Why I Use ETFs

I am not the only dividend investor on the internet. It turns out there are plenty more. Through Twitter alone I have found many other bloggers who blog about dividend investing, which I think is great because it allows us all to learn from each other.

What I have noticed from reading the blogs of other dividend investors is that most of them seem to invest in individual stocks, and lots of them. They may hold shares in thousands of different companies.

Most of these bloggers give monthly updates where they break down how much they receive from each share. Most even go further and report on how much they spend. They divide their spending into categories such as groceries, mortgage payment, repairs on the house, gas bills, etc.

I thought for a second maybe I should do the same, but honestly I don’t really know how much I spend, and I don’t really know how I spend it.

I also personally don’t think it’s necessary to record everything you spend down to such a minute detail. It may be great to know that for one month you spent $500 on groceries but more important than knowing what you’re spending money on is knowing how much you’re spending overall.

I believe in keeping things simple, and for saving money I recommend the David Bach recommendation, which is “pay yourself first.”

In other words, talk to HR and have them send, say, 20% of your salary into your normal bank account and then set up another bank account where 80% of your salary goes. For the bank account that gets 80% of your salary, leave it alone. Let the cash accumulate. Meanwhile, try to simply live off the money in the bank account with 20% of your salary coming into it.

By doing this, you don’t need to worry about calculating whether you have spent $x on entertainment or $y on groceries. You just know that you’re spending 20% (or whatever percentage suits you). At the end of the day, it’s how much you spend that matters, not what you spend it on.

Every once in a while, access the money in the bank account where 80% of your salary is going and then use that money to buy ETFs.

Why ETFs? Why not research and buy stocks in companies that pay high dividends?

Personally, I believe it’s much easier to invest in ETFs. There are many ETFs in the market dedicated to paying high income. These are the ETFs I recommend for dividend investors. You could do your own work, but it’s much easier to let a fund manager do the work for you and let him or her take a small fee.

In Australia, there are actively managed ETFs that use options and futures to generate more income and to manage risk by lowering volatility.

Many people believe that low cost index funds are best, and I used to believe the same, but I have noticed over time that low cost passive index funds simply don’t produce much income.

It is certainly more risky to invest in an actively managed ETF because you are relying on the skills of the fund manager, but this problem is easily fixed by simply diversifying across different income-focused actively managed ETFs.

Most importantly, I believe in keeping things simple. We don’t need to make things complicated. Having your savings automated and then simply investing your savings in high-yield ETFs is a very simple plan that allow you to build passive income from dividends without much effort. All you need to do is stay employed and maintain your 80% savings rate.

This is exactly what I did. I aimed for an 80% savings rate. However, when I started working I invested in normal Vanguard low cost index funds but was disappointed in the sporadic and low income I got, so I slowly started to put money into funds that were more tailored for income investors.

Over time, I noticed that I had enough money coming in from my investments to cover my living costs, so I instructed HR to send 100% of my salary to the bank account earmarked for savings. All my investment income is send to my normal transaction account for spending. I am therefore literally living off dividends. Hence the name of this blog. All my salary is invested and all the income from investments is spent.

Why live like this? Simply, if you learn to live off dividends, you condition your mind to live a standard of living that can be maintained even of you lose your job. This means that regardless of whether you work or not, your standard of living is exactly the same. Your life is unaffected by work, which means you don’t need to worry too much about sucking up to the manager. This takes away a lot of stress.

Most people, if they start earning more, automatically start spending more. They’ll let the money get to their head, think they deserve to spend more because they earn more, and then they become addicted to the spending and must therefore keep working, even if their enthusiasm for the job wanes over time.

If you live off dividends, you have the freedom to quit or move jobs, or take time off work to pursue other opportunities, knowing that you are capable of simply living off your investments because that’s what you’ve even doing for many years.

The Problem with Index Funds and Superannuation

Work has been tough for me, and when I talk to people about it (that is, complain and whine about it), they either tell me to just quit or to endure it because “that’s the way it is.”

I would love to quit and retire right now in my early thirties, but I don’t feel like I have enough passive income. Passive income is a great measure of how much freedom you have. When I was younger, I set myself a goal of producing $1000 per month in passive income (mainly from dividends from shares), and I achieved that about half a year ago.

When I was very young, I was investing in boring and ordinary low-cost index funds. I also in eating in a few direct shares here and there. If you read any personal finance blog nowadays (e.g. Mister Money Mustache), this is the advice they give you: invest in a wide range of low-cost index funds. Most of these people invest with Vanguard. Many mainstream personal finance bloggers also advise you to put your money into tax sheltered retirement accounts. As many of these people are American, the advice is to plow as much of your salary into 401(k) and IRA accounts. In Australia, we have retirement accounts as well. Everyone who works has what is called a superannuation fund (or super fund). Employers must by law put in 9% of an employee’s salary into this fund. Employees can then elect to salary sacrifice a portion of his salary into the super fund in order to save on tax as any income going into a super fund is taxed at 15% rather than whatever a person’s marginal income tax rate it (usually 30%).

So I have been following this advice. I have invested in low-cost index funds and I have plowed a lot of my salary into retirement accounts. However, about six months ago, when my passive income reached $1000 per month, I decided to change plans.

The problem is that most mainstream low-cost index funds do not pay much passive income. For example, the ETF issued by Vanguard Australia that invests in the US (Vanguard Total Stock Market ETF) has a very impressive management cost of 0.05% per annum (extremely low) but has a dividend indicated gross yield of 1.87% according to Bloomberg. Furthermore, superannuation funds lock up your money until you are around 65 (i.e. too long). It is clear then that if you are investing in low-cost index funds and plowing your salary into retirement accounts, your passive income will grow, but it will not grow much, and because passive income is the key to freedom, I needed to make a change.

It should be noted that superannuation laws are very strict in Australia. As far as I am concerned (and I am very happy to be corrected) it is virtually impossible for anyone to have access to his super until he is 65 (i.e. very old). In the US, intelligent bloggers have found loopholes that allow them to access their retirement accounts early (see these blog posts by the Mad Fientist:¬†Roth IRA Horse Race and Retire Even Earlier). The only arrangement that comes even close in Australia is the “transition to retirement” plan where you can take out money from super to top up any existing income if you take it out as an income stream. However, you need to be around 55 to 60 to be eligible for this.

Salary sacrificing into superannuation is definitely helping me build wealth, but this wealth could only be accessed far into the future, which meant that I had to wait until I was really old before I can be rich. I was building up too much future wealth while sacrificing present freedom. I started to realize all this when circumstances at work became difficult. Basically I had been saving up hard for about seven years but only had a passive income of about $1000 per month. I realized that most of my money was locked up in super as well as low-yielding investments.

My plan now is to take a hit with taxes, pay more, but focus on investing in funds that pay double-digit (over 10%) yield. Once I get about $4000 per month in passive income, I plan to quit my job and focus on trying to find a way to make money online. I am tired of working for a manager.

Don’t Aspire to Buy and Live in Your Own Home

There is much talk of a housing affordability crisis in Australia. Average house prices in Melbourne and Sydney are reaching $600,000 or even more.

However, for young people looking to buy a house, my recommendation is that you do not buy.

Instead, go to your parents and negotiate with them an arrangement whereby you pay, say, $300 per month to live with them. Depending on how nice your parents are, they may even allow you to live with them for free.

If this is not an option, try to arrange to share a house with other people.

If you do buy a house, consider ways you can offset the burden of a big mortgage, such as renting out spare rooms.

I know a friend who, after purchasing a house, decided to renovate the garage so it was liveable. He lived in his garage and rented out the rest of the house. The rent was pretty much able to cover the mortgage repayments, which meant he was able to pay off the mortgage in about six years.

I have lived with my parents for the past five years and have been able to save up about $60k per year. After five years that adds up to about $300k, but rather than invest in property, I prefer to invest in shares, index funds, and managed funds. Nevertheless, shares have gone up in value in the last five or six years, and my net worth has increased at a rate of about $100k per year, which gives a net worth of about $500k now.

It doesn’t matter whether you invest in shares or property. Both are good investments. However, I believe shares are better because they usually make more money and because you generally pay less tax (although this depends on which country you live in).

To sum up, try to live with your parents. If you rent, try to rent with others. If you buy, rent out the rooms. Any of these three strategies frees up money to allow you to invest. You’re not really investing much if so much of what you earn goes towards paying interest, which is the situation most people have when they take out a massive mortgage to buy their dream home. It is true that rent money is dead money, but interest is also dead money.

The main benefit of real estate as an investment is the ability to borrow money to invest. If you are able to borrow more money, you have more assets exposed to the market, which means returns are higher. However, this can be achieved via index funds or shares simply by getting a margin loan (i.e. borrowing to invest) and/or investing in internally leveraged ETFs (i.e. investing in a fund that borrows to invest).

Note that just because you can use debt to make more money, it doesn’t mean you should. Borrowing to invest can be profitable, but there are many assumptions you are making about interest rates and returns. With leveraged ETFs, fund managers usually use dividends to pay off their own debt, which means the investment produces very little income. Furthermore, when you borrow to invest, you usually need to make regular monthly repayments. These regular monthly repayments diminish the value you get from any passive income you may receive from dividends or rent. Debt is anti-passive income and therefore anti-freedom.¬†Borrowing money from the bank makes you are slave to the bank.

There is a myth pervasive in Australia and many other countries that renters are second class citizens who must aspire to own a home because owning a home makes money. This is a lie. What matters is how fast your net worth increases. Most people who buy a home have such massive mortgages with huge interest repayments that their net worth increases very slowly because any progress made when the price of the house goes up is quickly lost when they have to pay interest. Their net worth would have grown faster if they had rented a cheap place and socked the saved money into index funds.

It is not just interest. Buying a house is also associated with massive fees to accountants, real estate agents, and lawyers, as well as huge taxes (such as stamp duty in Australia). All these bring down the growth of your net worth, often by more than people expect.

When most people at my work “invest” in property, I never hear them talk about the rate of growth of net worth, rental yields, or variability of prices. They seem more keen to talk about how nice the patio is, whether the kitchen has a granite bench, and whether it has period styling. All this is bling that distracts them from the massive expenses associated with property.

Don’t bother buying a house. They are clunky massive assets that are taxed heavily and usually produce little returns. They tie you to one place and stifle your movements.

The Dismal Future of the Australian Economy

gold price vs asx200 27 august 2015
GOLD vs the ASX200 (Commsec)

The recent volatility in stock markets has gotten me worried. Everyone keeps telling me to relax because “economic fundamentals are sound,” but when I ask them to explain how this is true, it’s revealed that they don’t really know what they’re talking about. It seems that most people just hope for the best and rationalize away bad news.

The Chinese stock market is certainly wobbly. Some say the Chinese economy is very healthy. After all, they have low debt and a massive foreign exchange reserve. They are the biggest lender nation in the world with the USA the biggest creditor nation. However, we don’t really know much about the true size of China’s debt because there is significant activity in the underground economy that is not transparent, and I’m not too confident in official figures provided by the Chinese government. Of course, China has been manufacturing products from t-shirts to smartphones, but the government has in recent years been intervening in the economy to prop up the stock and property markets. It’s uncertain whether these distortions can be held together by the government or whether the market will eventually strike back.

America has resorted to printing money, which has resulted in surges in the stock and bond markets. However, unemployment is still high and wage growth is low. Printing money doesn’t seem to have done anything other than make the holders of stocks and bonds wealthy (these are mostly wealthy people anyway).

In Australia, our economy used to be dominated by two sectors: the banks and the miners. The miners dug resources from the ground and shipped them to China. China makes goods and ships them to US consumer who buys these goods.

But the American consumer (or consumers from any other developed country) is not buying as much as they did before the GFC. This means China is slowing down, the price of resources is dropping, and the mining sector in Australia is getting crushed. We only have the banks left, and how do they make money? The balance sheets of Australian banks is mostly in loans to consumers who buy real estate. Real estate prices have been going up thanks to profits from mining. In other words, banks do well because house prices have been sustained by profits from the resources sector. Now that mining is dead, what will sustain us? Where are our strong fundamentals? House prices only go up with people buy houses, but to buy houses you need to make money in the first place. You can’t make money from houses without putting money into it in the first place.

Many who have bought stocks have made great wealth from quantitative easing, but now that tears are emerging in a bubbling world economy held together by printed money, it’s time to look at investing in gold.

Gold tends to shoot up significantly when stocks tumble, and when stocks go down, gold tends to go sideways or go up anyway, so there doesn’t seem to be any downside to investing in gold.

Personally, I will be buying this shiny metal from now on.

Reduce Spending vs Increase Income

I currently aim to save 85% of my after-tax pay (as recommended by Early Retirement Extreme). I try not to tell too many people in real life about my high savings rate, but back in the days when I was more naive, I’d talk about my savings rate all the time, and one common response I hear is the recommendation that I should be focusing on increasing income rather than reducing spending.

My response to this recommendation is: why not do both? Why not increase income and reduce spending at the same time? Why assume that you can only do one or the other?

While I recommend increasing income and reducing spending at the same time, I recommend you put more effort into whatever gives the biggest bang for your buck. In other words, do what gives the greatest return on effort.

For example, when I graduated from university and started working, I was earning only $40,000, and four years later that has approximately doubled. I have received only one promotion. I am on a fixed salary with zero bonuses. I get paid the same amount regardless of my performance. I don’t consider this to be spectacular, but I have been saving approximately 80% to 85% during that time, and adding my salary plus my passive income from investments, my total income today puts me into a higher tax bracket whereby I pay approximately 40% on income tax. In other words, due to progressive income taxation, higher income is rewarded with higher taxes. I am a big fan of progressive income taxation mainly because it earns government significantly high tax revenues while also reducing the gap between rich or poor, but there is no disputing that for some people progressive income taxation reduces the incentive to work hard because once you are at a certain income, effort is not sufficiently rewarded.

This is why I prefer to save. Saving is easy. One very easy way to save money is to automate. For example, talk to HR and ask them to send 85% of your income into a separate savings account. All this will take about one hour. Assuming you earn an average salary of $50,000 and pay zero tax, you will be saving $42,500 per year. In other words, one hour of work will give you are return of $42,500.

Now suppose I were to try to increase my income. I’d have to search for jobs, catalogue my skills and achievements, update my resume, write a CV, talk to referees, apply for the job, talk to the relevant contact at the firm, practice for the interview, go to the interview, and follow up after the interview. All this will take maybe 50 hours and even then there is no guarantee I’ll get this job, and even if I do, the increase in salary is only about $10,000, and that is not counting taxation.

Which gives the better bang for your buck: one hour of work yielding $42,500 or 50 hours or work yielding $10,000? This is extreme example, but I think it illustrates my point.

Everyone is different. For those working in jobs that pay performance bonuses (e.g. real estate agents), a structure is in place that rewards hard work, so there is no question that you should be working hard at achieving these performance targets. Furthermore, while automatically saving 85% of income is easy for some, if your circumstances are such that you must spend a lot (e.g. you have a mortgage, children, or expensive housewife) then you may have no choice but to focus on increasing income rather than reduce spending.

The bottom line is that is does not matter whether you make money by making money or saving money (“a penny saved is a penny earned”). What matters is that you devote your limited time and efforts to whichever area provides the greatest return.

Thoughts on “Early Retirement Extreme”

I love listening to podcasts when I’m driving, exercising, or stretching. It’s free education and entertainment. A recent podcast I’ve listened to that I feel I need to write about is one on the Survival Podcast featuring Jack Spirko interviewing Jacob Fisker of Early Retirement Extreme.

I have always been fans of both Jack Spirko and Jacob Fisker, so having these two together in a podcast is brilliant. Basically, Spirko is a “modern survivalist” who works to set up a homestead in the country where he can take refuge in if there is ever some disaster scenario. He focuses on self-reliance, independence, frugality, and being prepared. Even if nothing happens, it doesn’t hurt to be prepared.

Jacob Fisker of ERE, on the other hand, is different. Whereas Jack Spirko works outside the system (or “off the grid”) in order to free himself from it, ERE is about using the system to your advantage, i.e. applying capitalism to achieve freedom (or as the ERE website sometimes says, taking advantage of “rentier capitalism”).

Fisker’s story is remarkable. He takes retirement to the absolute extreme. Mainstream retirement advice is that you save up 5% or 10% of your income and then over forty years or so, assuming some wildly optimistic rate of return and then harnessing the power of compound interest, you will retire when you are incredibly old and frail with an income that is about $50,000 a year.

ERE, in a nutshell, states that you save up to 85% of your income and then retire within five years. Because you are saving up in five years, compound interest does not matter. What is remarkable about Fisker is that he was able to retire at age 33 after saving 85% of his income with an income of only $25,000. He achieved this by e.g. not having a car and walking to work (walking about five miles back and forth).

Suppose the typical person earns $50,000, and assuming zero taxation (for simplicity), then in five years, assuming you save up 85% and assuming zero rate of return on your savings (again for simplicity), you’d have a little over $200,000 saved up. Assuming a rate of return of 5% on the savings if invested in a mixture of cash, bonds, stocks, REITs, etc, you’d be earning about $10,000 per year or about $800 per month.

Can you live off $800 per month? In a country like Australia or even the United States, I think it’s highly unlikely. Maybe you can buy a place in the country and scrape by, but I’m not too sure.

However, in a country like Thailand, $800 per month is more than enough.

JC of Retire Cheap Asia is a retirement consultant who lives in Thailand. He advises expats from America and other developed countries on how to retire in Thailand. According to him, the minimum amount you need to survive in Thailand is $500 per month. At $500 per month, you live a very rough and bare life. However, if you have $1000 per month, you live a life of luxury. An income of $800 per month achieved through five years of Early Retirement Extreme would afford you a comfortable existence in Thailand (see Retire Cheap Asia Retirement Income Categories). This applies not just to Thailand but other countries like Cambodia, Philippines, and maybe even Belize and many others.