'm going to watch it for a year or two more but if results do start to converge toward the index I may just go passive.

Valuing the Housing of England and Wales at County Level – Year 3

Every year in May I like to spend a few hours of my life that I’ll never get back preparing a house Valuation metric that goes beyond that generally presented by the mainstream media by getting more granular and trying to Value housing at County level.  This should then for example help us to understand if there really is a north south divide when it comes to housing.  Last year’s efforts can be seen here.

My definition of Value is simply how many years of gross earnings (median and average) are required to buy an average house.  This is a simple average Price to Earnings Ratio (P/E) and is not unlike how some might value a company share.  Importantly I am not interested in Affordability which is one’s ability to service debt at current interest rates and is what I think actually drives the UK housing market.  This is because I believe that the average punter doesn’t ask is this house good Value but instead asks how much can I borrow and then spends to that limit.

For House Prices I am using average house prices as published by the Land Registry. This is calculated by using:

• The Land Registry House Price Index (HPI) dataset.  This index uses repeat sales regression (RSR) on houses which have been sold more than once to calculate an increase or decrease.  As it analyses each house and compares the latest buying price to the previous buying price it is by definition mix adjusting its data also.  It uses all residential property transactions made in England and Wales since January 1995 so covers buyers using both cash and mortgages.
• Average prices are then calculated by taking Geometric Mean Prices (as opposed to an arithmetic mean), to reduce the influence of individual values, from April 2000 and adjusting these prices in accordance with the Index changes.  They are seasonally adjusted. I am using the latest published data which comes from March 2015.  

The Valuation analysis is arranged according to the Regions and County’s defined by the Land Registry and is shown in the Table below.  Unlike the mainstream media I am calling high house prices bad (unsurprisingly the County with the highest house price is London at £462,799 and is shown in dark red) and low house prices good (the County with the lowest house price is Middlesbrough at £62,546 and is dark green) with all other prices shaded between red and green depending on house price.

For Earnings I am using the 2014 Annual Survey of Hours and Earnings (ASHE) which provides information about the levels, distribution and make-up of earnings and hours paid for employees within industries, occupations and regions in the UK.  To ensure that our Earners and Homes are located within the same County I’m using the Earnings by Place of Residence by Local Authority.  This dataset presents weekly Earnings at both median (the middle point from each distribution) and mean (the average) levels which we have arranged into each Land Registry Region and County in the Table below.  I then multiply the data by 52 weeks to convert it to an annual salary.  I am calling low earnings bad (the lowest average earnings are £17,638 in Blackpool and are dark red) and high earnings good (the highest average earnings are £36,982 in Windsor and Maidenhead and are dark green) with all other earnings shaded between red and green depending on earnings.

Transferring my Company Pension into a SIPP – Part 2

On Saturday the SIPP of choice for my Company Pension transfer was heading towards Interactive Investor and their annual costs of £176.  Valued reader comments plus some more DYOR has instead led me to Hargreaves Lansdown.  Before you Comment that they are an expensive percentage fee broker/platform with annual charges of 0.45% let’s run through my thinking.

Firstly, dearieme highlighted that provided you stick with Shares, investment trusts, ETFs,
gilts & bonds and don’t add any funds Hargreaves Lansdown become a percentage fee broker/platform but with a capped maximum annual expense of £200.  I can work within that no fund criteria.  So now once your pension is greater than £44,444 that 0.45% starts to reduce.  Transfer £100,000 and it’s down to 0.2%.  On top of that John and Cerridwen also raised some red flags against Interactive Investor.

Secondly, even though the SIPP is now capped I hear you saying that it’s still £24 a year more expensive than Interactive Investor and sweating the small stuff matters.  This is where it gets interesting.  Hargreaves Lansdown currently have a promotion running until the 12 May 2015 that provides a cash back incentive for transfers of Stocks & Shares ISA’s, Cash ISA’s, Junior ISAs/Child Trust Funds (CTFs), Funds, Shares and Pensions.  They also advise that “if you need more time to decide please let us know and we will extend this deadline for you (up to three months for ISA, fund and share transfers, and six months for pensions).”  Transfer big sums and it’s a significant amount.  Between £100,000 and £124,999 and its £250 cash back which means you’re now ahead of Interactive Investor’s current annual charges for 10 years.  Transfer £125,000 or more and its £500 which puts you ahead for 20 years.  Dealing costs for me are going to also be £1.95 more expensive than Interactive Investor but I think I can set the SIPP up with 9 trades which would take a bit under 1 year off that benefit.

I highlighted in Saturday’s post that the reason for not just using my current YouInvest SIPP was the all eggs in one basket risk.  I currently have some of my HYP in a Hargreaves Lansdown Vantage Fund & Share Account and so adding a Hargreaves Lansdown SIPP will increase my exposure with this provider from 6% to 21%.  I’m ok with that level of risk.

So by switching from Interactive Investor to Hargreaves Lansdown I can save some money while also moving to a wrapper that I know and am happy with while keeping provider risk to acceptable levels.

Transferring my Company Pension into a SIPP

About half of my current monthly savings are salary sacrificed into my employers Defined Contribution Pension plan.  I do this over adding directly to my own personal SIPP for a few reasons:

• My employer matches contributions up to a certain level;
• My employer adds the majority of the employers National Insurance that they save into the pension; and
• The 2% employee National Insurance that I would have paid is also able to be added into the pension

Wealth Warning: Before I proceed it’s worth reinforcing that my employer pension plan is a Defined Contribution Pension and not a Defined Benefit Pension.  It also provides absolutely zero additional benefits.  If it was or did either of those things what I describe below may not be the right approach.

These benefits definitely outweigh the high 0.6% to 0.76% expenses I'm then paying for trackers and the lowest cost active funds (where a tracker is not available) within the Pension.  That said if I could find a way to get the money in through salary sacrifice as I do today but then transfer at regular intervals into my SIPP I’d get all the salary sacrifice benefits of the company pension as well as all the low cost benefits of a DIY SIPP.  This effect would be noticeable as I've been with my current employer for a large portion of my Financial Independence Retire Early (FIRE) journey meaning some 15% of my total wealth is now held within the company pension.  I estimate it would reduce my total wealth annual expenses from 0.31% per annum to about 0.25%.  0.06% doesn't sound like much until you run the numbers and realise its £60 per annum if your wealth is £100,000 and £600 per annum on £1 million.

Regular readers will know I've been trying to find a way to do this for some time.  I've tried two different angles:

• Get my employer to open me a new Pension policy with them salary sacrificing into that new account.  The old account would then be dormant allowing a trivial SIPP transfer by simply filling out the short transfer form that is available from any SIPP provider.  Unfortunately my employer wouldn't budge here as it was just too much “admin”.
• Ascertain from the insurance company who provides the Defined Contribution pension if and how this can be done.  They obviously have a vested interest in being as slow and obstructive here as possible.

I am however pleased to announce that many emails, phone calls and a lot of time later I have achieved success.  In case any readers are trying to do something similar the form I needed is what is called a Declaration of Claim Discharge which is a simple 2 page form which importantly includes a section called a Partial Transfer Request which enables me to check a box entitled “If you wish to move the ‘maximum amount’, please tick the box opposite”.  All I have to do is complete this form and then attach it to the SIPP transfer form from my chosen SIPP provider and I'm away.

The £0 Budget

A lot of my posts in more recent times have been focused on how to earn more and spend less.  I acknowledge they’re pretty dry topics, quite personal and certainly nowhere near as exciting as deciding should I buy the Vanguard FTSE Emerging Markets UCITS ETF or the iShares Core MSCI Emerging Markets IMI UCITS ETF for the Emerging Markets portion of my portfolio.  So why do I keep coming back to the non-exciting topic of earn more and spend less?  Simply because my personal journey has shown me thus far that saving has a much bigger impact on reaching Early Financial Independence or even Early Retirement than investment return.  While investment Compound Interest is for sure a very important concept, particularly over the long term, and is certainly making a contribution it’s just not making as big a contribution as my saving.  This is not what I expected when I started on my journey.

Let’s have a look at my journey data thus far in the chart below.  This chart shows for each year (2015 is only until end of March and so shows as 2014.25) the percentage contribution made to my change in wealth each year from both Saving Hard and Investing Wisely.  Therefore the percentage for each year that shows as greater than 50% has been the greatest wealth contributor for that year.  So in 2008, 2009, 2010, 2011, 2013 and 2014 the honour of most wealth growth contributor has gone to Saving.  In contrast 2012 and 2015 year to date has gone to Investment Return.  So even in year 7 of my Financial Independence Retirement Early (FIRE) journey Saving is still out in front.

Click to Enlarge, Wealth Growth Year on Year

Of course regular readers will know my Savings Rate is quite high and I’m trying to reach FIRE quickly but I'm not going to make apologies for that.  As savings rate decreases journey time to the goal, whether it’s FIRE or some other objective, should increase with an average wind which should mean that Saving will make less of a contribution and Investment return a greater one.  So maybe I'm just an anomaly given I'm trying to reach Financial Independence in less than 10 years.

Buying Gold – April 2015 Update

With Gold well off record highs the mainstream media currently have no interest in the precious as they need sensational headlines.  Even the blogs, unless the owners are predisposed to tin foil hats, are these days rarely mentioning the yellow stuff.  I'm going to mention Gold today though and I can assure you that all tin foil is still firmly located in the kitchen.  I'm mentioning it as I've just bought a healthy dollop.  It was the fourth place I deployed my bonus.

I bought the ETF Securities Physical Gold ETC (Ticker: PHGP) which is physically backed with allocated metal subject to LBMA rules for Good Delivery, has UK reporting fund status, is ISA eligible, SIPP eligible, is priced in £ and has a Management Expense Ratio (MER) of 0.39%.  I paid £77.47822 a unit so with prices closing at £78.12 on Friday I'm up a little.  Not that I'm worried as I am prepared to hold for a long time.

Let’s look at some Gold numbers.

My first chart shows how the Monthly Gold Price in Pounds Sterling (£’s) has changed since 1979.  Over the past year its Price has risen 3.5%.

Click to enlarge, Gold Priced in Pounds Sterling (£) 

Regular readers will know that I despise these nominal charts that are so often presented because the unit of measure they are presented in is continually being devalued by inflation.  Let’s therefore correct for that and show the Real Gold Price in Pounds.

A Retirement Investing Today Q1 2015 Review

The primary purpose of this blog is to hold myself accountable and chart my progress to Early Financial Independence (FI).  At FI my wealth will also be sufficient to make Early Retirement optional at the same time.  This is not a model or demonstration but my real DIY financial life.  Get it right and it’s smiles all round in a short period of time.  Get it wrong and my derisory State Pension is still a long way off and likely to get longer still given the financial and demographic state of this great country.

In line with my Plan, Do, Check, Act (PDCA) strategy let’s today some Checking by examining the three key focus areas that I believe are essential to get over the Financial Independence line - Save Hard, Invest Wisely and Retire Early.

SAVE HARD

Saving Hard is simply defined as Gross Earnings (ie before taxes) plus Employee Pension Contributions minus Spending minus Taxes.  Earn more and one is winning.  Spend less or pay less taxes and you’re also winning.  Savings Rate is then Savings divided by Gross Earnings plus Employee Pension Contributions.  To make it a little more conservative Taxes include any taxes on investments but Earnings include no investment returns.  This encourages me to continually look for the most tax efficient investment methods.  It’s a different and tougher measure to most of my fellow personal finance bloggers who don’t include tax in the calculation.

Savings Rate for the quarter ends at 53.8% against a plan of 55%.  While a miss it’s a lot better than the 37.2% I managed for the first quarter of 2014.  Additionally in physical pounds, shillings and pence in my pocket it’s more than twice as much as Q1 2014.  The miss was also a conscious decision with the RIT family taking a winter trip to Puglia, Italy to assess the location as a possible Early Retirement location.  At these savings rates I'm also now in the surreal situation where my spending is significantly less than the tax I pay.

Click to enlarge, RIT Savings Rate

Saving Hard score: Conceded Pass.  Savings, including help from a healthy bonus where I saved 100% of the after tax amount, have added 5.7% to my net wealth in this quarter alone.  My big problem remains taxes which I'm struggling to control as I'm a simple PAYE employee.  Any extra £ that I now make is taxed at the Higher Rate of 40% plus 2% National Insurance plus as my non-tax efficient investments continue to grow in size I'm being taxed on these as well.

INVEST WISELY

Investment returns for the first quarter of 2014 were 5.8%.  An incredible amount given the structure of my portfolio.  This return means for only the second time in my investing career investment return has exceeded savings rate.  Is compound interest finally starting to do its thing or has Mr Market just become a little excited?

Click to enlarge, RIT Year on Year Change in Wealth

My investing strategy remains largely in line with that developed at the start of my DIY journey except in recent times I've started making 2 tweaks given my closeness to Financial Independence.  The first is to increase cash like holdings to give the option of a family home purchase.  Cash moves from 8.2% of portfolio value at the end of 2014 to 9.4% at the end of the quarter.  Increasing portfolio dividends to 3% of non-home purchase wealth on the other hand is not going so well even though I continue to add to my HYP.   At the end of 2014 I was at 2.3% and today this has fallen to 2.1%.  Not much I can do here as it’s simply been caused by the Mr Market price rises over the quarter and is not something I can control.  My plan is to just keep at it and see what washes out in the next 12 months or so.  The 3% number comes from a decision to drawdown at 2.5% after expenses which then leaves a little for reinvestment also.  Psychologically I feel this would result in a more relaxed Early Retirement than one where you are selling assets off continually to eat.

Safe Withdrawal Rate (SWR) Thoughts

Many of us in the Early Financial Independence, Early Retirement, community are chasing an amount of wealth which when achieved will allow us to as a minimum call ourselves financially independent and as a maximum allow us to head into full early retirement.  To calculate that target wealth number it’s likely (I know I have) we've ascertained how much we intend to spend per annum and then divided that number by a Safe Withdrawal Rate (SWR) we’re happy with.

The 4% Rule is a SWR that is bandied about freely as a rule of thumb.  Personally it’s too bullish for me and so as I type this I'm planning on an SWR of 2.5% plus 0.25% to allow for investment expenses for a total withdrawal rate of 2.75%.

When we choose a SWR we’re likely trying to calculate the maximum real inflation adjusted annual income we can take while ensuring we don’t run out of wealth before we run out of life.  In doing so what we are really doing is trying to protect ourselves from worst case sequence of returns risk.  In trying to protect ourselves from this sequence of returns risk (and assuming history repeats which we all know is not guaranteed) we actually end up with a scenario where in the vast majority of cases we end up with a lot more wealth than we started with at check out time.

Let me demonstrate with an example.  To do this I'm going to teleport myself to the US and use the excellent cFIREsim calculator as we’re pretty starved of decent free tools here in the UK.  I'm going to assume I retire with one million dollars ($1 Million), give myself a 60% US Equities : 40% US Bonds asset allocation, spend at an inflation adjusted $25,000 per annum (a 2.5% SWR), assume annual expenses of 0.25% and assume I need that level of spending for 40 years.  The output of that simulation is shown below:

Click to enlarge, cFIREsim output