Category: Investing

I love the idea of passive income.  Some magic is performed, and a steady stream of money comes into your life every month.  A Google search on this site with the term “passive income” turns up 55 hits, so its definitely a popular topic.  As much as I think passive investing in index funds is pretty tough to beat, real estate and dividend paying blue chip stocks that offer regular cash payments are pretty enticing.

Mike has made the point that there isn’t a big difference between being sent some money every month or redeeming a small portion of a stock portfolio as needed.

People will sometimes suggest things like writing a book or writing a song as a way to generate royalties which becomes a “passive” income stream.  While collecting the royalty checks is passive and easy, writing a book sure wouldn’t be (especially if it was any good).  Taking a risk that the public will like your work, investing all the labour upfront, then getting paid out over time seems like reasonable trade-offs for the income stream.  Why is this better than working hard at a 9-5 job and collecting a check for your efforts?  Both seem like reasonable compensation for the amount of work, risk and delay of payment involved.

Often passive income streams are proposed that aren’t very passive, such as real estate or starting a business.  I don’t buy the suggestion that a property management company or hiring employees will make these totally passive.  I’d say with either of these options you’re sacrificing income to DECREASE the amount of labour you need to invest (which is ok, but its just a trade off like any other, nothing magical).  If you turn over the company ENTIRELY to other people to run, I think you’re sending your risk into low Earth orbit.

Paul Graham proposes the idea that startup companies condense a lifetime worth of labour into a couple of years (and pay accordingly). While this isn’t a passive investment (usually founders sell their company and walk away with a big check rather than getting monthly payments for life), it does seem like a reasonable way to spend a couple of years if you have a good idea and are confident in your ability to build a company that could be sold.  It would be possible to live off the the proceeds of the sale for the rest of your life.  Similarly someone could sell the rights to a book or song, and then live off that money.  How is this getting paid upfront worse than an income stream?

GICs (or CDs for our American readers) pay money over time, but these are rarely recommended as a passive investment.  The higher returns from what is usually considered passive income seem to me to mostly be a risk premium.

Choosing the right combination of length and amount of investment, amount of risk tolerated and labour invested seems to me to be considerations all investors make, from Donald Trump to whether you want to work at the McDonald’s or at your friends new car detailing business.

Is there an important aspect of passive investing or income streams that I’m missing?

There’s a lot of fear about the stock market right now.  As Mike wrote recently, we’re in a bear market.  You read about people who are upset, people who are excited, and people who don’t seem to care.

What is the right reaction?

I think all three are the right reaction.  Which one is right for you depends on who you are and where you are in life.

The sky is falling, panic!

I think this might be a reasonable reaction for someone who just retired, or was expecting to retire soon.  If your finances are RIGHT at the border of maintaining an acceptable lifestyle, this downturn has hit at the worst possible time for you.

Since you’re still fairly young, it might be reasonable to consider coming out of retirement or delaying retirement (yeah, I know it sucks – desperate times and all that).  If you can leave your portfolio alone (and maybe keep adding to it) for a couple of years, you’ll probably be in a much better place to start / continue your retirement with a bit more of a cushion.

Its too late to sell (the market has already dropped), but if the drop has made it that you can’t live off of a 4% withdrawal from your savings, it’d be better to reassess your situation sooner than later.

Start Spending Like a Drunken Sailor

The Warren Buffett approach views now as a great time to build or add to a portfolio at discounted prices.  If you aren’t currently investing in stocks, now might be a great time to consider setting up something like the couch potato portfolio, or the Vanguard Global Stock Index Fund.  My brother has been making weekly contributions to the TD International Index (diversified international index fund with a reasonably low MER – 0.5%).  Its down 41% YTD, but I think he’s going to come through this smelling like roses.  Some people (like Buffett) have been stockpiling cash, looking to try to find (and buy) the bottom, but I think regular, consistent buying through this will look like a pretty savvy strategy in hindsight.  Some might argue that increasing your contributions right now amounts to market timing, but I think this would be a reasonably good idea (if you have any extra cash).

This might be the ideal outlook for someone who is putting away money they won’t need for at least a decade (such as retirement funds).

What Market Downturn?

If your not willing to invest in the stock market (or you don’t have any money to add to your position, like some grubby grad students we all know), the whole situation is pretty irrelevant to you (feel free to ignore the headlines and carry on with your life).  They’re talking about recession, but chances are if you have a stable job that you’re good at, it won’t make much of a difference in your life.

This would also probably be the case for someone who is well into retirement.  The downturn sucks (a 40% drop could really hurt), but HOPEFULLY you’ve got the necessities of life covered by fixed-income or annuities.  If it’s your heirs that will be hurt by the downturn, let them deal with it and get back to enjoying Matlock.

Wrong Response for You

I was talking to a friend recently and she was worried about the market, and thinking she should stop her bi-weekly retirement contributions (she’s about 30 years away from retirement).  Panicking (and getting out of the market) would be totally the wrong decision for her.  She has time on her side to see a recovery (and probably multiple more bull and bear markets) until her retirement.

Similarly, if someone was recently retired and decided to try and take advantage of the market downturn, I think they might be behaving a bit foolishly.  Things might still get worse, or might not improve for an extended period, and if you’re not working you definitely want to protect the lifestyle you have.  A friend of my father’s mortgaged his paid off house to buy Nortel stocks during the dot-com boom and had to come out of retirement after the crash.  Not fun.

The markets have not done well lately….the TSX in particular has gone down from around 15,000 points down to a bit less than 10,000 points as I wrote this (one week ago).  Hopefully there will be some stunning rallies and we will all get a good laugh out of this outdated post!

I have to admit I’m handling the market drops much better than back in 2001 when I was switching out of equities – only to miss out on some of the increase which followed.  However my dog-eared copy of Four Pillars of Investing – “Stay invested in equities” – is now getting a bit drooled on since I’ve taken to sleeping with it under my pillow.  Bernstein’s wonderful book is the best way to put things in perspective – there have been much bigger drops than we have experienced and the market has always come back.  Also – it’s too late to do anything if you are still invested – just ride it out.

Another idea I’ve heard around the blogosphere is that now is a good time to buy.  While I don’t think that stocks are necessarily cheap (were internet stocks “cheap” in 2002?), the investment gods all say to buy when things look their darkest.  Problem is that it has been dark for a while – will it get worse?  Who knows?  But the markets will come back – it just might take a while.

For those of us who are fully invested or just don’t want to buy anything right now – keep in mind that not selling is the same as buying.  Not selling right now is a vote of confidence for your inability to time the market which nobody can do accurately over the long haul.

Are we there yet?  The week before last, the TSX dropped 11%, last week it dropped 16%.  Oddly enough on Friday I was expecting the worst day so far since the Asian markets had crashed about 8% and the Japanese market had dropped almost 10% overnight.  When the TSX went down 5.5% I felt oddly relieved since I was expecting more.  5.5% drop in one day and I thought that was acceptable!  Yes, this is a bear market – not one of those cute and cuddly, babyish, koala bear type of markets where maybe you lose part of a year’s gain, but rather a far more vicious, huge grizzly bear that is intent on ripping out your insides until you sell what is left of your holdings.

I haven’t had the courage to actually see how much damage has been done to our portfolios, however I know that it won’t be as bad as the actual market declines for the following reasons:

• We aren’t 100% invested in stocks – We started the year with 75% equities and 25% fixed income.  Now partway through the year I did switch some of the bonds to REITs – which have done ok, but not great.  Part of the bonds were real return bonds (known as Treasury inflation-protected securities in the US) which apparently haven’t done all that well for some reason.  Regardless, having any kind of non-equity investment in your portfolio will reduce the decline in a bad market.
• Some of the portfolio is temporarily in cash – As I discussed a few weeks ago, we are moving our accounts to RBC to take advantage of the 1% bonus offer.  Since my wife’s accounts were invested in mutual funds, they were all sold about 2 weeks ago and the transfer was done in cash.  This was done because we wanted to convert her holdings into ETFs.  I checked on the weekend and the funds that she had been holding were down about 20% in the last two weeks.  Her investments represent about 1 third of our total investments so this cash holding will really help out.  The hard part of course is pulling the trigger to buy – that might take some courage!  I’d like to say this was the result of some brilliant market timing but of course – it was sheer luck!  Of course the falling dollar isn’t helping since all the cash is in Canadian dollars but what can you do?

Note [added Monday, Oct 13] – the various markets have all gone up some astonishing amounts so it looks like we should see a rebound in the Canadian market today.

I’ve had this post bouncing around in my head for a while. It would have been far more valuable to post it before Oct 7th: some of the ideas may be obvious in hindsight now.

Dividend investors love seeing a long history of uninterrupted dividend payments (ideally growing steadily as well). Often we’ll trot out the idea that “Bank of America (BAC) has been paying dividends steadily since 1903” or “Bank of Montreal (BMO) is the longest-running dividend-paying company in Canada, having been paying a dividend since 1829”.

The reasoning goes, if BMO has paid a dividend for 179 years, through the great depression and 2 world wars, why would it stop today? In answer to that question, Bank of America cut its dividend in half yesterday (back in June MoneyGardener asserted that BAC was priced for a dividend cut, my hat’s off to him for his prediction).

What does 105 or 179 years of dividends really tell us? Clearly no one who was involved with the company when they started paying a dividend is still there. Without a doubt, the companies have changed in major ways over the years. What does their history really tell us?

From one perspective, Bank of America disappeared as a company in 1997 when it was acquired by NationsBank.  NationsBank decided to use the BAC name, but it was really the stronger company.  Perhaps we should view Bank of America as a re-branding of NationsBank, and from that perspective its recent acquisitions of Countrywide Financial and Merrill Lynch make sense.  Perhaps BAC (née NationsBank) is now good at acquiring companies, not at paying a regular and increasing dividend?

The counter-argument is that investors value stability and predictability with companies, and NationsBank adopted the BAC identity to offer that.  By undermining it now, they’re undermining a big part of what they bought from BAC.  There have been cases where stock prices GO UP after bad news is announced, as investors are reassured to know what the problem actually is instead of the rumors that have been floating around.  For any company that is a long term dividend payer, maintaining that reputation has value.  Yesterday BAC kicked itself off of the dividend aristocrats AND the dividend achievers (and, worse, greatly annoyed Mr. Cheap).  I suspect in years to come, they’ll be the cautionary tale to anyone focusing on a blue-chip dividend strategy (Mike and the Canadian Capitalist have always been good at warning that no dividend is guaranteed).  What is the cost to the company of ending its incredible dividend payment history?

BAC made some interesting decisions recently, which we’ll only be able to evaluate from a historical perspective.  They picked up a couple of great companies dirt cheap, but did so by snatching money out of their shareholders’ pockets.  In addition to cutting our dividend, they’ve also diluted our ownership in the company by issuing $10 billion dollars of new common shares (much as GE has also done with Warren Buffett’s recent sweetheart deal – where can I get a deal like he did?).

Only time will tell if the acquisitions were worth kicking shareholders between the legs.

For any BAC shareholders, what are your plans with your stock?  Have you already sold?  Planning to?  My intention is to wait 6 months, let BAC shake off some of the stigma of their dividend cut, then sell it (it doesn’t fit the type of company I want to own anymore).  If it gets some good news and surges close to my average cost, $35.90, before 6 months is up, I’ll take it as an opportunity to dump it).

What, me worry?  Yes, of course I’m worried – it’s tough to watch the markets fall and hear about how the American credit market is seized up without wondering if we edging too close to the end of civilization as we know it.  I was quite surprised when the “Great American Bailout” vote didn’t pass on Monday although given that Bush seemed to be one of the main spokespersons in favour of the bailout, maybe I shouldn’t have been.  Couldn’t they have found someone/anyone more palatable (Palinable?) to the American public for that role?

Anyways, the markets are in turmoil and as Mr. Cheap pointed out yesterday, now is not the time to panic with your equities.  He also pointed out that maybe you shouldn’t watch the markets at all.  If you are having trouble dealing with these crazy markets then take his advice.  If you really want to worry about something then worry about something important – for most people who aren’t planning to retire anytime soon – your career is your biggest asset! As long as you have your job, then you can pay the bills, mortgage and put food on your table which is the top priority.  That’s right – your retirement savings could disappear overnight and your day to day life won’t change a bit.  Ok, if that happened you might want to do some retirement planning and maybe kick up the savings a bit but your lifestyle will only change if you want it to.  If you lose your job and can’t find something equivalent then you are screwed – it will be impossible to keep up with the same lifestyle.  In that case, you will have to cut back somewhere – either your expenses or your early retirement dreams or both.

I’m at a point where I have a half decent sized retirement account and I would probably weep uncontrollably for days if it disappeared…however, the reality is that given the choice between losing my career or losing my retirement savings – I would choose to keep the career.

Bottom line is – focus your worries on the things that are most important – your career is far more important than your retirement savings so when the markets are tanking – just enjoy your commute to work.

One of the most basic of stock buying strategies is to buy low and sell high.  It makes absolute mathematical sense, but the difficulty is the execution.  Psychology works against us: when markets are high there’s a euphoria that makes it very easy to join in with the herd and buy high.  Conversely, when markets are low, it can seem like the world is ending and it makes it easy to sell low.  Both temptations will undermine your long term investment returns.

Years ago when the dot-com bubble burst I was tangled up with all the standard greed-driven tech stocks (JDS Uniphase et al.).  About 2 months after the burst, I was talking to my broker in New York (I’d never pay for a broker again!).  He told me that everyone says buy low, sell high, but no one does it.  This is the time to buy low he assured me and tried to get me to put more money into the market.

I agreed with his philosophy, and told him so, but at the time I wasn’t working and was gearing up to go back to school so I just didn’t have any extra cash.  It was lucky for me that I didn’t, as things kept going down further and further.  Part of the scary part of bear markets is that no one knows where the bottom is.
Some people decide to sell, thinking they’re being wise to move into a cash position.  They stay in cash and miss the rally, and end up having to pay top dollar to buy back stocks later on.

Its scary times right now, with the TSX dropping 840 points yesterday.  If you get out now though, you’re buying high and selling low, which is probably not a great idea.  Some people will say they need their money and they can’t risk any more loses.  I’m sympathetic to this view, but if this is the case, they never should have had so much invested in equities to begin with.

If its not that you need the money, but just that you can’t stand the thought of losing any more, it might be worth considering leaving your stock alone, stop reading about the market, and let it play itself out.  They say a rise in stock price isn’t a valid reason to buy, and a drop in stock price isn’t a reason to sell, so make sure if you’re thinking about selling, you have reasons beyond the recent volatility.

Personal finance bloggers have been saying that evaluating your reaction to the current market tells you how risk averse you are.  If you’re panicking right now, in the future it’s probably best to keep a large fixed-income portion in your portfolio and stay very diversified.  If you’re able to ride this out without getting too excited, you’re probably a more risk-tolerant investor.

Have you sold stock recently?  Bought?  Stood pat?

As most readers know I’m pretty big on low cost investing – it’s one thing to talk about it – how about some actual suggestions on how to do it!!

1. Save on taxes – Investing in a taxable account when you have tax free retirement accounts available is costing you money.  Max the rrsp/401(k)/roth accounts first!
2. Save on taxes part II – If you have both taxable accounts and non-taxable accounts then make sure you have the less tax efficient investments (ie bonds) in the non-taxable accounts.
3. Merge accounts – If you are paying annual account fees then it doesn’t make sense to have multiple accounts with the same account type (ie RRSP).  Get organized and streamline.  This also applies to bank accounts.
4. Buy ETFs and index funds instead of managed funds – They are much cheaper and do the job better.  Do this at a discount broker.
5. Lower MERs are better – If you have to buy managed mutual funds then keep an eye on the costs and returns – lower costs are better.   Monitor the returns – are the high-priced funds outperforming a passive alternative?
6. Pay the lowest trading fees possible – There is no benefit to paying higher costs.
7. Trade as little as possible – If you can’t conclusively show that your trading increases the return then don’t do it.  Each trade costs money so less is better.
8. Don’t invest so much – the less investments you have, the less your costs will be – pay off debts instead.  It also doesn’t hurt to live a little once in a while.

There you have it – follow some or all of those rules and you’ll be just fine!   Do you have any suggestions to lower investment costs??  Can you come up with the 9th way to lower costs?