May 23, 2020
Recent events have prompted me to think more deeply about our investments, our personal situation, and how I want to invest going forward.
Most of you will know, we’re steadily transitioning from property to shares over time. The strategy is a bit like this.
This lets us build our share portfolio in a more methodical way. Especially while I’m still learning, experiencing and thinking about all this stuff as time goes on.
We get to adjust things as we go, which makes this process more relaxed and less stressful. Compared to if we had decided to sell all our properties on day 1 of early retirement, and then need to invest all that cash immediately! Stressful much?
So, with all that said, let’s get into how I’m currently thinking about dividends, diversification, and our personal situation. Warning: this is a long one! Maybe grab a cuppa?
Unless you’ve been living under a rock, you’ll be aware of the huge disruption to almost every person and company on earth, caused by the economic shutdowns.
This means company earnings will take a big hit in the short term. And so will dividend payments. In fact, a number of companies have already ‘deferred’ dividends until a later date – which, let’s be honest, is really the same as paying zero.
And it does make sense. Companies can and should do what is necessary to stay afloat and come out the other side of this in a sound financial position. Dividends are a nice source of income for investors. But there’s no point paying out cash to shareholders if you may need it to survive!
For whatever reason, I started thinking of a bizarre parallel universe…
In this world, companies decided to pay absolutely no dividends for the foreseeable future. Mrs SMA and I also earn zero income, and have no ability to do so. It’s just us and our investments.
So I asked myself, “would I be okay trimming our shares to create income?” The answer came back, “well, yeah, I guess so.”
After all, in this universe, the companies held on to the cash – it didn’t disappear. Obviously, the share price would still be dictated by the market, but all else equal, their market value would be a bit higher than if they’d paid out the dividend.
So, with us having no personal income and no dividend income, then sure – I could sell a few shares to create some cash. This strange newfound mental flexibility had me thinking that I should probably be okay doing that during normal times too.
Until this point, readers will know I’d been strongly focused on dividends from Aussie shares, not wanting to sell shares to create income, whether by choice or necessity. But this weird daydream seemed to point out my stubbornness and lack of flexibility.
Oddly enough, I actually pride myself on being an adaptable person. For example, whatever happens during our early retirement, I have zero fear of us running out of money. We will make it work, whatever the circumstances.
So, essentially, my thoughts on our strategy going forward have changed. I’ll always have a soft spot for dividends, but I feel like more global exposure than we currently have (0-20%) is a good idea.
Basically, we’ll move towards a more diversified portfolio by adding global shares to our personal portfolio.
Currently, we have our super setup as 100% international shares, which is 15-20% of our net worth, while our personal share portfolio is 100% Aussie shares. For more info, see our latest portfolio update.
We haven’t done anything yet. But in the coming months, we’ll add an international index fund – VGS (Vanguard International Shares) – to our portfolio, and casually add to it over time.
Where will we end up with our portfolio? Well, currently, I feel as though 25-50% international shares would suit us and our situation.
Over the very long term, 50% Aussie / 50% Global seems like the simplest choice, and a reasonably conservative one. So that’s the direction we’ll head.
Irrelevant side note: I’ve long thought that if I won lotto, that’s what I’d do with the cash. But I don’t play, so there goes that idea!
In case you think this is a wild change of heart, I’ve mentioned on this blog multiple times that we’d later add international shares to our portfolio.
That date has been pulled forward due to my thoughts on the subject changing, and the outlook for our personal situation evolving. We’re enjoying our individual part-time work more than expected, and earning reasonable income.
This also means our portfolio doesn’t need to be as dividend-heavy. So, after mulling it over for a while, here’s the thinking behind all this…
This should be obvious, but by owning international shares, we’re exposed to a much larger basket of companies. And those companies are operating in other countries and economies, each with their own strengths.
More importantly, it offers a unique and complimentary spread of sectors and businesses to what we have here in Australia. We can see this from the sector breakdowns for the ASX 300 (VAS) compared to Developed Markets outside Australia (VGS).
As you can see, we have more resources, real estate, and financials. And other developed markets have more technology, communication and consumer stocks. Complimentary, no?
Mash ’em together, and then dividends and profits are coming from a bigger, more diverse base. Just out of interest, here’s what they look like combined….
Health Care: 14.0%
Info. Tech: 11.6%
Cons. Discretionary: 8.8%
Cons. Staples: 7.8%
Real Estate: 5.0%
Recent events have highlighted risks (in all areas of life) that seemed almost unimaginable six months ago.
As mentioned, the pandemic has caused many companies to severely reduce or halt dividends entirely while this thing plays out. Not ideal for investors who are reliant on their dividend income, especially some older Aussies who have large holdings in bank shares!
Some commercial tenants are refusing to pay rent, or demanding serious rent reductions. This affects the ability of REITs to pay their distributions. These two sectors provide a decent portion of the income paid out by ASX companies. Other sectors are obviously being affected too.
Owning global shares alongside would reduce the drop in dividends across a portfolio, given the different sectors.
The old fashioned LICs will attempt to smooth out the fall in dividends for shareholders, by using small amounts of cash and excess franking credits. But the underlying dividend cuts still hurt their ability to do this for very long.
Some folks increase diversification by adding small/mid size companies to an Aussie portfolio, given our market is dominated by large companies. I’ve done this myself.
But adding international shares tends to achieve much greater diversification, for very little cost. That’s when it comes back to our desire or bias towards receiving higher dividends or not. More on this in a minute.
Now, I’m not sure if this is a rational reason, but who cares. There are a number of companies which impress me and that I’d like to own more of.
The obvious examples are US tech giants like Google, Amazon and the like. Of course, I’m impressed at their size, which at $1 trillion each seems ridiculous in itself!
But what amazes me most, is how incredibly invasive they’ve been in our lives. To the point where most of us couldn’t think about life without their Apple iPhone, or having the ability to ‘google’ something.
That’s what’s fascinating – our sheer reliance on them. We notice their tentacles surrounding us, but we embrace it and pull them closer.
So yes, I’d like to own a bigger slice of companies like that. And it’s worth saying that some great companies pay no dividends.
I like the ease and simplicity of dividends as much as the next guy, but I don’t believe it makes much sense to exclude a giant like Amazon from a portfolio, just because it doesn’t send a sliver of cash to shareholders each year.
You could argue it was a speculate investment in its early days. But that argument is now out the window as it becomes a modern day version of Standard Oil.
No company lasts forever though. So at some point, today’s giants will be overtaken by other enterprises. In this case, I’ll end up owning those too.
There’s a great article here – The Rise and the Fall – explaining the inevitable rise and fall of businesses over time. It’s exciting and sad at the same time.
By adding global shares to our portfolio, there’s also less chance of a poor long term outcome. I’m not talking about a few years of volatility. Here, I’m talking about decades of economic and corporate performance.
There’s always a chance Australia doesn’t do as well as the rest of the world. Mind you, it could also do better. But by diversifying, this averages out, helping to insure against a poor long term outcome.
A combo of global and Aussie shares seems high risk in theory, due to the volatility of markets. But if we look forward 50 years, the chance of this mix delivering poor returns, seems very low.
Indeed, if that does happen, we’ll probably have bigger problems on our hands!
Any changes to tax policy and franking credits would likely have an affect on what companies do with their excess cash. This risk to dividends has had plenty of air time in the last two years.
Tax benefits were not my main motivation for investing in Aussie shares. But changing the current system would make Aussie shares less desirable to some extent.
It does seem fair that there is a limit placed on franking refunds at some point. While it’s not a big deal to remove a tax incentive, it could have some unintended consequences.
If dividends are no longer tax effective, companies may decide to dramatically lower dividend payments and use cash for other purposes. Whether for research and development, growth plans, or share buybacks (which are like dividends).
Some of these efforts will bear fruit, others will not. You’d hope companies would use the cash wisely if this did occur. But it could create a problem for income focused investors.
If the franking system is scrapped altogether for some reason, the high yields of Australian shares could become a thing of the past.
We could move to a US style system, where companies pay out around 40-50% of earnings, versus 70-80% here. The remaining cash tends to get used for buybacks (which boost earnings per-share, and as a result, share prices) and other things.
The point is, we could end up with a dividend yield of 2-3% like some overseas markets. That would mean much more savings are needed to retire on dividend income alone.
Or… one has to be open to selling a few shares to create more income. While less convenient, the above system isn’t the end of the world. Some of the returns would simply move across from the income column, to the growth column.
Here’s roughly how it works: Instead of paying a 4% dividend, a company could pay 2% in dividends and buy back 2% of its shares. This shrinks the amount of shares in the company, which increases the stake of remaining shareholders by 2%.
As mentioned, each person now owns 2% more than before, and earnings per-share increases. Of course, if you wanted a 4% dividend, you could then sell 2% of your holding, and you’re back to square one.
Anyway, some people think franking credit changes in Australia are inevitable at some point. It’s certainly a risk to be aware of. Which brings us to the next point…
Readers will have heard me say that being an adaptable and flexible person is important, because no early retirement plan is bulletproof. Well, this is me eating my own cooking!
I don’t want to be so religious in my approach that I ignore changes or other ways of doing things. So, rather than be reliant on dividends alone, I’ve decided to be more flexible and be willing to trim our holdings to create income if needed.
It’s true, I would prefer to ignore the market and just receive cash dividends, but it makes sense to leave that door open. Having said that, I’m confident my love of receiving income from investments will not go away.
When we have an economic downturn, market crash, or, say, a global pandemic, the Australian dollar tends to fall. When that happens, global shares are worth more in Aussie dollars.
Not only that, but global dividends are also worth more when converted back into Aussie dollars.
In practice, if we’re experiencing a global recession, a lower dollar means global shares and dividends would hold up better as a result. That’s a nice bonus for a portfolio if it occurs, and perhaps a bit of comfort when the shit hits the fan.
Holding both local and developed markets gives you more chances to buy what’s on sale. These markets will both take turns at struggling, and out-performing. Plus, the currency movements mentioned above mean they will often move differently to each other.
When one is up heaps, the other might be up a little. When one is down a lot, the other may only be down a little.
In practice, that’s an opportunity to buy what is cheaper, what has under-performed recently. Doing this over time is another form of dollar-cost averaging and a form of value investing with zero effort.
Obviously, the reverse is also true. If you’re living off your portfolio, you could trim the one which has performed better recently, while also topping-up whatever is lagging.
Adding a global index to our portfolio arguably makes the portfolio stronger and lower risk. In the sense that it’s able to withstand more things going wrong than a one-country portfolio. The increased likelihood of a solid long term outcome is what I care about most.
Granted, this combo will still be volatile and get hammered when markets head south. But the long term result should be better than many other options. And it’s one I feel confident about.
Investing this way should lead to a stronger financial position than we’d otherwise have. And building financial strength is kind of my message around here, so maybe I should take it more seriously! 😉
As we’re now 3 years into ‘retirement’ we are able to get a good handle on what we want life to be like going forward.
In my experience, for the first year or two, you’re still getting used to your new life and creating a lifestyle that is enjoyable and satisfying.
Anyway, the realisation is that we’re both likely to earn some sort of income for the foreseeable future. Mrs SMA plans to keep working part-time, and I’m happy doing my own thing with this blog which also produces some income.
So while it’s nice, we don’t really need the higher income from Aussie shares as we anticipated before. Because of this, even with a lower yielding portfolio, we may not even have to sell shares at all.
Plus, as our allocation to shares increases, it feels safer to have a larger spread of companies, with less of our savings invested in each business.
For example, CSL is a great company. But do I really want to end up with close to 10% of our net worth in one company? Not really.
I still think of myself mostly a ‘dividend investor’. Just with some added flexibility.
To me, companies and the sharemarket are a handy source of cashflow. And I’d prefer most of that came from dividends.
It’s a simpler and more hands-off way of generating income to live on. But if it comes to it, I will trim our shares for income if needed.
By the way, I created an easy-to-use spreadsheet to keep track of our portfolio. It gives me a running estimate of our annual income from investments after every purchase. Download it free here.
The lower income from global shares is made up for with higher earnings growth, partly due to share buybacks.
But even then, a 50% Aussie/50% Global portfolio would still deliver close to 3.5% per year in distributions, plus franking credits. Not bad.
Also, I still think the future for Australia is bright, as highlighted well by Pete Wargent in our interview here. But we can never be 100% certain, so I’m hedging my bets.
Some may assume I’m panicked by recent events. But I don’t think that’s it. Large market falls and dividend cuts are something I’ve written about several times on this blog, and are certain to occur over any long period.
This isn’t about that. It has really come from an ongoing process of re-thinking diversification, what makes sense for our situation, and then somehow finding a loophole in my own flexibility (or stubbornness!).
By the way, nobody should be reading this and assume they should change the way they’re investing. We have to do what feels right for us, individually. We each have different circumstances, are wired differently, and have other factors to weigh up.
The FIRE crowd knows this all too well, but I’ll say it anyway. Whatever it is, we should do something because it makes sense to us after thinking about it carefully, not because other people are doing it.
Irrelevant side note #2: I’ve noticed that even long term investors tend to continually re-evaluate their portfolio, or even their strategy, as time goes on. It seems to be the natural order of things.
The one sentence summary? I’m tweaking our strategy and adding global shares sooner than planned, since my thinking and our circumstances have both changed a bit.
So there you go. A combination of regular daydreaming, newfound mental flexibility and other realisations are to blame for this long-winded post!
But hopefully you found it interesting! And, selfishly, writing helps clarify my thoughts.
We’ll soon begin a slow and steady path towards more diversification. This should result in a stronger long term portfolio, with more certainty of a solid outcome.
We can then enjoy owning a larger spread of businesses, from more diverse industries and multiple economies, and of course, the still-healthy dividends that flow from that…
p.s. Pat and I are overjoyed at the positive response we’ve received for the podcast so far. Because of your support, we somehow managed to hit #1 in the Apple Podcast charts for both ‘Investing’ and ‘Business’ categories.
Big thanks to everyone for listening! How cool is it that a dedicated FIRE podcast gets top spot?!