A Retirement Investing Today Half 1 2015 Review

On this blog I talk a lot about my own strategy and portfolio including how I'm managing and changing them as I learn.  Importantly, this is not a demonstration strategy or portfolio but instead reflects every penny I have to my name.  The journey also now represents a significant portion of my life with me now having been on this DIY Early Financial Independence (FI) path for seven and three quarter years which is nearly 20% of my life so far.  When I started in 2007 and even when I started this blog in 2009 I had no idea if I would succeed.  Today I'm far more confident that I’ll eventually get there and I also now believe that I have a level of personal finance knowledge that will enable me to self manage my portfolio to and into Early Retirement.  Even so I’m not yet going to relax.  At some point I'm also sure I’ll need to start thinking about how to set-up an autopilot portfolio (Vanguard LifeStrategy anyone?) but that’s for another day.

This strategy and portfolio is an essential enabler to how I want to live my later life – one not burdened by the need to work for The Man but instead able to focus 100% on what’s important to me which enables both location and time freedom.  Given its importance I like to stop every quarter and in line with my Plan, Do, Check, Act (PDCA) strategy do some Checking against 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 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%.  This is identical to last quarter.  While not achieving plan in pounds, shillings and pence it’s actually 56% more than I managed in Half 1 2014 thanks in part to a healthy bonus.

Click to enlarge, RIT Savings Rate

Saving Hard score: Conceded Pass.  While not achieving a plan of 55% in pound terms I’m a long way above 2014.  Savings have also added 7.6% to my net wealth in the first half of the year – a surreal amount given I’m towards the back end of my Financial Independence Retire Early (FIRE) journey.

HYP Mid-Year Update including Purchase 14

The vast majority of my investment portfolio is made up of passive index tracking funds.  Why?  Well as a person who’s now been investing heavily for a bit over 7.5 years I personally believe this is the best way for me to achieve my wealth ambitions.  One exception to this is my High Yield Portfolio (HYP) which is held within the Equities portion of my portfolio and can only be described as active investing.  So if I'm a tracker believer what am I doing actively investing I hear you ask.

Click to enlarge, RIT UK Equities Portion of Total Portfolio 

Simply, while 99% of my investing is all about non-emotional investing my HYP is an outlier as it’s there for psychological reasons.  I’m now fast approaching optional very early retirement and when in that retirement I’m going to be likely 100% living off my wealth.  I’m going to do this by drawing down from my wealth at the rate of 2.5%.  I have two ways to do this – spend dividends/interest and/or sell down capital.  For me, particularly in a severe bear market, I think that spending dividends/interest will psychologically be far easier and less disruptive to life than being forced to sell down capital.  With that in mind before retirement I’m trying to ensure that the dividends/interest I receive annually is as close to 3% of wealth as possible.  If I can achieve 3% in the good times I can draw down 2.5% and reinvest 0.5% and in the bad times I have some buffer to allow for dividend attrition.

This psychological advantage is however a fool’s errand if it causes my total portfolio to underperform the market.  Unemotionally what matters is Total Return which is Capital Appreciation plus Dividends.  So with this in mind I watch my HYP performance, particularly capital gains, like a hawk.  So as we pass the mid-year point of 2015 let’s take a look at my HYP's performance to date.

Firstly to what the HYP is all about – Dividends.  Performance here is still very good with the portfolio currently sitting on a trailing yield of 5.2% which is 1.4 times the FTSE100’s 3.6%.  So far so good.

Now let’s look at the risk associated with buying big, boring, non-cyclical industries – Capital Gains.  Since inception in November 2011 this is also ok.  The HYP has returned a gain of 31.0% vs the FTSE100’s 25.6%.  Where it gets interesting though is year to date gains to today.  Here the HYP has fallen by 1.7% vs the FTSE100’s gain of 1.6%.

A Sobering Income Drawdown Demonstration – 8.5 Years In

While my recent posts on sequence of returns risk during drawdown and bond to equity volatility vs returns are still fresh in our minds let’s return to our retiree's who are another drawdown year on having now been in wealth drawdown for 8.5 years.

For long term consistency I want to make as few changes to the original assumptions as possible however this year one change would seem prudent.  To represent the equities portion of the portfolios I use the iShares FTSE 100 UCITS ETF (ticker: ISF) as a proxy.  This year that ETF has become an iShares Core Series ETF resulting in a TER change from 0.4% to 0.07%.  I'm going to allow that change to occur within the assumptions as it simulates a real change that an investor might see.  All other assumptions are unchanged from the original post.  Re-emphasising some of the key assumptions:

• Our retiree’s are drawing down at the stated withdrawal rate plus fund expenses only.  This means any trading commissions, wrapper fees (eg ISA, SIPP fees), buy/sell spreads and taxes have to be paid out of the earnings taken.  For example, our 2% initial withdrawal rate retiree's are actually drawing down at between 2.10% and 2.21% dependent on the asset allocation selected.
• All calculations are in real (inflation adjusted) terms meaning that a £ in 2006 is equal to a £ today.
• 6 Simple UK equity / UK bond portfolios are simulated for our retiree's.  The UK equities portion is always the FTSE 100 where as mentioned above the iShares FTSE 100 ETF (ISF) is used as the proxy.  For the bonds portion a simulation is run against UK gilts (FTSE Actuaries Government Securities UK Gilts All Stock Index) where the iShares FTSE UK All Stocks Gilt ETF (IGLT) is used as the proxy and the bond type I prefer in my own portfolio, UK index linked gilts (Barclays UK Government Inflation-Linked Bond Index), where the iShares Barclays £ Index-Linked Gilts ETF (INXG) is used as the proxy.
• The wealth accrued at retirement (the 31 December 2006) is £100,000.  To simulate a larger or smaller amount of wealth just multiple by a constant. For example if you want our retiree’s to have £600,000 just multiply all the subsequent pound values by 6.

A 4% Initial Withdrawal Rate

UK Retiree Real Portfolio Value, £100,000 Initial Value, 4% Withdrawal Rate, 30 June Value, Click to Enlarge

I've picked a 4% withdrawal rate because of the often quoted (dangerously in some cases IMHO but that’s for another day) 4% safe withdrawal rate rule.  The 50% equity : 50% gilts portfolios (the red lines on the chart) are the closest representations to the 4% rule with obvious differences being that:

• the 4% rule was for a US punter with US based investments while I'm simulating UK punters with UK based investments; and
• the 4% rule doesn't consider fees where I'm capturing the OCF's of the ETF's which makes my withdrawal rate very slightly higher.

Bond to Equity Allocation Percentages

So you’ve decided that you would like to try and gain some volatility versus return free lunch via some Bonds mixed in with your Equities or Equities mixed in with your Bonds.  The next million dollar question to answer is then how much of your wealth should be allocated to each asset class.  This is a critical question as it will likely have a big affect on your long term portfolio return.

Unfortunately, as with many investing questions, I'm yet to find a silver bullet but considerations will certainly include your tolerance to volatility and risk.  Assessing this tolerance is of course easier said than done.  For example if you’re naturally risk averse you might choose to load up with more bonds as history suggests they might dampen volatility at the expense of some return however this adds absolutely no value if you then have a low probability of  ever achieving your long term goal.  Conversely there is then no point loading up with more equities to then sell at the first significant equity downturn.  On top of this there could also be age considerations.  For example every year that passes gives you less time to rebuild wealth before retirement.

So what do others have to say about bond to equity allocation percentages?

The granddaddy of value investing, Benjamin Graham, in his excellent first published in 1949 revised multiple times book, The Intelligent Investor, says “We have already outlined in briefest form the portfolio policy of the defensive investor.  He should divide his funds between high-grade bonds and high-grade common stocks.  We have suggested as a fundamental guiding rule that the investor should never have less than 25% or more than 75% of his funds in common stocks, with a consequent inverse range of between 75% and 25% in bonds.  There is an implication here that the standard division should be an equal one, or 50-50, between the two major investment mediums.  According to tradition the sound reason for increasing the percentage in common stocks would be the appearance of the “bargain price” levels created in a protracted bear market.  Conversely, sound procedure would call for reducing the common-stock component below 50% when in the judgement of the investor the market has become dangerously high.”

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