Suppose I buy a diversified portfolio of stocks hoping that over time they will increase in value so I can sell them. Until that happens, and I have consummated the sale, I have not made one thin dime. So, until that happens, I sit and I sweat. I worry about interest rates, the dollar, the economy, the possibility of terrorism. Everything is a potential boogie man lurking under the bed. No wonder investors are manic depressive!
Suppose instead I buy a portfolio that generates enough passive income, year after year, to pay all my bills and then some. Suddenly, interest rates, the dollar and geo-political events become much less scary because my standard of living is not at risk.
Now suppose we experience a ten year bear market. Both portfolios lose 80% of their value. The stock portfolio just sits there – dead – for ten years, doing nothing. It is not contributing to your well-being in any way. In fact, the opposite is true. You stress over it every day.
The income portfolio, on the other hand, is also down 80% in value but it continues to generate enough cash flow each year to pay all your bills, and then some. Which do you feel better about? Which causes the most anxiety? Which sounds like the better alternative for you and your family?
That is the power of a portfolio paycheck. It is the power to make your portfolio a source of comfort rather than a source of anxiety. It is the power to make work a choice rather than a necessity.
If an understanding of any two words has the power to change your financial situation, I believe it is income, or cash flow, versus capital appreciation. Let’s recap:
Capital appreciation is when you buy something for a dollar and hope it goes up to two dollars so you can sell it to someone else. The difference between what you bought it for and what you sold it for is known as capital appreciation. An example of capital appreciation investing is buying a piece of land in hopes that its value increases and you can sell it to someone else for more.
Income, or cash flow investing, is when you buy something for its ability to generate passive cash flow. Income investing is the farmer who buys the land, never intending to sell it, but buys it instead for its ability to grow crop that can then be sold for cash, over and over again.
In the past, we have thought of income investing primarily in terms of real estate (rental properties), bonds (coupon payments) and dividend paying stocks. Today, there are many more ways to safely generate portfolio income with much higher yields than what were available in the past.
I believe one of the reasons most of us are so stressed out by our investments is we have been taught to focus on capital appreciation investments instead of cash flow investments. Capital appreciation focuses on a number to gauge success – either account value, return percentage, or both. Income investing is focused on outcomes – can I live comfortably without fear of running out of money?
One of the biggest disservices done to investors was brain-washing them to believe that income investing is only appropriate as you approach retirement. Income investing is not only appropriate at all ages, I believe it is essential. Here’s why:
The biggest risk we face is not market risk. Our most valuable asset is what economists call our human capital. It is the skills and abilities we possess, which we trade in the form of employment, for money. Our biggest risk, therefore, is disability, losing our job or obsolescence.
There is no law that says you have to spend portfolio income. When you don’t need the income, because you have a W-2 paycheck coming in, you re-invest the income to create growth. But what a portfolio paycheck does for you that capital appreciation portfolios can’t, is it limits conversion risk.
Suppose you lose your job in your company’s most recent lay-off. Imagine that you are approaching retirement age and so you are finding it difficult to get a new job because no one wants to invest in training you only to have you retire a few years from now.
The good news is that you have saved a lot of money over the years and have invested it in stocks. The bad news is the market recently declined 50%. In order to live off that money, you have to sell those stocks at a depressed price. Once you convert the assets, the lost value can never be regained. That is what I refer to as conversion risk.
Now imagine, instead, that you had a portfolio of income producing investments that generated enough income to pay all your bills. While you were working, you just re-invested the income to get growth. Again, you are laid off and again the value of your portfolio is down 50%. But now, there is no need to convert assets and lock in the losses. You simply divert the income to your checking account and use it to pay the bills, leaving the assets intact. This allows you to participate in the long term growth of the stock market, which we all know doesn’t go up in a straight line, while at the same time protecting your standard of living.
Maybe, at that point, you decide to just hang it up and retire. You hadn’t planned on it, but the point is, you can – because a portfolio paycheck makes work a choice, not a necessity. When you decide to finally move on to the next phase of your life, there is no stressful reorganization of your assets. You already have the means in place to harvest the wealth you created. Whether the S&P is at 1000 or 1500 is no longer a consideration when you are deciding when to retire.
Modern Portfolio Theory, the most widely accepted investment theory, was developed in the 1950s. These are not the 1950s. Our parents and grandparents lived in a very different world. They went to work for a company and stayed there until they retired and got the gold watch. Today’s worker has changed jobs nine times by the age of 32! Pension? Social Security? Do you want to count on that? Not me!
Capital appreciation investing may have been appropriate when we our sources of income – both before retirement and after – were guaranteed. But today, if there is one thing I know to be true, there are no guarantees. That means it is up to you to create your source of permanent income that you can count on, both now, and in the future.
1. Elaine Chou. “Working Together to Build the 21st Century Workforce” Speeches by Secretary Elaine Chou, Department of Labor website; 15 Nov 2002.