When it comes to contructing your portfolio, you can get by with really only a few key principles; Live below your means, invest in diversified, low cost, total stock market index-tracking funds (such as Exchange Traded Funds or good quality, old school low MER Listed Investment Companies), and keep a small cash buffer for emergencies. As you transition from the accumulation into the retirement phase, you will need to hold more cash or fixed interest in order to smooth out the volatility and protect yourself from having to sell your shares at a loss or make up for reduced dividend payments. That is really all there is to it - but of course, no one wants to believe that it is this simple.

But what about those other asset classes? This chapter will explain those other asset classes and provide you with the details you need to diversify your portfolio! We'll explore the following sections:

• Bonds
• Cash and fixed interest
• Commodities and precious metals
• Investment properties
• Putting it all together
• Crash proofing your portfolio
• Portfolio rebalancing
• Automate your portfolio
• Dollar-cost averaging versus lump sum investing
• Day trading; timing the market
• Summary: How Captain FI invests

Bonds

Bonds are basically the same as a term deposit from your bank. You lend your money for a set period of time, and then at the end get it back with some interest paid along the way. Except it’s other people borrowing your money; governments, businesses etc.

Ever heard of the term war bond? These were issued by the allied governments during the war to raise funds for war fighting equipment, an IOU to the citizens to be repaid back with the spoils of war. Bonds once issued can be bought or sold on a secondary market just like a stock. The thing about bonds is that when the interest rate drops, new bonds come out with a lower coupon rate (they pay less interest). Which means the original bonds, with the higher coupon or interest rate, go up in value. Bonds are also seen as a ‘safe’ alternative to shares, since they pay out a known income - great if you’re a retiree looking for regular grocery money.

These factors mean that when the market drops and spooks investors, many flood into the perceived safety of bonds; making bonds and stocks move in opposite directions. Similarly, bonds could be called an inflation hedge; as a market deflates, currency increases in ‘value’ and interest rates decrease, they go up in value. Conversely, as the interest rate increases, the older ones go down in value (because the newer ones pay more interest)

Cash and fixed interest

The current financial planning industry might suggest your portfolio be something like: your age as the percentage of cash and fixed interest(bonds) you hold. This means if you were 20 years old, you hold 80% stocks (domestic and international) and 20% fixed interest (a mix of cash and bonds). To me, this sounds excessive, and the portfolio drag is unacceptable; the fixed interest lowers your volatility day today, but also lowers your total long term return.

As a 20-year-old, conventional work has you going another 40 maybe 50 years before retirement, why on earth would you care about volatility if you had half a century ahead of you? - do you really need bonds dragging your long term return down this whole time? I think you really only need to consider fixed interest during your drawdown phase, (once you’ve FIREd) and some starting suggestions could be:

• Your age divided by 5,
• 5-10% of your portfolio worth; but
• A year or two of living expenses is probably a better metric. It all depends on your cost of living or ‘burn rate!’.

There are some studies that show the benefits to holding a small amount of fixed interest in your portfolio, but since I am disciplined, like to keep things simple, and am in the accumulation phase I just keep a small cash cushion of up to $2000 to cover unexpected emergencies. Once I transition to the drawdown phase, I expect to keep a year worth of living expenses as cash (about $20K). If you have businesses or other streams of steady passive income like royalties, intellectual property rights or websites then your cash buffer probably doesn’t need to be as big.

Commodities and precious metals

So what about commodities or precious metals? Well let’s not start the conspiracy theorist debate about fiat currencies going to zero and Gold being the only safe asset… YES, Gold is money. Gold is a store of wealth. Fiat currency is currency, not money. Gold slowly grows in ‘currency value’ over time because it is a hedge against inflation; as the fiat currency slowly inflates as per Reserve Bank controls, you need more of it to buy the same amount of gold. But the gold itself doesn’t really do anything.

Warren Buffet (regarded as the most successful investor in the world) once said he could buy the biggest block of gold around and he could just stand around and marvel at it all day - but it still wouldn’t do anything for him; which is why he is focused on buying productive assets like stocks. Gold is a defensive play, a non-productive asset that is really just a hedge against inflation, a bet against the economy and a tool of fear; in the long term it underperforms productive assets. But in the short term, it could move in the opposite direction to stocks as people fear an impending crash.

Investment Properties

Personally I also invest in property; seeking cash-on-cash yield and the power of leverage to accelerate my journey to financial independence with minimum deposits and interest-only loans (I treat this like a business and divorce all emotion from the dealings).

Property is great for the accumulation phase, but in the drawdown phase having equity locked up in a property can be troublesome; just like appreciated values (capital growth) of shares, you have to sell it to realize and live off the gain.

Property is not as frangible or liquid as shares and this is why most FIRE people end up switching from property in the accumulation phase into ETFs in the drawdown phase. But if you have solid fundamentals, a low interest rate interest-only loan, and a high yield property with low capital growth (such as a block of units in a regional area), then this could be an ideal FIRE asset for the drawdown phase.

See Chapter 19 for more about property.

Putting it all together

OK so now we have a bit more of an understanding of a few of the different asset classes, but there are far more out there. How do we put them together to make a portfolio? And then what about further subdivisions within an asset class? Well this is the crux of the problem.

No one really knows, and those who tell you they do and can quantify risks in the future are liars. You can get somewhat of an idea by quantitative analysis of old data, but past performance is no indicator of future performance. What is risk anyway?

Risk is conveniently described as the probability that something bad will happen. So can we assign a probability that the stock market will fall or crash? Unfortunately, no one can predict the performance of the market; whilst efficient, it is certainly not rational.

The old data shows that in the long term, investing in stocks is the highest yielding asset. We can also look at company fundamentals or so-called ‘technical stock analysis’; would you buy a company because they are the ‘next hot stock’ and are tipped to grow massive, or would you buy a company with low debt, great sales performance, a powerful business ‘moat’ (such as trademark or copyright on a novel process) and a track record of increasing dividends? I know what I’d be investing in.

We know the risks associated with trying to pick stocks, and the benefits (financial and psychological) of omitting this process altogether and adopting an index-based investing approach.

But even an index investing approach will still fluctuate and subject investors to some gut-wrenching volatility as the stock market moves and are continually priced every few seconds! At its extreme, volatility can also mean ‘crash’ with a short bear market causing prices to fall by 20% or more within a week or so. Any less than that is usually called a ‘correction’. The good news is that these bear markets are usually short-lived and tend to recover within a few years; which is why a sensible cash buffer, a low cost of living and a diversified stream of passive income will allow your portfolio to be ‘crash-proofed’!

Crash proofing your portfolio

While you can't predict a crash, you can’t really 'crash-proof' your portfolio - the capital value of your shares will go down! The trick here is just not to sell them when they have gone down; don't worry about the price - capital values are irrelevant if you don't plan to sell anyway and are looking to dividends for income.

Consider dividend yield; during the 2008 Global Financial Crisis, share prices dropped around 50%, but their dividends were only cut by around 20% - hence why investors in Aussie Dividend shares like Peter Thornhill were not really that worried - the old school 'Grand-daddy' Listed Investment Companies he had invested in continued to churn out pretty solid fully franked dividends. Further, a solid cash buffer accounts for the reduced dividend during such a market recession, and you can draw this down until such time as the dividends or market recovers.

There is no magic solution, there is no reward without risk. If you want to think you have a magic solution, go pay a financial advisor heaps of money to get a false sense of security. They will tell you to invest in non-correlated asset classes like the ‘all weather portfolio’… In reality, in my limited experience and opinion, the best you can do is invest in all equities and keep a sensible cash buffer to even out the volatility; maybe a year or two of expenses. The more important thing in this equation is to be frugal and keep your expenses low.

Keeping this cash buffer is the key to not having to sell during a market downturn when you’re in the drawdown phase. As you transition from the accumulation phase (where you only need a very small cash buffer due to your regular high income) into the drawdown phase, you might consider a smallholding of bonds or fixed interest to complement your emergency cash buffer.

Portfolio rebalancing

Rather than portfolio tinkering, something can be said for the benefits of portfolio rebalancing at set time intervals. This means at regular intervals (once or twice per year) to sell your highest performing assets and reinvest into your lower-performing assets to get your portfolio ratios back up to your pre-defined splits.

This really only works properly if it’s automated and time-based, you have a good idea about what your splits should be, and you don’t let your personal bias get in the way. Because in effect yes you would have bought low and sold high and achieved the market timing everyone is desperate to benefit from.

But remember - Trying to time the market and jump between assets is akin to madly switching lanes in peak hour; it doesn’t really get you anywhere and the risk is immense! Brokerage and tax implications can also be factors here, but the bigger benefit is automation and having zero emotion involved.

Automate your portfolio

Awesome ways to automate your portfolio are to simply set an automatic payment from your bank account into your brokerage account. When your brokerage account exceeds your minimum buy size, make your purchase. I personally do this and am trying to buy $3000 worth of index fund ETFs or LICs each fortnight.

There are a number of other ways to automate your investing, like using robo-advisors or Bpaying directly into funds such as Vanguard’s retail/wholesale funds, but these approaches all cost you more management fees. If you are not disciplined or have only small amounts to invest then these could well be cost-effective ways for you to invest; but when you’re serious about investing then going through an Accredited stock exchange sponsored broker is the only way to go (in Australia this means being CHESS sponsored).

Dollar-cost averaging versus lump sum investing

Studies show lump sum investing is best; invest money as soon as you get it! This is because the market rises for longer than it falls; steady bull markets may continue to slowly rise for 10 years while a rapid sharp bear market may only last 1-6 months. Governments control inflation using reserve banks to ensure a target positive rate of around 1-2%; this promotes a bull market with rising equity values.

Continually investing income as soon as you get it is actually BOTH lump sum investing and dollar-cost averaging! Despite being statistically the better option, Lump sum investing can be psychologically very stressful; if you are not able to stomach investing $50K in one hit, perhaps try doing 5x$10K trades each month. Investing isn’t just about the numbers and ultimately you have to be able to sleep at night.

Morningstar Analysts have written about this in detail with examination of past 'simulated' portfolios, and two articles for further reading are Going all-in versus drip feeding your portfolio [Bourlioufas, 2018] and The dollar-cost averaging myth: why lump sum investing usually wins [Lauricella, 2019]

Day trading; timing the market

Some people advocate for jumping in and out of the market or between asset classes to profit from these assets moving in different directions? Buy low sell high right! Haha slow down bucko, the human brain just doesn’t work that way. Studies show actually, the majority of investors buy high and sell low! So when stocks are soaring you get FOMO and buy some, whereas when they crash you worry about them going to zero and you sell; this is because the human brain is more conditioned to avoid loss than it is to embrace gain!

The best investors are actually those who have forgotten they had money invested, or who are dead! Why is that? Because they don’t tinker with their portfolios. Timing the market just doesn’t work. This again goes back to the adage that markets will recover quite efficiently from crashes, so just give the thing time!

Globally, in the short term (under 5 years), the majority of active day traders and fund managers underperform the index. As you draw the time-frame out to medium term (15 years), the number of active traders underperforming the index approaches 85% [Perry, 2018], and in the long term (30+ years) this number approaches 99%.

To explore this more, read up on JL Collins blog and book 'The Simple Path to Wealth' as well as Pete Adeney's 'Mr Money Mustache' where they explain it quite well. Further reading and specific articles on the quantitative analysis behind actively managed vs index funds can be found online at the American Enterprise Institute, CNBC markets and the Australian Financial Review.

Summary: How Captain FI invests

Personally, I invest through the ASX in a split of three ETFs to gain exposure to the Australian, US and world economies: A200, VTS and VEU (listed and cross-listed on the Australian stock exchange).

I also consider investing in old school LICs such as AFI, MLT, ARG and BKI: but only if they are trading at a discount to their net asset value - which means I am picking up a bargain. When I do my yearly portfolio rebalancing I’ll check if these are now trading at a premium; if so I usually sell them and instantly buy ETFs.

I also invest in property, through cash-flow-positive rentals. These provide a small cash in hand yield and capital growth which provides me with a growing equity. As I transition to the retirement phase, I will seek to either refinance to extract equity (to invest in ETFs) or sell the property; either way I plan to never pay down the principal value of the loan.

During my accumulation phase, I hold a personal emergency fund of between $1000-2000, and a $10,000 offset on the IP1 to deal with property emergencies. Once I reach Financial Independence and no longer actively fly full time for a job, I plan to hold a minimum cash amount of one year’s cost of living (~$20,000) as well as a $10,000 offset on each Investment Property, up to a maximum of two years cost of living (plus $10K per IP).

The real trick to my financial security is my ability to live cheaply. As I continually reinvest my surplus dividends after I reach Financial Independence, I can afford to allow my cost of living to slightly rise without taking on the undue risk of portfolio failure. For a detailed analysis on my three-stage retirement plan, check out my blog for my monthly updates!

About Captain FI | captainfi.com

I’m Captain FI, and I’m flying my way to Financial Independence! I grew up below the poverty line in a single parent family, and vowed to make a change to master my finances. I left home at 17 on a scholarship to become an Engineer, but I always wanted to fly. After graduating and working multiple jobs to afford flight school, I eventually managed to become a professional pilot with an Airline Transport Pilots Licence and instructor qualifications. I’m on track to become Financially Independent by 30. Follow my journey at www.CaptainFI.com.

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