Since money and investing will be one of the main themes of my blog, I think it is natural to start off with a quick introduction into my investing philosophy. If I had to sum up my investing philosophy in once sentence, it would be get rich for sure. I have tried various things over the years, but one consistent lesson has been that the get rich quick methods do not work very well. So here is a brief introduction into my thoughts regarding investing for passive income.
Investing vs Speculation
Before we get started, I have to present some definitions that I use. My definition of investing means buying an income-generating asset, while my definition of speculation means buying an asset that does not provide income. These two asset types have a very clear and important distinction. An income-producing asset provides a stream of cashflow while I hold it (and that cashflow should be steady and predictable). As long as that income stream does not stop, fluctuations in the market price of the asset are not critical, assuming that eventually the market price reaches the purchase price. Meanwhile I collect the income and I really like the concept of being paid to wait. However, if an asset does not provide income, the only way for the investment to be profitable is for someone else to pay more for it at a later date. In this case the success of my investment rests much more in the hands of other investors and this feels inherently more risky to me. The less my success is dependent on others, the better I feel.
Considering these points, I think only income-producing assets are consistent with the get rich for sure strategy. I am not saying speculating is wrong, only that it should be recognized for what it is. I have some speculative assets as well, but I do think that speculative assets should not be included in the core portfolio of a starting investor.
Now that I have narrowed my choices to only assets that produce income, it is time to consider possible candidates which meet that criteria. Here are some examples.
If one is interested in putting in some amount of work, I think real estate has some characteristics that make it objectively the best asset class when measured by risk-adjusted returns. It is particularly attractive because banks are generally willing to lend money relatively easily when the real estate asset is used as collateral for the loan. Utilizing this high degree of leverage often produces good returns on invested capital. The downside of real estate is that it cannot be called passive investment until you have enough scale to hire someone else to manage the property. Another downside is that even with leverage, it requires fairly large amount of capital to get started, considering one should own multiple apartments to diversify risk. Third downside to consider is that apartments are not very liquid and can take a long time to sell.
Dividend-paying stocks of publicly listed companies are what I have chosen as my primary investment vehicle. While I expect my total return to be lower compared to real estate (at least if measured by income alone), there are some great benefits to stocks that make up for it. First of all, it is a truly passive investment that requires no active involvement. The time I save (compared to real estate) can be used for other income-generating activities such as work. The second obvious benefit is the superior liquidity provided by stocks, allowing me to buy and sell whenever I want to. And thirdly, I can perform these transactions from anywhere on the planet, as long as I have access to internet and a computer. This level of freedom wins the case for stocks in my situation.
The problem I have had with bonds is that I have not found them particularly interesting. They are like the boring version of stocks. But they have an important distinction. Buying a bond generally means you are entering into a contractual agreement to receive payments from the issuer of that bond. If you are holding common stock however, the company can cut or even terminate the dividend payments at any time if the management decides to do so. What makes bonds boring is that you do not get to participate in any gains when the company is doing well or when it is being acquired by another company.
Land as an investment is definitely an interesting area, and one that I will hopefully explore further in some future blog post. From what I have studied so far, it appears that farmland is good if you can work it yourself (and be efficient at it), but if you are merely buying land to rent it, the return on investment is fairly low. The main income from owning forest is to sell the trees, but the problem is that trees take extremely long time to grow. Who can afford to wait 20 years for trees to grow? Not me. One positive about farmland or forest is that they will hold their value fairly well in a recession.
Individual Stocks vs Funds
The myth most often perpetuated by the financial services industry is that average investors should just buy an index fund, and not invest in individual stocks. While this is a complex issue, I tend to disagree. The underlying message here is that the average investor is too dumb to manage their own money, so they should let some “expert” in Wall Street to manage it for them. If a person is motivated to learn, there is nothing particularly difficult or complex about stocks or finance. The confidence one gets from successfully managing their own money is also a substantial benefit to consider.
Another problem with an index fund is that the stock market as a whole can get overvalued during a bull market. As I write this, in December of 2017, the market looks very overvalued to me. This condition of overvaluation can last for many years. If the investments are made during this kind of period, the expected returns for the following years will be low, or even negative. Another option is to just wait, but that requires a lot of discipline and is not a very exciting approach. The good news is that there will always be fairly priced individual stocks, even in a bull market. This is one of the main reasons why I invest in individual stocks.
Now that I have established why I am a stock picker, what stocks am I selecting for my portfolio? To answer that question, I must begin by considering what kind of stocks are consistent for the get rich for sure theme. The most likely stocks with long term staying power are the highest quality companies which lead their own sectors. Warren Buffett has said that he would rather pay a little more to own a great company, than to buy an average company cheaply. I fully agree with him here. Of course these highest quality companies tend to trade at a premium vs their peers, but that is the price one must pay for quality. It just doesn’t make sense for me to buy average companies when I can buy the best ones. When buying an asset, I also try to consider it from the viewpoint of other investors who would be potential buyers in the future in case I want to sell. I want to own assets that other investors want to own, because that is what determines their price in the market.
Since I am investing in income-generating assets, the dividend yield is one of the most important metrics for me. In the current market environment, I look for stocks with a dividend yield of 3.5% to 4%. I think this represents a sweet spot where the starting yield is substantial enough, but the company still has some growth potential also. I almost never invest in a stock with a dividend yield below 3%. I know many advocates of Dividend Growth Investing say that the starting yield doesn’t matter, only dividend growth does. They are willing to buy a stock with a yield of 1.5% as long as it is expected to grow, but the math just doesn’t add up for me.
Number of Holdings
I think a good number of stocks in a mature portfolio is 20. This amount provides very good diversification with each holding representing roughly 5% of the total portfolio. Since additional diversification results in diminishing returns, adding more stocks for that purpose is not required. Initially when starting out, I think 5 stocks is a good number to aim for, then build your portfolio to 10, and eventually to 20. The reason why you do not want too many stocks in the beginning is to minimize transaction costs, which can be significant if you are not careful. I will be writing another blog post about how and why to minimize transaction costs later on.
Buying in Increments
One of the most important ingredients for the success of my investing strategy has been entering into positions in increments. I usually start a position by buying just 1/4 of the total amount I intend to own. Then I hope the price keeps going lower so that I can build my position with even cheaper shares. I think this is the part that is the hardest to do for beginning investors, to have conviction to double down on a position that keeps going lower, and then buy even more at an even lower price. This kind of conviction can only be built with experience. Of course the key here is to identify why the price is going lower, and whether it is a temporary problem or something that threatens the existence of the company. Often the best time to buy is when the general opinion among investors reaches the point of maximum pessimism and that’s also where the bottom in price is often found.
My conservative expectation for return on investment is 8% annually, with 4% coming from dividends and the other 4% coming from capital appreciation. I think this figure is in line with what stocks have returned in the past as well. I realize this strategy may lose to an index during strong bull market years, but it should beat the index during bear markets. Of course my most important measure is that the passive income provided by the portfolio keeps growing every year.
My investment philosophy is extremely rewarding psychologically. Instead of chasing quick profits and trying to invest in the newest hot IPO or trending stocks, it is a solid portfolio that is grinding consistently higher and producing ever growing stream of dividend payments. And since I am only investing in the highest quality of companies, any drop in the price of their shares is usually a positive event, allowing me to purchase more shares at a discount. Additionally, this type of portfolio requires very minimal amount of maintenance and tracking, leaving time for other interests. While I usually like to check my portfolio daily, I would do just fine checking it once a week, or even once a month.