Two slightly late updates

I have made two investments over the last month which I managed not to post:

1. I made a small FX investment in the NZD, believing that it was undervalued (both in general and, in particular, relative to the AUD). Specifically, I was expecting the Reserve Bank to implement an interest rate rise which had been delayed because of the Christchurch earthquake. I was proved wrong, and have realised a loss of 1.4% on my investment as of last week when the contract closed. As I received NZD when the contract closed, I now need to decide what to do with that money;

2. I purchased shares in Automotive Holdings (AHE), listed on the ASX. This is a company which should benefit from a robust Australian economy and should not be adversely affected by the strong AUD. The company has reasonable growth plans in place for both its main car retailing business and its smaller logistics business. While I initially had concerns about the debt levels, a material part of the debt is the floor plan (i.e. inventory financing). The company sells on a FY2011 expected PE of less than 10x and expected dividend yield of more than 7%. I paid AUD2.35 per share.

Stress testing for inflation (2)

Inflation is an issue which I need to be highly confident that I will be able to manage once I leave the working world. Previous posts explained why I worry about inflation and just how vulnerable the private portfolio is to the impact of inflation.

So, how do I get comfortable with the inflation issue?

1. know my expenses: I've been running detailed monthly expense accounts since December 2009. A year into this exercise, I have a pretty good idea where my money is going;

2. budget for post retirement changes: I'll travel a bit more, go out more and increase expenses in a few other areas. I'll also cut back in a few places;

3. create sinking funds: I'm putting aside an allowance for some of the larger one off items, of which the largest is refurbishing our apartment;

4. over engineer the budget: I arbitrarily added 20% to our expenses. I made no allowance for the fact that at some stage in the distant future our young children will become financially independent (I hope);

5. have a few emergency sources of funds which are not in the financial plan: a small whole of life policy which matures when I am 55, some Bordeaux which is way too expensive to drink and debt free home (our mortgage will be paid off shortly after I retire);

6. work longer: if I retire now the portfolio passes Firecalc with inflation at 3.7% or less. If I work for one more year the inflation threshold rises to 4.2%. I will be working at least one more year;

7. allocate assets to protect against inflation: most of our money is in real estate or equities. There is a very small allocation to bonds (which will probably be a bit bigger when the time comes). Since the cost of mortgage finance is below the inflation rate, I will carry some debt on our investment properties into retirement;

8. constant vigilance: I will continue to monitor expenses and income post retirement. If a problem is identified, I will take action sooner rather than later - asset reallocation, cutting expenses, finding a job or other actions;

9. mental preparation: I have a massive list of things to do once I retire. Keeping myself mentally and physically busy will prevent me from spending excessive amounts of time brooding about an issue which I believe I am well prepared for. Have had at least three years advance notice of my retirement target date, I hope to have no difficulties making the adjustment when the time comes.

As things stand, I'm pretty sure I will be ready to pull the trigger in early 2012 - both financially and emotionally.

Stress testing for inflation (1)

When I retire, my expectation is that my cost of living will continue to increase due to inflation. Since I won't have employment related income, I need to be very confident that the private portfolio will continue to support our lifestyle over a lengthy time period. The point can be easily illustrated by using a spreadsheet (even for the semi-numerate such as myself) or one of the many calculators available on the internet. I used Firecalc at Early Retirement to illustrate the point.

If I plug in our current net assets, projected retirement budget, a 50 year retirement period and exclude the value of our home, Firecalc gives me the following results:

1. inflation at 3.7% pa or less: 100% success rate

2. inflation at 4.0% pa: 97.8% success rate

3. inflation at 5.0% pa: 75.6% success rate

The success rate falls very quickly as inflation climbs above 5% pa.

I also made an adjustment to reflect the fact that Firecalc assumes very low cost mutual funds as the investment vehicle of choice. Those funds are difficult to access from Hong Kong.

Even accepting that the calculator is using an average rate and that 3.7% is above the US CPI, these results do not give me the necessary level of comfort - CPI is not a satisfactory basis for estimating future cost of living increases. History tells us very clearly that extended periods of high inflation do happen and their impact can be devastating - the impact of the high inflation 1970s and early 1980s was an awful time to be relying on fixed incomes.

In any case, this is one of the reasons why I am still working (there are others).

There are a number of ways to gain the necessary level of comfort which I have written about before and will revisit in a future post.