How to start your snowball of passive income
Ok you have heard about the FIRE movement and want to start making your passive income stream, right?! Sitting back living off the growing rental/dividend stream without eating into the capital is the aim. However, buying shares can be daunting or don’t know where to start investing at all. Most people avoid it until it’s too late or they get burnt and don’t touch it again! We will share with our readers the simple Family on FIRE 1/3 Rule.
Share Investing – Awful Advice Everyone Gives
Taking a friend’s ‘hot tip’ to buy a single, non-diversified company share allocation when starting out is not wise advice. My wise uncle advised I should get into some shares at 14 and I was very interested in the concept of getting money working for me. When I asked my Dad about it, he said he bought a mining share once and once only in the 70’s and lost the lot – $600 which was a lot back in the day (they bought the brand new family home for $12k to put it in perspective). He advised me to call the radio station 774 on Saturday morning and ask Bruce Bond. I quickly went live on air and was told the same awful advice to buy a single share. I put my life savings on the punt ($500 from years of paper rounds, mowing lawns, vacuuming for $2, etc.). Initially it was great as I learnt to look up the newspaper to see that the share price went up and “let the money work for you”, I celebrated. This was short lived as a major asbestos claim hit the company and the share price was hit hard. Needless to say, I didn’t put any more money into shares for the next 7 years. However, 10 years later the shares were worth round $2k. If I had have put my money into an LIC share I would have been encouraged to contribute to my share portfolio over these years instead of leaving it in the bank doing not much.
If you want your money to work for you, firstly you need to pay off personal debt (non-deductable debt) and put your savings into assets that grow. Even in the example above, it was much better than doing nothing as CSR was a strong company and I ended up doing well out of my initial investment. However I could have lost the lot. That is why I wouldn’t recommend buying a single non-diversified share when starting out.
Why Is The Best Advice So Simple!
I went to the Peter Thornhill (Australian investment author and speaker) seminar recently and his opening advice was: “Spend less than you earn and borrow less than you can afford”. How could you go wrong by following this? The trick is to pay off personal debt as quickly as possible then grow your assets that have growing income streams. The share price will follow the growing income and look after itself.
Let’s start with a definition of “investment”. According to Merriam-Webster it is: “The outlay of money usually for income or profit.” The price of an investment will try to correlate to the income it produces.
Peter Thornhill said investing into companies that have growing income streams is the only correct investment and all other forms are pure speculation – i.e. property where the growth historically comes from capital appreciation is speculation in his opinion. The last 100 years of property growth of ~7.8% and similar for the last 1000 years in European history wages a strong argument against the notion it is speculation. However, dollar for dollar, investing in shares (without leverage/borrowing) has historically had higher returns.
So What Are The Investment Options?
Share investing can be a way to get a growing snow ball. However getting into the right method of you is important. I’ve list some of the common method below:
- Single shares – Anyone can get a company hot tip and put their investment into it. The risk is too high putting into a company that is not diversified and shouldn’t be done when starting.
- ETFs (Exchange Traded Funds). These track a particular share index and buys a weighted average of all shares within that index. i.e. The ASX 100 will a buy a proportion of each of the top 100 companies. As company’s market capital values change they will move in out out of the top 100 companies and the ETF automatically adjusts to buy or sell these companies. They often out-perform most active fund managers due to lower fees.
1. This type of trust structure is required to report capital gains or losses each year which is not good. For example, if you put money into an ETF and during the year the ETF rebalanced and sold some holdings it will trigger a CGT*. You then need to report this gain on your tax return even though you haven’t sold the ETF! In some cases you will pay tax on money you may not have as you haven’t sold the holding. However you will get the 50% CGT discount unlike an LIC or Share.
2. They work great in a booming market. However during a downturn they will also track the market. It also relies on the market being right. It’s like walking down a shopping strip and buying a proportional amount of every shop regardless if it has good fundamentals and assuming the values are correct. The rely on the market eventually getting it right.
- Managed funds – Your money is pooled together with other investors. An investment manager then buys and sells shares or other assets classes on your behalf. You are usually paid income or ‘distributions’ periodically but like ETFs they incur capital gains/loss. They usually have higher fees.
- LICs (Listed Investment Companies). A management team look after the underlying stocks, without your stress or risk of trading individual stocks. Similar to Managed funds your money is pooled with other investors to buy a stock portfolio. Unlike ETFs or Managed Funds they are not subject to reporting capital gains/losses each year. This will happen once you sell the share which is the best approach as you can choose when this happens. However they also don’t get the 50% CGT discount if they do trade internally.
Most people will either be pro-shares or pro-property. Both have advantages for different reasons at different stages of your investing life. Investing early in your career where you can do it for ‘free’ without having any cash reserves. i.e. buying a positive geared property using the equity in your home costs you nothing in deposits or ongoing costs. Pure returns for money invested in percentages will be less than shares however, with sensible leverage can obtain good total returns. Property can also be used later to borrow against to buy shares. Banks in Australia will let you borrow against property much more than against shares with better lending rates. Hence property forms a stable base to build your property and share investment portfolio.
Super (401k for those in the USA)
This is perhaps the best long term investing vehicle as long as you are in an Industry Fund in high growth or Shares. In Australia we are now limited to a maximum $25k (now $27.5k) in each year. Perhaps a little boring but for those wanting to retire early but an essential strategy for long term FIRE.
How about Cyber/Crypto Currency? Refer to the definition above about how investments pay income. This investment will be talked about in centuries to come (tulips comes to mind). Great technology, but gravely flawed from an investment point of view (no income and new currencies can be created destroying scarcity).
Family On Fire 1/3 Rule
No one knows for sure the future other than we can say for sure markets will crash, boom and policies will change at some point. For this reason we like to diversify our income generating assets. When looking at your NTA (Net Tangible Assets) you could consider once you ‘stop working’ to have 1/3 in Super, 1/3 direct shares via LICs/ETFs and 1/3 Investment properties. This ratio is excluding your own home, you may include it if you wish. Each category will have pros and cons, subject to government policy changes and market conditions. We protect our investments within a Family Trust, allowing good income and capital gain distribution. Here is a simply summary of our strategy:
- (1/3) Shares (LICs or ETFs) will give you good returns easily accessible for early FIRE. I also like that they self manage and if I were to leave this earth, my wife and family wouldn’t need to do anything other than receive the growing dividend stream. We like the LICs which have low MER (~0.14-0.17%), fully franked and highly diversified. They have been around for over 40 years and performed around 8-10% over this time which is good enough for us. We have 5 and our strategy is to put roughly 1/5 into each of these LICs which is decided on our current portfolio weighting and their NTA discount (we use this report from FirstLinks). We try to do this every month or so or when every we have saved up to put more into them.
- (1/3) Super is perhaps the best tax effective retirement scheme, but you can’t access it until you are around 60 (depending on when you were born). We try to hit the maximum $25k per year (edit – now $27.5k) contribution allowed. Both ours are in high growth and exposed to 40% international shares. At this stage we can’t access it until we are 60 so it is our second stage FIRE funding.
- (1/3) Property Investing can be leveraged to give great long term returns. We used these early in out FIRE journey and aimed to get positive geared investments as much as possible. We leveraged off our own home with little or no deposit. Our strategy was to get highly scarce properties with huge rental demands. This provides upward pressure on the capital and rental growth and has proved to be a great strategy for us. The land to building ratio needs to be at least 50% to avoid buying a depreciating asset (land appreciate, building depreciate). Most people get these part wrong and you need to research well from good mentors. I read dozens of property investment books and spoke with wise mentors who were very sucessful in this area before starting. When we retire we may sell some as the capital gains can be absorbed better when I’m not working. We will then pay off debt and put into shares (LICs/ETFs).
Our thinking is by having a 1/3 in each category, it takes advantage of each investment vehicle, but minimises a disaster when a market crashes or a new government policy is formed.
Thanks for reading and hope this helps during your research to hit FIRE!