New readers: This is an in-depth, chapter by chapter review and analysis of the book Your Money Or Your Life. Join us! You can buy YMOYL here, and you can find the first post in the series here.
Last week, we explained in ugly detail why we can't rely on Treasury bonds alone for our passive income needs. This week, we'll review a broad range of investment alternatives that will empower you to earn money from your investment capital.
First, however, a friendly warning and a few caveats. Today's post is long (more than 2,500 words) and packed with a lot of information. You're going to need to carve out 15 minutes at a minimum to ingest everything here.
Now for the caveats: Just as Joe Dominguez's advice to rely on Treasury bonds fails in the current era, some (or all) of the advice I give will also fail at various points in the future. Further, most of what you're about to read in this post is my opinion. Just that. And I'm wrong sometimes--heck, I'm wrong more often than I'd care to admit. As an empowered YMOYL reader, it's up to you to weigh the opinions of others, and then make your own investment decisions.
That said, an empowered investor should always be diversified in the broadest sense, so your job is to build a broad mix of income generating investments across every asset class. Thus, in addition to placing a portion of your capital into Treasury bonds, CDs and other low-yield, low-risk investments, you will also make investments across the entire risk spectrum, including:
* Tax-free municipal bonds issued by your state of residence.
* Preferred stocks, which in the current era yield as much as 5-8%.
* Corporate bonds, perhaps in the form of a low fee bond index fund.
* Consumer products stocks (examples: PEP, PG, UL, JNJ, etc.), which can be bought at yields ranging from 2.5-4.5%.
* Conservatively managed utility stocks (such as: ED, PPL, etc.) which can be bought at yields from 4-6%.
* Publicly traded REITs, yielding anywhere from 3-7%.
* Dividend-paying bank stocks based in the USA or Canada, now that our banking sector has stabilized. Yields here can range from 2.5-5%.
* Conservative, dividend-paying industrial stocks (RTN, HON, EMR, CAT, BA, and many more). Depending on their stock prices, yields can be as high as 3-4%.
Chapter 9 offers readers additional income generating investment ideas too, including:
* Mutual funds (which I generally hate because of their high fees and generally mediocre investment performance. Read Common Sense on Mutual Funds by Jack Bogle to wrap your mind around the drawbacks of these investment products).
* Index funds (which have far lower fees than traditional mutual funds, but which are usually not optimized for income generation).
* Lifecycle funds, such as Vanguard's low-fee LifeStrategy funds (I'm unfamiliar with these products, but they look intriguing).
Each of these investment categories has risks. Duh. Your job is to slowly experiment with each to see which meet your needs, which you feel comfortable with, and so on. Eventually, you'll want to own at least something in nearly all of the categories I've listed above as you build your broadly diversified income-generating investment portfolio.
Most importantly, you're going to rely on yourself, not on "experts." And when I say experts, I mean both those who make money selling financial products and those in the media who make money selling opinions on financial products. Finally, you're going to follow YMOYL's dictum about avoiding excessive fees and commissions and keeping your investment costs as low as possible. Do this, and you should be able to generate passive income from your investments that meets (and perhaps exceeds) the 4% hypothetical yield we discussed back in Chapter 8.
Readers just beginning their investing journey may have extremely basic questions at this point. How do you find these investments? Where do you go to buy them? How do I choose a stock? What do I even do? And so on.
There's really just one answer: Stop with all the questions and just get started. Go to Schwab.com, Fidelity.com or TDAmeritrade.com and open up a brokerage account. Get four or five well-regarded investing books (I've assembled an official YMOYL-specific reading list here which will make you better educated about investing than 95% of humanity), read them carefully, and then just start. Begin making some investments. Pick one or two, make a small investment of your capital, and keep reading and keep learning. You will learn and gain context as you go. Your success as an investor will depend on your willingness to learn by doing.
Scared? Intimidated? Afraid you'll make a mistake and lose some money? Irritated that this process seems difficult and that it might take a long time? These are all perfectly normal feelings. But, for goodness' sake, if those feelings stop you from taking action, you've somehow managed to learn nothing from the entire book. Reread Chapters 1 through 8, do all the exercises again--and this time do them for real. You haven't yet wrapped your mind around what it really means to be FI.
Create your personal list of investment criteria
We already know Chapter 9 has some flaws. But, once again, even a flawed chapter can still teach important fundamental principles. And pages 271-272 of Chapter 9--where the book outlines Joe D's personal investment criteria--is yet another exceptional example.
And just as Joe's one-dimensional "buy Treasury bonds" strategy doesn't function well in the modern era, his list of investment criteria has a few flops too. See, for example, criteria #2 (your capital must be absolutely safe) and #6 (your income must not fluctuate), both of which are unrealistic for investors who go beyond Treasury bonds for their income needs.
But the principle of establishing a list of personal investment criteria is incredibly sound. Create your own. Once you've shaped your own list of what specifically you're looking for in an investment, you'll better understand your true goals. You'll better understand your risk tolerance. And best of all, you'll have a checklist to help you filter and select specific investments that meet your needs.
As a reference for readers, here's Laura's and my personal investment criteria:
1) 90% or more of our investments must generate income.
2) Our investments must be well diversified across multiple asset classes (bonds, tax-free munis, stocks, preferred stocks, REITs, funds, cash).
3) Depending on the attractiveness of interest rates, we may invest in CDs or Treasury bonds.
4) Stocks should make up only 40-50% of our investment portfolio to help limit risk.
5) Nearly all of our stocks must pay regular dividends, and we must be diversified across industry sectors.
6) No single stock can be more than 5% of our total assets.
7) No one fund--either a mutual fund or bond fund--can exceed 15% of our assets.
8) We seek to minimize all fees and commissions.
9) We seek to minimize active trading, and seek to minimize short-term selling that triggers taxable gains.
10) We seek to make our investment income tax-efficient, which means emphasizing tax free municipal bonds and tax-favored income from dividend-paying stocks.
11) Around 5% of our investment assets is dedicated specifically to highly speculative investments.
If you're new to investing, you won't be able to make a list this long or with this kind of specificity. Don't worry. You'll shape your own list of criteria over time as you gain more and more experience. Get started, keep learning--and it will happen.
Dividend paying stocks
I'll close this week's post with a few observations about dividend-paying stocks. First and foremost: the best thing about stocks is that they can go down.
Yes, you read that right.
If you've purchased a stock with a safe, sustainable dividend and the stock declines, you now have the opportunity to purchase that same stream of dividend payments at a lower price. All else equal, the yield on a stock gets juicier as the stock price goes down.
In other words, YMOYL readers investing for income should be gloriously happy when the dividend-paying stocks they own go lower.
Here's another way to think about dividend paying stocks. The price of the stock doesn't really matter. If you own it for the dividend payments, and you have a reasonable degree of confidence in the safety of the dividend, what does it matter if the stock goes down or up? All you care about is the dividend, and now that same dividend can be had for less. Thinking about stocks in this way is enormously freeing.
The second best thing about dividend-paying stocks is this: Over time, the company can hike its dividend. An example: Laura and I bought our first shares of Coca-Cola [ticker: KO] back in 1999, right at the beginning of the so-called "lost decade" for stocks. It was a brilliantly-timed decision (uh, sarcasm), and if you were to consider the stock price and nothing else, it's been a mediocre investment at best. But over the 13 years that we've owned KO, the company increased its quarterly dividend from 16c per share to 51c per share. More than triple! Enterprising readers should be able to put two and two together here and see a rather obvious solution for managing inflation.
Let's say it once more, with feeling: All investments have risk. Dividends get cut. Interest rates go down. Stocks correct. And I (and you) don't have the foggiest idea what stock prices or interest rates will do over the next year, the next ten years or the next century. They may go up, down, or all around.
However, there have been precious few periods in modern economic history where so many stocks yielded so much more than "risk-free" government bonds. One such time was the mid-1930s, in the latter years of the Great Depression, when stocks were so universally loathed and reviled as an asset class that it was presumed that they needed to pay juicy dividends to compensate shareholders for their far greater risk.
Roll that over in your mind, and you might arrive at some interesting implications on the outlook for stocks in the coming years.
1) Czarist bonds: Joe D's habit of giving YMOYL students a yellowing Russian Czarist bond is a brilliant metaphor for understanding that nothing is certain. PS: Russia defaulted on its debt again in the late 1990s.
2) Don't confuse yield with return--and don't be unrealistic with your assumptions about returns: I can already anticipate some readers complaining: "Four percent? I don't want a stinking four percent! I want a return of at least 10% a year if not more."
First of all, let's review some terminology. Yield is the income that your investments throw off (remember our formula M x Y = PI?). Your return is the combination of your investment income plus any increase or decrease in the price of the investments you hold. An example: Let's say you own a $50 stock that pays a $2 annual dividend, and during 2012 the stock goes from $50 to $55. Your "yield" on that stock is 4% ($2 divided by $50), but your "return" was 14% ($2 in dividend plus $5 in appreciation divided by $50). Note that you can rely somewhat more heavily on your yield than you can rely on your return, because investments can (and regularly do) decline in value.
Last, a word of warning, and I'll try to phrase it gently: if you are counting on earning "10% if not more" on your investments, you need to grow up. We're not in the 1990s any more. There may be occasional periods in the future where stocks return 10% a year, but those periods are unlikely to be the norm. Never build your investment plans on unrealistically optimistic assumptions.
3) Here's where I make sure my readers are aware of all of the risks of owning stocks:
* Stocks can go down. A lot.
* Dividends can get cut, suspended or eliminated entirely. (They can also be hiked.)
* On occasion, you'll see a stock with dividend yield that looks too good to be true. It probably is. An unusually high dividend yield is often signal of a coming dividend cut.
* Never, ever reach for yield. I'll write more about this subject in the coming weeks.
* Entire sectors of the stock market can fall out of favor--for longer than you think.
* Things can happen that you never even thought of. Both good and bad.
* No one knows the future. Be humble about this, and be prepared to be wrong about your investments.
4) One final thought about stocks: Buying a stock and then getting mad that it doesn't go up right away is an act of supreme narcissism. Please keep in mind that the stock doesn't know you, and it doesn't care about your feelings.
5) Thoughts on the 2008-2009 credit crisis and aftermath: If there's one thing that has scared away (and scarred for life) many people who would otherwise have already started their journey towards freedom from work, it's the credit crisis that set off the 2008-2009 market crash.
A few thoughts: First, for a variety of reasons, credit crises tend to happen every 20 years or so (our last one here in the USA was the Savings and Loan crisis of 1989-1990). In the 2008-2009 crisis, which was a doozy, almost all major US banks (plus lots of other stocks in many other sectors) were forced to reduce or suspend stock dividends. Worse, quite a number of banks that looked like they had seemingly juicy dividends ended up failing and wiping out stockholders completely. (Again: never reach for yield--dividends that look too good to be true, probably are).
But remember: the credit crisis happened already. Now--more than three years after the crisis, and now that our country's financial sector is on extremely firm footing--it's time to pick through the rubble and look for good candidates for income-generating investments. Ironically, at exactly the time when banks are a truly hated sector of the stock market, you can find many well-managed banks (e.g., WFC, USB, JPM, plus dozens of smaller regional bank stocks) paying extremely attractive dividends, with lots of room for dividend increases. And don't forget: you may have as many as 15-20 years of runway until our next credit crisis.
6) Other, Unusual Investments: A few words regarding Chapter 9's What About Other Investments? section on pages 285-287. The authors address two types of "other" investments:
* Direct ownership of rental properties (which requires significant experience and expertise),
* Loaning money to friends and family (two words: no way).
Enter into both of these areas at your peril. A major problem with rental properties is this: a single property will likely make up a vast percent of your assets, which means you'll be undiversified. It may be safer and more profitable to invest in apartment REIT stocks instead.
As for loaning money to friends and family, perhaps one risk reduction strategy here might be to require any possible borrowers to read YMOYL as a pre-condition of receiving a loan.
7) Thoughts on risk tolerance: "Risk tolerance" is one of those finance euphemisms many people toss around without understanding. In almost every instance, people actually do not know their risk tolerance until it's too late.
Here's what's more typical: an investor thinks he knows his risk tolerance, and then has his investments cut in half during a 2008/2009-type stock market correction. Then and only then, he realizes his risk tolerance was way, way lower than he thought it was. This is a classic setup for an overconfident investor who gets blasted out of stocks at market bottoms.
I don't care who you are, how smart you are, how cool you are, or how experienced you think you are: your risk tolerance is lower than you think it is. For most people it takes a big and unexpected investment loss to drive this lesson home. Save yourself the losses and just learn it now.
8) "Experts" don't know either: Finally, if anybody tries to tell you they know what stocks or interest rates will do, they are lying. Remember this the next time you see some stock market pundit pontificating on CNBC, or the next time your read some authoritative-sounding article telling you to buy or sell.
Next Week: YMOYL Chapter 9, Part 3: Capital, Cushion and Cache
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