May 25, 2017
Hindsight is funny.
It’s only after having taken a certain action that we can look back and see whether it was a good idea or not.
Only when we learn new skills or pick up new knowledge do we realise that the way we’ve done things might not be ideal.
I’ve thought about this a lot since reaching financial independence a few months ago. There are a few things I would do differently if I was starting again and how I invested is one of them.
I focused too much on leveraging up in property to increase our net worth. You can read about our experience with that here. At the time, I (stupidly) didn’t worry about a passive income stream.
But I’ve learned that net worth only gets you so far. Net worth, without passive income, is damn near useless when trying to retire early.
Instead, creating a growing income stream by your side truly strengthens your financial position. Yes, you may pay some tax along the way, but it’s much more useful and powerful than using leverage to create spreadsheet wealth.
The most common form of financial leverage is to accumulate property, which usually chains you to your job whether you like it or not. Quite often, you become equity rich, cashflow poor.
An income stream empowers you with the greatest leverage of all… the leverage to get yourself out of your employment shackles, giving you your freedom back.
We have already considered briefly where we can put our savings to get started.
But to quit your job and retire early, you need an income stream from your investments that you can rely on. There are many different retirement income strategies.
We need to keep in mind that this income stream needs to grow over time to keep up with inflation. Essentially, when we’re investing, we’re really just buying an income stream.
If you buy an investment property, you get the stream of rental income from that house from now into the future. When we buy shares, we get the income stream (dividends) from that company for as long as we own it.
Ideally, we want to purchase the most income we can for our money. As long as we remember, that the income needs to keep up with inflation over time. If the income stays the same, it won’t be very helpful in 30 years time.
This is because the money won’t go as far when paying your bills because inflation will reduce it’s purchasing power. The income stream we buy needs to meet this criteria.
In my opinion, the best income stream to reach financial freedom as soon as possible is from Australian Shares.
The sharemarket scares most people at first, myself included. We are fearful of what we don’t understand.
It doesn’t help when scary headlines drum into us that the sharemarket is risky and goes up and down like a yo-yo. When people do get comfortable with it, they often use the market to buy what I would call expensive lottery tickets.
These Aussie punters bet thousands on a speculative gold mining stock, lithium company, or whatever’s hot at the time and they then hope they’ll get lucky and the shares will go through the roof!
This is the totally wrong way to approach the sharemarket. Get rich quick = get poor quick!
People focus way too much on the prices of shares and nowhere near enough on the dividends paid!
Getting a cheque in the mail or cash paid into your bank twice a year is unlikely to get your heart racing (although it does for me), but this is the real value of being a shareholder.
The whole reason companies are in business is to make profits. Cash profits. Behind the share prices are real businesses that are making real cash for their shareholders, regardless of what the share price is doing.
The true benefit of being a shareholder is the dividend income stream, not the price on the screen showing what someone else wants to pay for your shares.
When our shares go up in price, that’s a paper profit. When we get paid a dividend, that’s a cash profit, passed from the company to us. Forget paper profits and focus on cash profits (dividends).
Let’s do a little comparison to see how dividend income stacks up against rental income.
The average dividend yield for the Aussie Sharemarket is around 4% to 4.5%. Perhaps we take an average rental yield on property (being generous) of around 4%. To use even numbers, we’ll call them both 4%.
Are they really the same though? Let’s see….
The property has expenses such as management fees, strata fees, building insurance, landlord insurance, council rates, water rates, vacancies, repairs and maintenance etc. This will typically equate to around 30% or more of the rent. This takes the rental yield down to 2.8%.
Now, the dividends we receive from most Aussie Shares are fully franked dividends.
This basically means they come with ‘franking credits’ attached to them. We get a tax credit for the tax that the company has already paid on these earnings, before they pass them onto us as dividends.
Australia has this rule in place to avoid double taxation. The tax credit is the same as the company tax rate, 30%.
You’ll receive the 4% dividend as cash. The remaining tax credit will be available come tax time. This either takes care of most of the tax for us or becomes a tax refund if you’re in a low/no tax environment, such as early retirement 🙂
So an easy way of calculating the gross dividend yield from your shares, if they pay fully franked dividends, is like this…
Take your dividend and divide by 0.7.
4.00 / 0.7 = 5.71.
So our 4% dividend yield becomes 5.7%, once we include franking credits (as we should). As you can see, it makes a massive difference.
So the rental yield becomes 2.8% after expenses. And the dividend yield becomes 5.7% after franking credits. That’s double! Comparing the two streams of income, you can see that you’ll receive twice as much income from the shares.
This means an investment property worth 700k paid off will provide an income of 20k. But the same 700k in Australian Shares will provide a income of 40k. Don’t know about you, but I know which one I’d prefer!
Having a quick glance at the yields on offer and assuming they’re equal, can be very very deceiving. It’s downright dangerous!
Just out of interest, the property yield required to match the dividends is around 8%. Once you take away the 30% for expenses, rental yield comes to 5.6%, matching the shares yield of 5.7%.
Using these figures, a 4% dividend yield is equal to an 8% rental yield. Always remember to add on the franking credits to work out the gross yield to make it a fair comparison to other income streams.
It should go without saying that you can’t just buy any shares and hope to do well. Almost everybody is better off with a set and forget type of approach, with minimal fuss and monitoring.
Picking winning stocks/companies is notoriously difficult and even most professionals struggle to outperform the market over time. The simplest and safest approach to investing in the sharemarket is by buying an index fund, or a well diversified Listed Investment Company (LIC).
A stock market index fund will simply own all the stocks in the market index (such as the ASX 300, the biggest 300 companies in Australia) and achieve the same return as the market, after a small fee is taken out.
If going down this route, one highly regarded low cost index fund provider is Vanguard. They invented the index fund, after all. The gross yield of the Vanguard Australian Shares fund is usually around 5-6%.
Listed Investment Companies are just like a managed fund, that is ‘listed’ on the stock exchange.
A good Listed Investment Company (LIC) will invest in a large diversified portfolio of shares, with the aim of providing shareholders with a growing income stream.
Check out my LIC Reviews page for in-depth info of these companies.
These LICs both own shares in approximately 100 different companies, so you’re money is well spread around. If a couple of companies in the portfolio do poorly, or even go bust, the overall portfolio will remain solid.
The gross yield (including franking credits) of these LICs is often close to 6%. This means every $1700 invested will buy you around $100 of annual dividend income.
Every purchase you make, buys you more shares, which means more dividend income. This means you get closer and closer to early retirement!
These LICs also have extremely low fees and their performance is quite similar to the market over the long term. In my view, both index funds and low cost LICs are a great place to start investing for passive income.
Don’t forget to use a low cost broker so more of your money goes to investments, not fees.
Most importantly, make sure you’re using the dividends you receive to buy more shares, using compounding to start rolling a giant passive income snowball!