Why Not Just Invest in Stock Index Funds?

Financial Independence recently asked in the comments why I don't just invest in a portfolio of stock index funds. I answered that I am more interested in protecting against the downside now than getting richer. But basically I think you can do better than that. This is the simulated performance of our target portfolio against the MSCI All Country World Index and ASX200 in Australian Dollar terms:

Notice what happened during the 2000-2002 Tech Wreck and 2007-2009 Global Financial Crisis? The target portfolio more or less flatlined, while Australian shares dropped 40% in 2007-9 and the MSCI fell around 20% in AUD terms. Over this whole period the portfolio also outperformed the MSCI index, though not in recent years.

Contributions of Individual Investments 2019

Here are the contributions of each of 86 individual investments or trading vehicles in the 2019 calendar year (Australian Dollars):

Of course, these deoend on how much we have invested in each one and the superannuation funds that head the list are our biggest investments.

Annual Report 2019

Investment Returns

In Australian Dollar terms we gained 12.61% for the year and in USD terms we gained 12.16%. This is a lot less than stock markets gained, but I now prefer to compare our performance to the average hedge fund, which gained 10.35% in USD terms. The MSCI gained 27.3%  in USD terms and the ASX 200, 25.6% in AUD terms. These are the US Dollar returns month by month compared to the MSCI and HFRI indices:

We followed HFRI very tightly until September, when, apparently because of an increase in the volatility of the Australian Dollar, our performance became more volatile than the hedge fund index.
I posted equivalent Australian Dollar returns in the December monthly report. The next chart shows long term returns in Australian Dollar terms compared to the MSCI, ASX200, and the target portfolio:

In recent years, we've followed the target portfolio quite closely. Here are annualized returns over various standard periods:

US Dollar returns are not very good over longer periods, but they still beat the HFRI, especially over the 3-5 year horizon.

Investment Allocation
The main change in allocation over the year was that we converted cash into bonds and gold and then began to run down the bond allocation mostly in favor of hedge funds:

Also, at the beginning of the year, I was still a part owner of my mother's apartment, which was then sold.

Accounts
Here are our annual accounts in Australian Dollars:

There are lots of quirks in the way I compute the accounts, which have gradually evolved over time. There is an explanation at the end of this post.

We earned $152k after tax in salary, business related refunds, medical payment refunds, tax refunds etc. We earned (pre-tax including unrealized capital gains) $251k on non-retirement account investments. The latter number was up strongly from last year. The former number continued its decline. The investment numbers benefited from the fall in the Australian Dollar ($40k in "forex" gain). Total current income was $403k. Not including mortgage interest we spent $133k. Total actual spending including mortgage interest was $147k, which was up 12.3% on last year.

$9k of the current pre-tax investment income was tax credits – we don't actually get that money so we need to deduct it to get to the change in net worth. We transferred $135k into retirement accounts from existing savings in "non-concessional (after tax) contributions. Near the end of the year we paid off the mortgage. Including mortgage payments during the year, that meant a total $520k transferred to our housing account.


The change in current net worth, was therefore -$394k. Looking at just saving from non-investment income, we dissaved $636k. Both these are crazy numbers...

The retirement account is a bit simpler. We made $46k in pre-tax contributions (after the 15% contribution tax) and made an estimated $204k in pre-tax returns. $23k in "tax credits" is an adjustment needed to get from the number I calculate as a pre-tax return to the after tax number. Taxes on returns are just estimated because all we get to see are the after tax returns. I do this exercise to make retirement and non-retirement returns comparable. Net worth of retirement accounts increased by $362k.

Finally, the housing account. I estimate that our house gained $24k in value. We spent $15k on mortgage interest. We would have paid $17k in mortgage interest if we didn't have an offset account. After counting the transfer of $520k into the housing account housing equity increased $527k of which $504k was due to paying off principal on our mortgage.

Total net worth increased by $495k, $48k of which was saving from non-investment sources. These numbers are steeply down from last year. The net worth increase last year mostly came from the inheritance.

Though our saving is down sharply on last year, we still saved in total 24% of our after tax non-investment income. Of course, this is less than last year's 33% and 2017's 54%! Including investment income our savings rate was 77%. This is based on our income calculated here at a ridiculously high $643k.

How Does This Compare to My Projection for This Year?
At the beginning of the year, I projected a gain in net worth of only $60k based on an 0% return on investments and a 6% increase in spending. As you can see, spending rose 12% and return on investments was also about 12%. As a result net worth increased by $495k. So, this was a big forecasting fail, as was last year's projection.

So, it's probably a mistake to try to make a projection for 2020 :) The baseline projection in my spreadsheet is for a 12% rate of return, a 6% increase in spending, and flat other income, leading to a $425k increase in net worth. I expect that forecast will fail big time again.

Notes to the Accounts

Current account is all non-retirement accounts and housing account income and spending. Then the other two are fairly self-explanatory. But housing spending only includes mortgage interest. Property taxes etc. are included in the current account. There is not a lot of logic to this except the "transfer to housing" is measured using the transfer from our checking account to our mortgage account. Current other income is reported after tax, while investment income is reported pre-tax. Net tax on investment income then gets subtracted from current income as our annual tax refund or extra payment gets included there. Retirement investment income gets reported pre-tax too while retirement contributions are after tax. For retirement accounts, "tax credits" is the imputed tax on investment earnings which is used to compute pre-tax earnings from the actual received amounts. For non-retirement accounts, "tax credits" are actual franking credits received on Australian dividends and the tax withheld on foreign investment income. Both of these are included in the pre-tax earning but are not actually received month to month as cash.... Finally, "core expenditure" for housing is the actual mortgage interest we paid. "Expenditure" adds back how much interest we saved by keeping money in our offset account. We include that saved interest in the current account as the earnings of that pile of cash. That virtual earning needs to be spent somewhere to balance the accounts... It is also included in the "transfer to housing". Our actual mortgage payments were less than the number reported by the $2k in saved interest. For current accounts "core expenditure" takes out business expenses that will be refunded by our employers and some one-off expenditures. This year, there are none of those one-off expenditures. "Saving" is the difference between "other income" net of transfers to other columns and spending in that column, while "change in net worth" also includes the investment income.

December 2019 Report

This month I decided to stop short-term trading again. I think you can make money doing what I was doing, but trading at a size that makes a real difference generates too much anxiety for me. I didn't hear from HSBC on refinancing our mortgage. I sent them one email. Will need to chase them more in January.

The Australian stockmarket fell a bit in December and the Australian Dollar rose, but overseas markets rose. The Australian Dollar rose from USD 0.6764. to USD 0.7023. The MSCI World Index rose 3.56% and the S&P 500 3.02%. On the other hand, the ASX 200 lost 2.08%. All these are total returns including dividends. We gained 0.28% in Australian Dollar terms and 4.11% in US Dollar terms due to the rise in the Australian Dollar. The target portfolio is expected to have lost 0.82% in Australian Dollar terms and the HFRI hedge fund index is expected to have gained 1.07% in US Dollar terms. So, we out-performed all our benchmarks, which is rather unusual. Updating the monthly AUD returns chart:

MSCI is negative here in December because of the rise in the Australian Dollar. We haven't lost money on a monthly basis in Australian Dollar terms since November 2018...

Here is a report on the performance of investments by asset class (futures includes managed futures and futures trading):

Hedge funds and gold did very well, which is the opposite of last month. Trading detracted most from returns. The largest positive contribution to the rate of return came from hedge funds. The returns reported here are in currency neutral terms.

Things that worked well this month:

• Hedge funds Platinum Capital/International Fund and Tribeca did very well. Tribeca (TGF.AX) is no longer our worst ever investment in dollar terms, though it is still hugely drawn down.
• Gold did well, almost reaching this year's highs again.

What really didn't work:

• Bitcoin lost heavily and we stopped trading it.

We moved a little bit further towards our new long-run asset allocation:

This is what the target portfolio would look like:

On a regular basis, we invest AUD 2k monthly in a set of managed funds, and there are also retirement contributions. Other moves this month:

• USD15k of Ford bonds were called and we didn't buy any new bonds.
• We bought AUD 40k by selling US Dollars.
• We traded very badly...
• We bought 500 shares of a Commonwealth Bank hybrid (CBAPI).