Hi Gaz,

My portfolio IRL is heavily invested for passive income. I'm in my 30s working full time but am working towards early retirement. I've just completed my tax return and owed the ATO for the first time in my life. All I can say is I'm really glad I had franking credits sitting there cause I'd owe a whole lot more if I didn't. So that's one positive for investing for passive income prior to retirement (with franking of course).

Thanks for posting GazD.

Whilst I’m not in the industry it seems like a pretty logical approach. Hold good businesses and only sell out if and when it no longer makes sense to hold them.

I am a few years younger and have an appetite for about 10-20% speculative shares in my portfolio, with the rest being good long term opportunities. I have a higher risk appetite now but will reconsider my approach over time based on opportunities and how close I am to retirement.

As an individual I don’t like taking huge risks and I tend to feel really uncomfortable having big positions in small caps (I am trying to work on this) having been burn in the past with liquidity issues and companies getting wound up.

However, I there still is a lot of personal preference that needs to be considered and you will need to be comfortable your investment strategy and decisions you make. The fact that you are making a conscious effort to invest for your future is a huge head start and gives plenty of positive compounding momentum

I'm already in my 60's @GazD and turned my SMSF into pension mode as soon as I turned 60 purely for the nil tax and the benefit of getting the full franking credits returned by the ATO after doing my annual tax return. I also have National Rental Assistance Scheme (NRAS) properties that are let to qualifying tenants (usually income <$100K I think) that get ~25% discount to the standard rent. NRAS then compensates my SMSF by giving ~$2,500 from the State Govt and about $8-9K in tax rebates annually (treated the same as a franking credit where it simply goes to the bottom line for a full tax return).

So yes, I love franking credits but only use (say) 40-50% of my SMSF share portfolio to have this focus ideally with capital growth as well, as CGT is of no consequence now or in the future if legislation gets passed if your Total Super Balance is less than $3M (I think the regs will actually be around an Adjusted Total Super Balance, but I think you know what I mean). I reckon your slow morph into solid companies that (hopefully) have both capital growth and 100% franking yields makes a lot of sense, assuming these will be in your Superfund name. I did write a forum article a while back about using in-specie transfers to move shares from an entity or individually into your SMSF, but that needs you to work through such scenarios with your accountant/financial adviser, etc.

Good luck, you've got this!!

Thanks @SudMav appreciate your thoughts. I think I’m unusually risk tolerant sometimes to a fault but even now having been burnt by some highly speculative investments I’m still comfortable with small caps as long as they have decent fundamentals. In fact I am probably 70% small caps and 30% etfs/large caps

I think I might have a very different view to the conventional wisdom so I'll put it out there... And I say this as someone who is a long way from retirement so maybe my mindset is different to what it will be in 20+ years.

I always see investing returns as BOTH capital gains and dividends, doesn't matter which bucket it comes from. If you need income why not trim a growth stock position by 4% if say you need a 4% income from your capital base. A dividend of the same gross yield will see a price drop of that amount anyways all being equal so what's the difference? I think there is a mental thing with investors that you can't touch the capital base because of the compounding effects but if the stock isn't compounding because all the income is distributed in dividends than again whats the difference? A dividend should be excess capital the company doesn't require, if a growth company can provide greater returns with the cash then Ill trim the amount I need for income and the shares over time should appreciate at a rate greater or equal to my income expectation from my capital base. In the end increasing my income and overall yield.

Personally, I see some individual "blue chips" as high-risk in my situation due to the fact that they won't grow much and only providing an income a few percentage points above what you can get in the bank (and currently likely equal to the deposit rates).

I guess maybe more appropriate wording would be looking for stability rather than income. Which I would definitely agree with as you can't afford the sequencing risk of having a large draw down right after your point of retirement.

Completely agree with this. Watching people obsess over dividends is frustrating... as if selling a few shares every now isn't an option. Plus it's a forced tax event. You could always buy something growing, hold for 12 months to get GCT and then create your own income selling some when you want.

Some tax situations make FF dividends attractive, but people seem to become zealots.

thanks @Dominator for your view. I haven’t thought about it deeply perhaps because I do see capital gains and dividend gains as essentially the same thing. But… I thought franking credits in retirement adding a decent chunk on to fully franked shares in a very low tax rate environment (potentially 0%) maybe swung it a little towards divvies! But yeah I agree with your point in theory. The other point I guess is that dividends are pretty dependable if you buy the right businesses (see dividend aristocrats) but growth might not be quite as consistent which might be a big deal in retirement if you’re living off it

I agree with several remarks here and I focus on total returns.

My ASX portfolio is growth oriented and relatively high risk. I do draw a small component of income from it each year (3-5% per annum) and with a yield of around only 1%, the balance comes from sales not fully reinvested.

Excellent posts all round, and a great discussion. My personal approach has been to look, not so much at the dividend yield, but whether the dividend has increased every year, and is expected to do so ad infinitum. Which is kind of saying is this a quality company.

so if company a) pays a dividend yield of 2% but has increased this every year by 25%, and operates in an industry with plenty of room for growth. And company b) pays a dividend yield of 7% and has little prospect of increasing earnings as it it is in a mature industry

Assuming you hold both companies for 20 years or so, by the time you want to retire, not only will the share price of company A be much higher than that of company B but its dividend will be as well. (Insert maths here, but the difference in total returns is extraordinary)

so if you are buying for future dividend yield then a mature high yield approach at this stage in life doesn’t make much sense.

@GazD if i was in my 40's i would have liked someone to show me this graph. it shows quality, ie companies that can reinvest well above the cost of capital vrs those that can't. over the LT the differences are stark. where you can come unstuck, is twofold, paying too much or a company reinvests at poor returns going forward. thats it. dividends are a red herring, they are good that they indicate profitability but bad that if large indicate a lack of growth options.

this is a slide form my last ASA presentation if anyone wants the whole preso just ask

Hey @GazD

Why do you have to crystallise your whole portfolio, why can't you create your own income stream selling some shares every 6 months? A tiny bit of work but you control how much and when.

Also people who set up a passive income stream often then treat the capital as too sacred to ever sell. So they basically set up a situation to live off modest income and die with a huge chunk of capital. (That they often worked hard for but never enjoy.)

I recommend Die with Zero as very good book on the topic.

@ArrowTrades thats what i do, just sell some when any share is overvalued to add to cash, and keep cash around 1-2 years of spending. TR drives the portfolio.

This is how I think about dividends. My main focus is on return on my investment (ROI). When you invest in a business, price is what you pay for a share, equity is what you get. Equity is the part of that business that you actually own. If you are buying a decent business the equity is nearly always worth less than the share price. I use stock valuation to determine if it is worth paying a premium for a slice of equity in a business or not.

Return on Equity (ROE) is the annual return a business makes on the equity you own. If the business can consistently reinvest earnings at a very high rate of return (say +30% ROE) then I would prefer that business reinvested all its earning back into growth and to continue compounding the earnings at +30%. With ROE of 30% and all earnings reinvested, your equity (or Book Value) in that business will double every 2.4 years (Rule of 72). If you assume the PE remains constant the share value will double every 2.4 years also.

It is very rare for a high performing business (+30% ROE) to reinvest all its earnings for a very long period of time unless they have a long runway for global growth. Microsoft has an ROE of 27.7% and pays out 25% of earnings in dividends. Microsoft might find it difficult to reinvest all its earnings into growth without lowering ROE because the opportunities to reinvest this amount at a similar ROE simply don’t exist. We don’t want a business to reinvest our earnings at a lower ROE just for the sake of earnings growth. This will lower the quality of the business and eventually the PE ratio also. This is not what we want!

OK, back to dividends. To have a view on whether a business should pay dividends or not you need take a look at the ROE. If the ROE is consistently below 8% and you don’t expect this to improve you would be better off if all the earnings were paid to you as fully franked dividends and you could reinvest the dividends in a better business. In fact you are probably better off selling this business and finding something better because 8% is the best return you can expect in the long term, and you still have the risks of business and economic cycles. Between 8% and 15% a mix of growth and fully franked dividends is probably OK. When a business is consistently delivering ROE above 15% you are probably better off with less dividends and more earnings invested into growth if the business can continue to grow at the same ROE. A business with a constant ROE of 15% reinvesting all its earnings would double the share price every 4.8 years assuming the PE remains constant (Rule of 72).

If you want to read more about this there is a brief discussion about McNiven’s Formula here. I probably touch on this in the meeting with Strawman, and if you think what I’ve discussed makes sense you might be interested in reading “A Concise Guide to Value Investing” by Brian McNiven - available on Amazon here: https://www.amazon.com.au/Concise-Guide-Value-Investing-McNiven/dp/0731407938?dplnkId=434055cc-4583-4692-9739-1f79f4dc86dd&nodl=1

Thanks @lowway this is really interesting especially the NRAS properties which I've not really heard much about before. Love the social good side there too. The shares I'm referring to are held by our family trust rather than in SMSF. I think we're probably going to seek formal financial advice next year so I might look at your article regarding in-specie transfers etc prior to that meeting.

@mikebrisy Does it bother you when you have a 'down year'? ie if your portfolio is 10% lower for the year and you also need to drawdown say 5% for income?

100% @Chagsy agree. The only long term 'dividend stocks' I have bought thus far are SHL, IEL and BKW which have all grown per share dividends consistently... I do note now reflecting on my positions that their franking is pretty variable... These form a small minority of my holdings right now.

I love this graph @Solvetheriddle it's very impressive. Were the ROEs as obvious at the start of this 20 year period as they are in retrospect? I guess the value in this insight rests on being able to assess ROE on a prospective basis...

Great take @Rick. In the end I guess it's all about ROI for us and ROE in the businesses... I'm always on the lookout for a good read/education so I'll take a look at Brian McNiven's book!

Yes @ArrowTrades you're 100% right that I could derive the income in retirement from selling rather than from dividends. I had supposed that the tax benefits of fully franked dividends and the relative smooth passive income based less on the swings of the market might be preferable. Love the behavioural psychology reference with regards 'too sacred to sell' this makes so much sense to me and I can certainly imagine falling into that psychology.

@GazD Yes that's right, i tried not to cherry-pick in both samples. so no PME etc that did not have the track record back then. As Munger says investing is simple but not easy, the hard part is identifying those companies that continue to reinvest well (or don't more to the point), and not paying too much. at least limiting the scope of what's important is helpful. for me anyway

@GazD, if you are 20+ years from retirement, you can be pretty certain that SMSF tax benefits and the franking credit system will be changed by the time you become eligible for it.

There will be little, if any grandfathering for existing investments.

Outside of SMSF, the effect of losing or heavily modified franking credits will be less of an issue, but ultimately, the long term game in my mind is RoE.

Yes, I'm probably no different to most others in that in a down year I have to remind myself that investing in equities is a long term game, and that in order to enjoy high returns over the long term, you have to be willing to accept "down years" - sometimes more than one at a time. However, so far, doing this has ensured that I have remained fully invested, subject to the caveat which follows.

The key is to not put yourself in a position where you are forced to sell at a short-term low point, especially any part of your portfolio that is subject to a short term over-reaction.

I avoid having to sell when the market is down by holding about two year's living expenses in cash and equivalents, including expected income from my part time side hustle. (I am reliant for 75-80% of my total income these days from investing returns, across my total portfolio.)

For example, my ASX portfolio had a bad run in late 2021 through 2022 (largely self-inflicted), and I chose not to sell equities and instead ran my cash reserve a little tighter than usual. Equally, it's done well over the last year and I have started harvesting a little harder than usual. So there is a degree of "option value", although I try to avoid thinking that I can time the market.

I also have the lion's share of my total asset base in a 70/30 global equities/fixed income portfolio of broad based index-tracking funds (like $VGS and Developed Markets Equities,.. although these are held offshore so the funds aren't ASX-listed), and it is less painfull to draw down on these assets in a bad year as the overall portfolio is less volatile. My ASX-portfolio is only about 9% of my total assets, and my investing behaviour as observed on SM is a lot riskier than overall in real life.

I first held equities in 1994 and have been in the market through multiple equity cycles, starting with the 2000 dot-com boom/bust. So, I've developed an emotional resilience. Not being bothered in a "down year" is the other side of the coin of not getting big-headed in an "up-year", and speaking from my own experience, I think it is easier to be more level-headed when you've experienced a few of the cycles of highs and lows.

I hope never to retire, and will put provisions in place to transition to a less active strategy should I lose the mental capacity to actively manage my portfolio. I really enjoy investing, as it drives me to have to do a lot of research and keep learning, which I really enjoy.

Yes, FWIW, I have always viewed investing income as being derived from both capital gains and dividend/capital return income, and I have used a mix of both for income. That has only changed this year because of a circumstance I have found myself in having been forced to quit my full time job due to advanced OA and not being able to access my super until I'm 60, so 18 months from now, and because my super is in an industry fund, if I want to take it out, it has to be as cash, meaning I have to sell up to move anything out of my super, so my plan is to try to maintain the current balance as a minimum and to hopefully grow it over the next 18 months. Easier said than done in a market crash, if we get one, but that's what I'm trying to do right now, which means that my risk tolerance is a lot different right now than it was last year, and I'm prepared to sacrifice some growth if I can maintain income while minimising downside risk.

But on the whole, as a general rule, as long as the CGT implications aren't a major factor, then income can come from any source; it doesn't have to be all via dividends. I don't have any sacred cows myself, or companies that I would not sell. A few years ago, I was saying I would never sell Monadelphous (MND), but I did, and I currently don't own any. I said another time I would probably always hold ARB, but I don't currently hold them, although I wouldn't be unhappy if I did to be honest. They keep on keeping on, and they are certainly quality, both in terms of what they sell, and their management. NST is another - has been my favourite gold miner for years, however I would sell them in a heartbeat if the investment thesis was obviously busted. I just think there is no "one size fits all" answer to this - it all depends on each person's (a) stage in life and (b) personal circumstances, as well as (c) their own personal tolerance for risk, i.e. what they can invest in and still get a good night's sleep. And A & B can have a big impact on C.

I like the thinking @Bear77 and once you factor in the tax realities and get to a net return result, money is money whether from dividends or capital growth. It buys the same things whether you sell a few shares or collect a dividend payment. Sorry to hear about your work and health situation and your plan sounds solid, so good luck.