Our investment strategy – for the next 3 years

I’ve spent a good amount of time thinking about our investment strategy for the short term.

When I put together our first progress report back in February, I made the observation that our asset base is very property heavy, and that we are facing serious cashflow problems. This is a problem of our own doing; not being quick enough to recognise the issue, and not being agile enough to adapt when we realised that our original strategy wasn’t working.

Our immediate priorities for the next 2-3 years are to:

Pay off the debt on our home, as much as possible

Create an additional source of income to help ease our cashflow issues

Reduce our expenses

So let’s look at how we will turn our ship around.

Given that we’re over exposed to property, it makes zero sense to make any additional investment beyond annual property maintenance, as the properties are currently negatively geared and not returning any additional income after expenses. The only exception would be to make extra payments into our PPOR loan to pay the non-deductible debt off sooner.

We’ve also got a large amount of cash saved up for a rainy day, so it wouldn’t be a good idea to pour more money into cash which would be sitting there and not utilised to its full potential.

That leaves equities – shares, exchanged traded funds (ETFs), and potentially Listed Investment Companies (LICs). I really like this asset class. The cost to enter is low, much lower than property. There are no maintenance issues. No tenants to manage. However – I’m no stock picker, so I’m shortlisting ETFs and LICs as potential investments.

Why ETFs?

Many other people have written about the benefits of investing in an ETF, so I won’t reinvent the wheel. However I will say the main benefit for me is instant diversification. ETFs are typically designed to track an index that represents an asset class (for example, Vanguard’s VTS tracks the US stock market), so holding a single ETF can provide instant exposure to a diversified portfolio over an entire asset class.

The other benefit for me is cost. ETFs are typically passively managed, which means that its cost savings is passed through via low Management Expense Ratios (MERs).

Why LICs?

A Listed Investment Company (LIC) is an ASX-listed company established to invest in a portfolio of securities, managed by a fund manager. They are actively managed, however I’m interested in some of the older LICs primarily for their focus on returning consistent dividend incomes. Historically most LICs have returned a yield of 4% (fully franked dividends), which appeals to investors seeking a consistent income stream.

Our investment strategy

A. Debt recycle

Due to some poor tax and financial advice given by a banker at the start of our investing journey, one of our investment loans has been contaminated with non-deductible purpose. Even though the loan was taken out for income producing purposes, we had inadvertently mixed borrowed funds and personal funds in the same account. This resulted in a large sum of money that is no longer tax deductible.

To mitigate the issue, we split the loan to segregate the deductible and non-deductible components, and fully offset the non-deductible portion.

What we now plan to do is to fully repay this loan with the funds in the offset, and then immediately redraw the available funds. This will essentially ‘reset’ the loan. As long as the redrawn funds are used to purchase income producing assets, we can claim the interest paid as a tax deduction against our income.

We’ll be using the debt-recycled funds to invest in income-producing shares which will eventually help pay off our home loan.

Side note – we will also look at splitting our PPOR loan into manageable chunks to debt recycle – but first, we’ll need to build up sufficient cash to repay the loan in parts.

B. Buy more shares

Since the immediate goal is to generate a second stream of income to ease our cashflow problems, I’m planning to invest 70% of our spare cash into Australian ETFs and LICs focusing on dividend returns.

However Australia makes up a small percentage of the world’s economy (approximately 1.6% of world market capitalisation in 2018). There is significant benefit in diversifying across different geographical regions and markets and reducing concentration risk. I don’t want to miss out on international growth, so the remaining 30% will go into low cost ETFs tracking global indices. A very small percentage of that will be invested into emerging market ETFs.

Why the 70-30 split? Australian shares tend to pay higher dividends than international stocks. Given that one of our immediate priorities is to ease our cashflow, we want to load up on shares that give us more income.

We also want to pay off our home loan as quickly as possible, and the best way to do this is – you guessed it – more income, from high yielding shares. Later on when our cashflow is in a better state we’ll start going more heavily into international shares.

How would we go about purchasing these shares? Pretty simple really. When we’ve got our debt recycling set-up sorted out, we’ll be making one lump sum investment into the market – all in, just like that. There has been some evidence that lump sum investing can overperform dollar cost averaging. Plus I’m not too worried about timing the market – it’s all about time in the market.

We’ll also purchase smaller parcels when we’ve got enough excess cash saved up throughout the year. I’m planning to use a modified arbitrage strategy – if my shortlisted LICs are trading at a discount, I’ll buy them. Otherwise, I’ll buy an Australian or global ETF, depending on which asset mix requires rebalancing.

C. Grow the side business

FireDad has a hobby (digital art and photography) which he has monetised, with a small degree of success. A large aspect of the business requires active effort (in short, he’s commissioned to produce artwork), but has the prospect of earning passive income via merchandise sales. Our challenge is to grow the merchandise part of the business so that we benefit from another stream of passive income.

In all honesty, this side income isn’t likely to be large, and definitely not enough to live on. But what it can do is fund FireDad’s rather expensive hobby. Then the money currently allocated for his hobbies from the household budget can be redirected towards something else (more investments, perhaps?). It will also give us both an opportunity to learn new skills relating to running a business, which could come in handy later on.

D. Explore other investment options

I like to keep an open mind to see what else is out there. We’ve invested in investment bonds as a tax effective investment vehicle – primarily for FireKid’s school fees and house deposit, should he need them in the future. Investment bonds have worked out really well for us in the tax department, but we can’t withdraw the funds for 10 years, lest we be penalised tax-wise.

Now we’ll look at other investment options that can help meet our immediate goals. P2P lending is something that piqued my interest, particularly RateSetter (and Harmoney, when they get their retail investor license).

What about property?

I don’t plan to sell off the investment properties just yet, for three reasons. One, both the Sydney and Melbourne property markets are declining, so selling will take longer, and we wouldn’t make much off the sale. Two, I still think that the properties fundamentals are still sound, and all things considered, are still worthwhile investments to retain for the short term. Three, selling off the properties was, and still is part of our exit strategy when we are finally ready to FIRE. At the moment selling off a large asset would result in a huge capital gains tax bill for either Mr FireDad and me – which is not what we want! This third reason is fluid though – if there is a clear opportunity and corresponding benefits to liquidate then we will definitely do so.

In a few years time when the property markets have recovered and when our equities portfolio have grown, I will reassess our strategy to work out if it has been effective for us. Chances are in three years time we’ll be in a different place financially, with different objectives, which may mean that we’ll need to put a different strategy in place.

Disclaimer: What I’ve outlined in this post is NOT financial advice and should not be construed as such. It is simply what I plan to do with my money based on my personal situation, risk profile and my own research. Please seek professional financial advice before committing to any financial decisions.