May 5, 2018
International shares have provided incredible returns in recent years.
And Aussie investors are wondering how much they should have allocated to this area.
This question is even more common in the Financial Independence space.
Early retirement chasers are torn between the dividends on offer in Australia, and the growth prospects of International shares.
So today, we’ll be playing around with some numbers and comparing some of the available choices. That is, portfolios with different amounts invested in Aussie and International shares.
Before your eyes glaze over, don’t worry, it’s all pretty simple stuff!
Hopefully this gives us a clearer picture to look at. And the aim is, it makes for simple comparisons if you’re currently thinking about diversification, and how that might affect your investment income.
Now, obviously I’m no expert and none of this stuff is advice. I’m just laying out some numbers for you. Only you can decide what’s best for you.
That’s because everyone has their own preferences, comfort zones and risk tolerance.
But I will share what our personal approach is and why it makes sense to me.
Also, I’ll just say, there’s far too many variables to go into to keep everyone happy. It’s just a general outline of my thoughts. And this post is long enough as it is!
We’re making pretend portfolios here. So the numbers we’re working with, can change.
Really, the only accurate number we have, is the current dividend yield. The rest we are guessing (more or less). And the figures I use are my own simple estimates. In other words, don’t shoot the messenger!
Hopefully they’re in the ballpark, but feel free to use your own figures.
So, I’m going to assume Aussie shares and International shares, perform roughly the same over the long term.
Some of you may already think that’s nonsense. But these two markets have done this, on average, for over 100 years. (The article uses US shares as an international comparison, being the largest global sharemarket with the most available data.)
If 100 years isn’t good enough, what is?
And I’m not talking about returns over the next couple of years here. Obviously, anything can happen in that short amount of time. I mean long term, as in 20-30+ years.
But, the point is not to compare markets. It’s to compare portfolios, and the options you have.
And to make it simple, we’ll use plain vanilla index funds in these pretend portfolios – Vanguard Australian Shares Index Fund (VAS), and Vanguard’s International Shares Index Fund (VGS).
Of course, we could do this using Aussie LICs. But let’s just keep it ultra simple for today.
For those unsure, these are both ETFs you can buy from your online stockbroker.
Let’s assume both Oz and International shares will earn a long-term return of 8% per annum.
Breakdown for each 8% return is as follows…
In Australia, that means an average dividend yield of 4.3%. Plus growth of 3.7%.
(And the dividends from VAS are around 75% franked, which means the gross yield becomes 5.7%)
For International shares, that means the current dividend yield of VGS – 2.3%. Plus growth of 5.7%.
Still with me?
OK great. So far, so good!
Now, using the above figures, let’s look at the four simplest portfolio options you have available as an Aussie investor. And what type of income and growth we can expect from those choices…
5.7% gross dividend yield. 3.7% growth.
4.85% gross dividend yield. 4.2% growth.
4% gross dividend yield. 4.7% growth.
3.15% dividend yield. 5.2% growth.
2.3% dividend yield. 5.7% growth.
For those of you who are still awake, well done!
On first glance, it appears that Aussie shares will have the highest return, due to franking credits. But this isn’t fair to say. Because many of you are working and saving hard, you’ll likely be paying a solid amount of tax on those dividends.
Franking credits take care of the tax for those shareholders on a tax rate of 30% or less. But higher than this, and tax starts chipping into those dividends.
Clearly, you’ll need to deduct your own rate of tax from the gross yield, to see what you’d receive today – net of tax.
Of course, in retirement it’s a different story…
Most of us who are living less spendy lives, will naturally be on the lower tax brackets. Unless of course, we choose to dial-up the income from new ventures we head into, after reaching Financial Independence.
Another thing I notice is, the more we have in Aussie shares, the more dividend income (and less growth) our portfolio produces.
Everyone has a different opinion on diversification and what feels right for them, so I’ll provide no recommendation here.
Personally, if I was starting my journey today, I’d still want the bulk of my savings to be in Aussie shares.
Why? Because it fits best with what I’m looking for as an early retirement income stream.
Ideally, here’s what we want:
If we were going to use solely International shares, we’d need around $2 million to generate the dividends we need to live on. And that would’ve meant an extra 5-10 years at work. No thanks!
Let’s pretend I was beginning my FI journey today. What would I do?
Well, given my desire for freedom and slightly obsessive personality, I’d want to reach early retirement as soon as possible!
So, to do that I’d need to generate the highest (yet still growing) income stream, as fast as I could. As long as it can keep up with inflation, the growth rate doesn’t matter too much.
Remember, reaching FI is all about your savings rate – investment returns are less important. Because of our freakishly short time-frame, compounding doesn’t have time to make a huge difference. This means, focusing on capital growth makes less sense to me.
And these points would lead me to Aussie shares.
But what about the tax?
Honestly, I wouldn’t mind paying extra tax in the short term. Because after a decade of hardcore saving, those Aussie shares would be pumping out a juicy income stream, where the cashflow is either sheltered from tax, or it’s boosted higher by franking credits.
In other words, if you want to reach early retirement as fast as possible, yield matters. It’s not everything. But it does matter.
As readers will know, I don’t invest in International shares for our own portfolio.
But later, this may change. And the reason for that is, International shares adds diversification while reducing reliance on the Australian economy.
As we continue transitioning from property to shares – after we’ve built up our dividend income to cover our expenses, we’ll look at investing in International shares.
This will compliment our portfolio and reduce risk. I don’t deem it totally necessary, but nice to have.
Basically, we’re making the assumption that Australia’s economy does just fine over the next few decades. And the big basket of companies that is the Aussie sharemarket, are able to grow their dividends over time, as they have done for as long as we have record of.
Depending on what you think, you may consider this somewhere between extremely likely, and extremely unlikely. Obviously, I’m banking on it being the first one.
It’s pretty simple really…
Let’s say your living expenses are $40k per year.
Now, if you had $2m in savings – you could invest $1m into Aussie shares, and $1m into International shares. According to our numbers above, your portfolio would have a gross yield of 4% – meaning $80k of annual dividend income.
But, let’s say you’re working with a smaller number, say $1m of savings.
With the same 50/50 allocation, this would generate around $40k in dividends.
Probably too close for comfort.
But investing only in Aussie shares, would generate around $57k of gross dividends.
Now of course, there’s risks here. There’s less diversification. For some people, that’s a deal-breaker. Others, not so much. Also, there’s a chance that the franking credit system is changed.
While there is the odd chance that changes are made, the message of this article remains. Axing refunds would simply mean a reduced income after reaching early retirement. But the income from Aussie shares would still be much higher than most other assets.
Well, everyone needs to decide for themselves how much to allocate to International shares. And whether they feel better for having the extra diversification (or not).
Also, we need to consider how it affects the overall dividends from our portfolio and how much we might need to save.
Obviously, if you win lotto, that $10 million is going to earn plenty of income for you almost anywhere. Even in a stodgy old savings account, it’d pay over $200k per year in interest.
But for the rest of us, we need our savings to be a lot more effective at generating income.
Here’s one way to benefit from the growth of International shares without sacrificing dividends for early retirement: simply switch the allocation in your Super fund. You could even change it to 100% International shares!
That way, you can still benefit from the worlds largest and most profitable companies, which will be growing your Super nest egg for later on.
At the end of the day, I’m all about creating your freedom as soon as possible.
After all, this is an early retirement blog! Not a steady-as-she-goes-take-your-time-retire-in-30-years-blog!
To me, this means it makes sense having a very large portion of our funds invested in Aussie shares, due to the far higher dividend income we can achieve.
Some people will consider that reckless. Personally, I think it’s worth taking the (supposed) extra risk to get your life back sooner.
My thinking is, we should strive to build investment cashflow quickly, which allows us to venture off from the typical soul-draining workweek to find new adventures.
Once you reach early retirement, you’ll have a surprising amount of energy. And you’ll end up earning money because you find things, or think of things, you want to work on.
So the point being, your investment portfolio doesn’t need to be a giant fortress, with assets in every corner of the world.
Also, the ability to realise how good we already have it, be flexible, and adapt to a changing environment (which the world is), is absolutely priceless.
If you can become that kind of person, your freedom will be earned many, many years sooner!