Annual Report 2018

Investment Returns
In Australian Dollar terms we gained 2.3% for the year while the MSCI gained 0.9% and the ASX200 lost 1.1% (all pre-tax including dividends). In USD terms we lost 7.7%, while the MSCI lost 8.9% and the S&P500 lost 4.4%. So we beat Australian and international markets but not the US market. In the longer term perspective, our returns and market returns were closely aligned this year:

Australian Dollar Returns

Here are returns over various standard periods (not annualized):

We have done well compared to the ASX 200 over the last 5 years. Not as great over 10 years. In USD terms we have done well compared to the MSCI over the last three years and underperformed over longer time periods.

Investment Allocation
The main change in allocation over the year is the large increase in cash and real estate when we received the inheritance:

I also reduced my allocation to Australian large cap stocks around the same time, in early October. Earlier in the year, the allocation to cash falls as we increased trading and invested more in the Winton Global Alpha Fund (commodities) and subscribed to some IPOs. Private equity also increased with investment in Aura and IPE and then decreased with the takeover of IPE.

Accounts
I stopped reporting monthly accounts this year, but I've still been computing them. Here are our annual accounts in Australian Dollars without including the inheritance:

Annual Accounts

There are lots of quirks in the way I compute the accounts, which have gradually evolved over time. Here is an explanation:

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 $6k 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, I think 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.

We earned $170k after tax in salary, business related refunds, medical payment refunds, tax refunds etc. We earned (pre-tax including unrealised capital gains) $35k on non-retirement account investments. Both of those numbers were down strongly from last year. I stepped down from an admin role that paid extra salary and earned less in consulting etc. The investment numbers would have been worse without trading and the fall in the Australian Dollar ($31k in "forex" gain). Total current after tax income was $204k. Not including mortgage interest we spent $117k – Total actual spending including mortgage interest was $133k.

$9k of the current pre-tax investment income was tax credits – we don't actually get that money so we need to deduct it. Finally, we transferred $45k in mortgage payments (and virtual saved interest) to the housing account. The change in current net worth, was therefore $34k. Looking at just saving from non-investment income, we saved $8k. Both these numbers are down steeply from last year.

The retirement account is a bit simpler. We made $38k in contributions (after the 15% contribution tax) and the value fell by an estimated $23k in pre tax returns. $4k in "tax credits" is an adjustment needed to get from the number I calculate as a pre-tax return to the after tax number. Taxe on returns are just estimated because all we get to see is the after tax returns. I do this exercise to make retirement and non-retirement returns comparable. Net worth of retirement accounts increased by $19k.

Finally, the housing account. We spent $16k on mortgage interest. We would have paid $24k in mortgage interest if we didn't have an offset account. I estimate our house is worth $24k more than I did last year based on recent sales in our neighbourhood. After counting the transfer of $45k into the housing account housing equity increased $46k of which $23k was due to paying off principal on our mortgage.

Total net worth increased by $99k, $69k of which was saving from non-investment sources. Comparing 2018's accounts with 2017's, we saved 49% less and net worth increased by 79% less. Total after tax income was almost $230k, down 60% on last year. This number feels a lot more "reasonable" than last year.

Though our saving is down sharply on last year, we still saved in total 33% of our after tax non-investment income. Of course, this is less than last year's 50%. Including investment income our savings rate was 43%.

Here are the same accounts expressed in US Dollars:

How Does This Compare to My Projection for This Year?
At the beginning of the year, I projected a gain in net worth of $250k based on an 8% return on investments and a 6% increase in spending. As you can see, spending rose 25% and return on investments was only 2%. As a result net worth increased by only $99k.

Looking to 2019, I think we will be lucky if our investment return is 0%, as I am quite bearish about the world economy and stockmarket. If I pencil in a 6% rise in spending, then we would only increase net worth by $60k.

New Investment: U.S. Treasury Bills

Interactive Brokers currently pays 1.7% interest on U.S. Dollars. But U.S. government bonds pay more than that and are supposedly risk free, so I thought I would give it a try. I am concerned that U.S. interest rates could still rise and so I don't want longer term bonds. So, I just bought a U.S. Treasury Bill expiring on 12 February. My idea is when that matures, I'll put part of the proceeds towards buying Australian Dollars. I plan to build a ladder of these and so force myself to buy Australian Dollars slowly.

At IB the commission for buying bonds is $5 and it turns out that the minimum trade size for treasuries is $100k. This isn't stated anywhere, but when I tried buying $50k last week, I got a message that my trade size was too small, whereas this trade went through. I'm gradually moving U.S. Dollars to my IB account - I can move up to $100k every 7 business days using the ACH method.

I've thought about municipal and corporate bonds too, but these can be illiquid. For example, for the nearest term Berkshire Hathaway bond, only $1000 is currently being offered.

Investment Policy for Trust Accounts

My brother is opening the trust accounts. They will be invested in local mutual funds. Unlike Australian or US managed or mutual funds these do not make distributions but like an Australian listed investment company (closed end fund) they pay tax on their earnings. The tax though is the relevant investment rate not the corporation tax. This is 25% of the inflation adjusted gain. Also, if you sell a mutual fund in Falafelland 25% capital gains tax is withheld. Looks like we can't really avoid this tax. Foreign tax paid is not refundable as cash in Australia – it can only be deducted against Australian tax liable.* Because my son's earnings would be way below the tax free threshold (initially each of these accounts will have about AUD 44k in them) he wouldn't need to pay tax if the investment funds were based in Australia.

My brother suggested investing 70% in bonds and 30% in stocks. As a long-term investment policy – we will be investing for the next 20 years for my son – I think this is too conservative.

This is both because in the long run stocks have performed better than bonds in most countries but also because interest rates are now low. This chart shows the real returns on US investments over the last century:

Since 1980, bonds did well as interest rates fell from historic highs. But in the 40 years up to 1980 bonds lost money in real terms as interest rates rose. So, I told him if we are adopting a "set and forget" investment policy then we should go for 60% stocks and 40% bonds. The mix between local and international investments should be 50/50. The local market is one of the cheaper ones globally.
OTOH the local currency is quite strong currently. If we can revisit investment policy periodically then 70% bonds is OK for now. If there is a future larger decline in stock markets we would then switch to a more aggressive stance.

My brother's children are much older and so their trust accounts will exist for less time. If they intend to spend the money when they get it then I guess a more conservative stance might make sense. The youngest though will still need to wait 9 years to get her money so I think she can be more aggressive.

* Labor wants to make franking credits from Australian companies non-refundable as well. This would bring back symmetry in the way these credits are treated. Of course, I think we should go in the other direction and make foreign tax refundable :)

Target Portfoilo Performance December 2018

In AUD terms the target portfolio lost 1.85% in December, gaining 0.3% for 2018 as a whole. The MSCI gained 0.9% for the year and I gained 2.3%. The graph shows the returns for the each month in 2018 for the target portfolio, the MSCI World Index in AUD terms, and the target portfolio:

The target has lower volatility but is more correlated to the MSCI than I was. So the target portfolio wouldn't have provided very useful diversification in 2018.