Measure Your Investing Success By Your Annual Passive Income
You May Miss Out on Some Good Investments But the Trade-Off Can Be Worth It
Over the past fifteen years, we have talked a lot about passive income. For the uninitiated, passive income refers to the money you earn from sources like dividends, interest, and rents. It is the money that your money earns for you; that gets deposited in your family's bank account or CCDA whether or not you get out of bed in the morning. The ultimate goal of most investors is to generate enough passive income that they can live a comfortable life upon retirement when they are no longer able to earn a paycheck.
For more information, here are 4 Things To Look For In a Passive Income Stream.
When building an investment portfolio, one trick you can use to stay the course and get rich is to measure your success by the total amount of passive income your portfolio generates in cold, hard cash each year. Following this philosophy seems to work for people because it is simple and you can see tangible proof of your progress as checks are sent to you in the mail or directly deposited into your bank account.
An Example of Using Passive Income As Your Measuring Stick
Imagine you have $10,000.00 in savings that you want to invest for the long-term. You decide to buy 500 shares of General Electric at $20.00 per share. Let's say, the current dividend is 17¢ per quarter. That is, every 90 days, you would get a check for $85.00. If you have the money directly deposited, at the end of the year, you'd have $340.00 in cash sitting in the account.
Next year, you save an additional $10,000.00. You add the $340.00 in cash from your General Electric dividend, giving you $10,340.00 in fresh cash. This time, you want to diversify so you buy 159 shares of Johnson & Johnson at just under $65.00 per share. Let's say their annual dividend is $2.44 per share.
At the end of the second year, you are now generating $340.00 in passive income from your General Electric dividends and $387.96 in passive income from your Johnson & Johnson dividends for a grand total of $727.96. You ignore the fluctuations of the stock market entirely, focusing on one thing and one thing only: Whether you can get that passive income figure to grow faster than inflation as the years pass. You think like a long-term business owner, not a speculator.
A Good Passive Income Portfolio Grows With Time
One of the hallmark traits of a good passive income portfolio is that the cash generators it holds, whether they are stocks, real estate, equity stakes in private businesses, intellectual property, mineral rights, or anything else you can imagine that throws off funds, grow each year so they are throwing off more money than they were the prior year. It is important that the growth rate in cash distributions exceed the inflation rate so your household income is always expanding, giving you more capital to give away, reinvest, save, or spend.
Take the two stocks we mentioned. At the time I originally wrote this article, Johnson & Johnson increased its dividend for the 50th consecutive year. General Electric has increased its dividend several times in the past few years, too, although it still has not reached the level to which it had previously climbed prior to the Great Recession. A good company is one that is able and willing to constantly increase the dividend payout to its owners so they get ever-growing dividend checks because the underlying operations are somehow superior to the typical organization.
Think of a firm like Kraft Foods. No matter how hard someone tries, Oreo Cookies are probably always going to rank among the world's best-selling cookies. Think of Coca-Cola or Pepsi. No matter how much money you invest in a competitor, it will be virtually impossible to unseat the two soft drink giants from their perch atop the carbonated beverage category.
Likewise, a good real estate investment can support increasing the rent slightly in excess of inflation. You do not want to own struggling, hard businesses. Life is too short to go that route. Leave it for someone else. Your job is to make sure that you end each year with 1.) expanded ownership of great, high-quality businesses, and 2.) those assets are throwing off more cash than they were twelve months prior. Taken together, it isn't hard to build wealth if you have enough time.
Using the Passive Income Approach Can Help Protect You From Overpaying for Assets
The major advantage of focusing on annual passive income as a metric for success is that it can help protect you from overpaying, like the foolish Home Depot investors we discussed here. This is a function of basic math. As prices rise, cash yields fall. An investor focusing on increasing his passive income isn't going to find these low-yield investments nearly as attractive, providing a countervailing force as optimism sweeps the stock market or real estate market. He or she has inadvertently protected his or her family's investments.
The Biggest Danger for Passive Income Investing Is the Risk of Falling Into a Value Trap or Dividend Trap
One of the biggest risks for men and women focusing on passive income investing is falling into a so-called value trap or dividend trap. As a general rule, if an asset is yielding 3x, 4x, or greater than the 30-year United States Treasury bond, be wary. Most "cheap" assets are cheap for a reason. In today's world, if you see a dividend of 6%, 8%, 10%, 12% or greater, you are probably walking into one of these so-called traps. It might be a company that had a special one-time dividend from the sale of an asset, such as a subsidiary, or the settlement of a lawsuit that won't repeat.
It might be a pure play commodity business structured as a master limited partnership that had record earnings from high prices, which the market knows cannot be sustained. It could be a cyclical business displaying what value investors call the peak earnings trap.
In any event, be careful. Passive income investing can serve you well but don't get greedy and overreach for yield. As Benjamin Graham reminded us, more money has been lost by investors reaching for an extra half point of passive income than has been stolen at the barrel of a gun. He was right.