The Myth Of Passive Income

I see a lot of people chasing the dream of passive income.

Like unicorns, the Tooth Fairy, and – sadly – Santa Claus, truly passive income does NOT exist!

The only true ‘set & forget’ passive income comes from sub-standard investments such as bonds, CD’s, mutual funds, dividend stocks, and the like.

All true income-producing investments require at least some work in selecting/maintaining the income source

e.g. Rental real-estate requires work to locate the best deals, then requires further work to locate and retain the best tenants, and requires even more work to maintain the property.

Of course, some of this can be outsourced to Realtors and property managers, but you cannot outsource your worry (e.g. if the property lies vacant and your mortgage payment falls due).

Even more, a business can never truly be passive: you will always have to worry about staff, clients, and finances.

Even if you hire staff to manage all of these areas for you, you will still have to oversee – and, worry about – them!

In my experience, the higher the return you expect, the less passive is your investment.

Why I don’t have a wealth manager …

madoffThere’s a debate going on at Quora (the question and answer site) about the cost of wealth managers:

What are the pros and cons of wealth managers vs passively investing in an index fund?

One of the issues is comparative fees:

– Index Funds typically charge 0.07% of funds under management.

– Wealth Managers typically charge 1.00% of assets under management.

So what do you get for the 14 times increase in fee?

Well, I wouldn’t know, because I wouldn’t go near a “wealth manager” with a barge pole …

… but, Scott Burns said it best:

40 years of investing has taught me that rented brains seldom help us build our nest eggs. Rented brains feel a deep spiritual need to build 20,000-square-foot log cabins in Jackson Hole with the return on our money.

It would be OK if that 14 times extra fee equated to extra returns, but the research shows that it really does only buy the wealth manager a good living – not us:

Eugene F. Fama and Kenneth R. French looked into this issue in their working paper titled, Luck versus Skill in the Cross Section of Mutual Fund Returns. Their study focused on U.S. equity mutual fund managers from 1984 to 2006. It’s no surprise that they found that in aggregate, actively-managed U.S. equity mutual funds performed below the market after costs. The big question they were trying answer was did the winning managers have skill or were they just lucky?

So, if you are prepared to read a few books and try a few things, then go ahead and try your own luck in the stock market … failing that, simply put your money into a low-cost index fund – a least, you’ll avoid the heavy management fees!

Transitioning to retirement …

withdrawal1You’re hard at work, trying to to reach Your Number, and you’ve cranked up your Perpetual Money Machine to make sure that you get there …

… now, there’s not much to do except work the plan.

So, let’s fast-forward a few years and think about what happens when you finally reach Your Number.

If you recall, you calculated your Number simply by:

Taking your Required Annual Living Expenses (which you adjusted for inflation) x 20.

Now, where did this Rule of 20 come from?

It is simply the same as withdrawing 5% from your Number each year.

Picture your Number as a pile of cash that you made by saving, investing, or even selling your real-estate and/or business portfolio, and now it is sitting safely in the bank as cash or CD’s, earning bank interest each year. The question is, how much can you safely withdraw each year to live off (like paying yourself a wage) so that you never run out of money?

When you are busy ‘working’ (be that on a job, in a business, or on your actively-managed investment portfolio) you will dream of nothing but having that pile of cash that equals Your Number just sitting there.

But, when you have that pile – hopefully, very large pile – of cash you will suddenly realize:

1. You have to pay taxes on the interest,

2. You have to beat inflation,

3. You have to spend some of your capital to live,

4. You have to survive market downturns.

You have to hope this money lasts as long as you do!

… all of a sudden, you have to be VERY protective of Your Number.

When you are working, you fear losing your job. When you start to invest, you fear losing some or all of your investments. When you start or buy a business, you fear closing down. The reality is that you can recover from any/all of these scenarios given a little extra time and work. But, if you lose Your Number, you have lost everything … and, the longer it takes to lose it, the less time/chance you have of recovering it.

So, a key question becomes: what is a SAFE percentage of Your Number to withdraw each year? Usually, a great place to start is by looking at what ‘the experts’ recommend …

Unfortunately, there is support out there for just about any annual % of Your Number (i.e. your retirement nest egg) that you may choose to spend, for example:

7% – Not so long ago, the financial services industry proposed spending as much as 7% of your portfolio each year in retirement.

6% – More recently, Paul Graangard wrote two books proposing a combined bond-laddering and stocks strategy that, he suggested, supported a spending rate as high as 6.6% of your portfolio each year.

5% – Investment funds routinely allow spending of 5% of the portion of their investment portfolios dedicated to simply keeping up with inflation. Indeed, my Rule of 20 appears to support this withdrawal rate, too.

4% – A large number of studies – probably, the most famous of which is the so-called Trinity Study – advocate spending up to 4% of your initial portfolio (ideally, 50% stocks and 50% bonds, rebalanced each year), which provides somewhere between a 90% and 100% certainty that your money will last at least 35 years.

3% –  A whole slew of new retirement planning tools (generally using a Monte Carlo approach to modelling tens, hundreds, or even thousands of potential economic scenarios) have been released over the last 4 or 5 years by the financial services industry, purporting to analyse hundreds of alternative economic scenarios to try and model what would happen to your retirement portfolio (i.e. simulating changes in interest rates, market booms and busts, etc.) to find the ideal ’safe’ withdrawal rate. A lot of these advocate very low withdrawal rates, typically in the 2.5% – 3.5% range.

2% – Some even advocate a totally ‘risk-free’ approach to retirement savings by investing close to 100% of your retirement portfolio in inflation-protected bonds (e.g. US Government Inflation-Protected Bonds – TIPS; Municipal Inflation-Protected Bonds – iMUNIs); historically, these have provided less than 2% return, after inflation but with total protection of your starting capital.

So, which is right?

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A new year’s resolution …

2 doorsThe New Year brings new choices … think of each choice or decision as two doors, and you have to choose one to step through.

Choose the wrong door and it seems you have changed the course of your life forever … but, will it change for the better or worse?

My son has finished high school and now has to choose from his top two college / course choices. What decision will he make?

Will it even matter?

I’m not stressed for him, even though he may be – facing such seemingly life-altering choices – because I remember that I made a few – and, really important – ‘wrong’ choices in my Life’s Journey, yet here I am today.

You see, I now believe that I would have arrived at roughly this point, no matter (within reason) what choices I would have made – or, decisions I would have taken – along the way …

… and, if you implement just one key change in your life, you will come to see that, too.

First, you need to understand that when you choose to go through Door A or Door B, as my son is now, that’s not the end!

There’s always another two doors behind Door A, and yet another two doors behind Door B

Door A

What are the correct choices to make, when presented with these two new doors? How will you know for sure?

The answer lies in knowing your overarching goal: if you know your Life’s Purpose, then you will have a compass that will guide you back to the right course, even if you choose Door A, when perhaps you later realize that you should have chosen Door B.

Door B

Life is really just a series of decisions and choices that we need to make – or, doors that we need to go through. Our choices can sometimes be difficult … as a result, our decisions can seem random or less than optimal. Sometimes, we make the out and out wrong choice.

But, when you have the compass that is your Life’s Purpose, then it will guide you back to the correct path through later and later choices.

With your Life’s Purpose to guide you, no matter whether you choose Door A or Door B, you can end up living your Life’s Purpose; your choices along the way may affect exactly how you get there and what you will be doing when you finally get there …

… but, it will be close enough.

For example, I now know that no matter what path I would have taken, I would ultimately be sitting here and writing this blog post for you.

How do I know this?

Simple. Because I would not have stopped choosing doors until I got here!

So, I’m not sweating my son’s choices … neither should he.

And, neither should you sweat the choices that you make this year.

May it be a good one!

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A personal finance hieroglyph …

Screen Shot 2012-12-10 at 7.05.04 PMIf you left a review on Amazon for my new book, then your personal, signed copy is on it’s way!

[There’s still time: if you downloaded the Kindle version, please leave an honest review at Amazon and I will send you a personally signed, printed version as my way of saying ‘thanks’]

Inside the front cover, along with my ‘AJC’ signature, you will find a scribbly hieroglyph much like the one above …

… hopefully, it’s not too difficult to translate; it simply means:

Your Money is not your Life!

Too many of us live our lives as though money was its sole purpose: we work more than 1/3 of our life away; we constantly argue with our spouses about it; and, we spend much of the remaining time simply worrying about it.

I haven’t been immune; this was me until a critical date in 1998, when I discovered my life’s true purpose. Without getting all New Age’y on you, I’ll give you a hint: it had nothing to do with money.

My Life’s Purpose was all about how I really wanted to live.

But, I quickly discovered that money does come into it …

… but, only as a means to an end.

My first book (co-written with Debbie Dragon) shows you how to separate your money from your life; but, it doesn’t shy away from the subject of money. Because, as I discovered, money is the key enabler of a fulfilling life for many of us – not all – but, certainly for me.

Probably, for you, too.

So, the real purpose of my book is to help you find out how much money you need in order to be happy. Simple!

If you want to understand a little more about my journey and how I think about money and its real (subordinate) place in life, check out my video interview; it’s with Jaime Tardy at Eventual Millionaire:

Screen Shot 2012-12-14 at 3.41.21 PM

And, if you can, leave a comment to share how you think about your Life … and, your Money!

 

The only personal finance chart you need …

When I’m not blogging, you can often find me hanging around on Quora, the brilliant question and answer site …

… and, that’s where I found Chris Han’s personal finance chart (to the left).

Chris says:

  1. Wealth is the shaded area in the diagram.
  2. You can increase the shaded area by increasing the slope of the green line, or by decreasing the slope of the red line.
  3. Decreasing the slope of the red line becomes significantly harder over time as you grow accustomed to your lifestyle.

Chris is right, but he needs to add a 4th bullet-point, and it’s the same observation that I made when I used a similar chart in this post to explain how businesses should manage their finances for growth:

4. Notice that it is easier to grow Wealth dramatically by increasing the slope of the green Income line than it is to decrease the slope of the red Expense line.

So, let’s break this down …

Regular personal finance will tell you to concentrate on the red (expense) line.

These authors will say that frugality, paying yourself first, and debt reduction (thereby, reducing your interest expense) will increase your wealth through the combined effect of:

– Decreasing expenses, and

– Time.

Decreased expenses allow you to save more, and time allows the full effect of compounding.

Voila! 40 years to fortune!

But, I think that you give up too much for too little, if you follow their advice:

First of all, you give up too many of life’s little pleasures now for little-to-no-reward later (if you can’t afford the lattes now, you sure won’t be able to in retirement).

Next, you have to wait – hence work – for far too long.

Instead, you should focus on the line that they are missing: the green (income) line. If you take my advice, you will concentrate on:

– Increasing your income,

– Using that increased income to build up a larger investment pool, quicker,

– And, aim to get better returns (hence, even more income) through better – and, more leveraged (i.e. using even more debt) – investments

Of course, you can’t simply ignore expenses, but they are best kept in control through delayed gratification, which means:

– Waiting to make purchases; the more major, the longer you should wait, and

– Not increasing your lifestyle (hence expenses) as your income increases.

It is this combination – increased/reinvested Income and controlled/slow-growth Expenses – that can quickly create a huge wedge of Wealth.

This is a very useful chart … you will do well to remember it.

What if money did not matter?

In my new video interview with Jaime Tardy (EventualMillionaire.com) I talk a lot about finding your Life’s Purpose. Now, here is an even stronger argument for finding your Life’s Purpose before working out your financial plan …

Note how the philosopher, Alan Watts, suggests that if you do what you love, the money will follow!

Failing that, do what you need to, but only for a short period of time, so that you can put aside the money that you need in order to do what you want. That’s why I came up with my original ‘$5 million in 5 year’ target (that eventually became $7 million in 7 years, achieved) …

What would you do if money was no object?

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Where’s the emergency?

When you get pulled over by the police for speeding, they often ask: “Where’s the fire?”

And, when anyone tells me that they have 3 to 12 months living expenses sitting in a CD, I have to ask: “where’s the emergency?”

The assumption is that you will have unexpected expenses at some time in your financial life, and you will have to come up with a way to fund them without having to sell the kids or the dog … but, definitely not your boat!

So, the questions are: Do you need an emergency fund? If so, how much should it hold?

Today Forward presents an interesting way to look at how much to hold in your Emergency Fund:

According to the author:

If you have a full year’s worth of expenses set aside, only once every 33 years would an emergency come up that would wipe out these reserves.

Basically, you look at the chart to see how often you would tap out the fund according to how large the fund is (i.e. how many months of expenses do you have set aside as an ’emergency fund’?):

  • 0 months = 100%, guaranteed to have problems
  • 1 month = 70% chance (or every 17 months)
  • 2 months = 49% chance (or every 2 years)
  • 3 months = 31% chance (or every 3 years)
  • 6 months = 10% chance (or every 10 years)
  • 1 year = 3% chance (or every 33 years)

But, these are hypothetical numbers; what is the real-world chance of an emergency cropping up?

Well, the Pew Research Center set out to find out the answer to that exact question …

… and, it was 34%

Only one in three of the 2,000 families surveyed had a ‘financial emergency’ in the past year.

Combining that with the graph above, and it would seem that you would need about 3 months living expenses set aside.

However, I think it’s also important to answer one more question: how much will the average ’emergency’ cost?

Well, the Consumer Federation of America found the figure to be surprisingly low:

Households … typically report unexpected expenditures annually of only $2,000.

What are these unexpected (or ’emergency’) expenditures?

The Pew Research study found they typically fell into the following major categories (which add up to more than 34% because many families reported more than one category as having occurred in the same year):

Given that the chance of an ’emergency’ is so low (34% in any one year), and the reality is that most are affordable (~$2,000 in any one year), why carry an emergency fund at all?

Let’s take a closer look …

Let’s say that you earn $50,000 and pay 25% tax. Since you keep an emergency fund, let’s also assume that you save 20% of your take-home. That means that a 3 months living expenses ’emergency fund’ for you is around $7,500.

Since you’re going to need to keep it in a CD (earning just 1%) instead of investing it (8%+), you are giving up at least 7% interest (or, $525 in Year 1) compounded.

On the other hand, you have a 34% chance of having an ’emergency’, which will then cost you $2,000. Where will that money come from? Well your break-even point on that expense, if you had to borrow it, would be 26%.

So, borrow it on your credit card for all I care!

[AJC: Actually, I do care … the key is to have a plan to pay it off within 12 months; if you do, then a 0% card set aside for exactly that purpose would be ideal. Borrowing against your home via a HELOC would be OK, too, as would borrowing against your 401k. Sure you wouldn’t like to do any of these things, but you are dealing with the unexpected so a little short-term discomfort is probably OK]

Now, the reality is that if you were merely going to stick the $7,500 in an index fund, and earn an extra $500 or so, then I would say just go for the emergency fund … for your peace of mind.

But, why have it lying around earning next to nothing, when it could be the seed capital for your new business or the deposit on your first piece of investment real-estate?

Oh, and if you’re worried about the possibility of losing your job, well, don’t (unless you have GOOD reason to) …

… I’m not sure how different these numbers are in the USA, but if you live in the UK (according to MetLife) you have only a 6% chance of losing your job in any one year. And, when you do, you have a 30% chance of getting a job within the next 3 months, or close to 100% chance in the next 9 months.

Rather than putting your retirement at risk by setting aside too much money for an event that has only a small chance of occurring, realize that:

1. Your money is always better off working for you, and

2. While you are able to work, you can always borrow (and pay back) enough to recover from any financial catastrophe that the typical emergency fund is large enough to cover.

That’s why, at least in my mind, the best defense is always a good offense 🙂

How to dig yourself out of a financial hole …

If you’d like to catch my nationally syndicated radio interview on Financial Safari With Coach Pete, click this link:

http://www.financialsafari.com/as-heard-on-show/interview-with-adrian-cartwood-11-24-2012/

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I really feel for the author when I receive an e-mail like this one from Rick:

My wife is leaving her job in December, I’m a paramedic here in Chicago and we’re both college graduates.  Our house is upside down, we don’t have much in the way of savings for retirement or otherwise and we’re trying everything to stay afloat financially.  Any help would be appreciated.

[AJC: I changed Rick’s job and location to protect his anonymity]

The worst part is that I can’t really help Rick, for a couple of reasons:

1. I’m not a qualified financial adviser;

2. I don’t know anything about Rick, other than what he has told me in (exactly) 50 words.

But, I can give Rick one piece of specific advice: see a qualified financial professional to help you decide how to deal with your ‘upside down’ house, and work out why you aren’t saving enough, and what to do about it.

I can also give a fairly general piece of advice that Rick can choose to follow or not; and, it’s the same advice that I would give just about anybody who is in a similar situation (under-employed; under-saved; and under-water on their house):

The best way to dig yourself out of a financial hole is to …

… find a way to increase your income!

Cutting costs, while admirable – necessary even – is simply too limited to produce the sort of financial turnaround that Rick and others like him need.

Maybe, Rick can turn his wife’s loss of income into a blessing by refocussing her on starting a business, even it it’s while she actively looks for new employment … a business that can be run part-time (at first) when she does manage to find a new job.

I would give similar advice to Philip, who is desperate for the opportunity to shake off the shackles of being imprisoned in a job:

In 5 years I’d like to not have an office job anymore, working for myself/having my own business. I’m stuck in a job, so I keep it to pay my bills. Designers don’t earn much, so I can’t exactly bankroll my parents’ retirement. I’ve been too afraid to go out on my own.

The best way for you (and, Philip) to overcome your fear of becoming your own boss is to actually start …

… but, start part-time.

Doing something is better than doing nothing, and can quickly lead to more/better opportunities in ways that you could not have predicted in advance: for example, and in Philip’s case, designers can freelance, work (cheaply) on crowd-sourcing sites such as Freelancer.com, 99designs, fiverr.com, and so on.

Even better, Philip could use his own design skills to help create his own web-site or product, and run that part-time to earn some extra $$$ and learn how to run a business – building up his confidence in the process, even if the business never truly takes off.

On the other hand, the business may suddenly find its own life and give Philip the confidence to quit his job and start working on it full-time.

Now, unlike Philip, you may not be a designer … I assume that Rick’s wife isn’t either … but, there are plenty of businesses that you can start part-time that require very little money.

Here are some thought starters (if a teenager can do ’em, surely you can?!): What are some potential low-cost businesses that can be started and operated by a teenager?

But, you’ll never know if you don’t start …

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Personal Finance = Emotive Finance

How many of you can honestly … and, I mean honestly … say that you are totally rational about money, and your personal relationship with it?

If that’s you, think again …

All financial decisions are made emotionally, then justified rationally later.

Of course, there will be a very few, clinical souls out there who are able to be totally rational about their personal finances: they read all the (good) books and blogs; they follow the experts; they max their 401k’s (at least to take full advantage of the company match); they examine investment classes and returns; and, they (generally) make sound investments.

But, they will never be rich.

Here’s why: in order to become rich, you need to drive your required annual compound growth rate sky high.

That takes passion … the kind of passion that drives massive action … and, it’s the massive action that will eventually lead to outstanding results.

But, passion is fueled by base emotion.

And, the two most powerful emotions – when it comes to money – are:

Fear and Greed.

I think, by far, the most useful of these two emotions is Fear.

You see, Greed will drive you to take speculative risks that may (highly unlikely) make you rich, or may (likely) send you broke. Even if you fail, Greed will make you try and try again, until you become rich …

or, you keep on failing until we simply never hear from you again.

But, Fear is the slow burn.

It drives some of us to:

– Create emergency funds: because we fear that we’ll run out of money

– Diversify: because we fear the market will tank

– Pay Off Debt: because … well … just because!

– Max our 401k’s: because we’re scared of retirement

– Live Frugally: because we’re simply too scared to spend money

Unfortunately, these tactics simply pander to your fear …

The irony is that these are the exact same financial mistakes that will – for most of us – bring about the outcome that we most fear: lack of financial security.

But, Fear also drives a fortunate few  of us to succeed, because we fear:

– That we won’t be financially secure

– That we will have to work for the next 40 years in a job that we will grow to hate

– That we will be overtaken by others

– and, so on …

So, we use that powerful emotion to push us well and truly out of our ‘comfort zone’ and help drive us to the only rational solution available: making the short term sacrifices, and taking the short-term (but, calculated) risks, that will ensure that we never have to worry about money again.

Still, if you discuss your wealth – or, desire for wealth – with most people, they will assume it’s Greed that drives you; typical is Kevin’s (@ Ask For Benefits) response:

Even 7 million is not enough if you allow your net worth and lifestyle to become your idol. At 7 million you begin to think, “if only I had 8, then I would be happy”.

True, for the person driven by money and Greed, $7 million won’t be enough … and, neither will $8 million. They’ll keep going and going until something stops them.

But, for the person driven by Fear – like me – we stop exactly when we have what we set out to get. And, that amount has been carefully calculated in advance to match exactly what we need for a financially safe, and fulfilling life.

No more, no less will do …