Autumn 2015 Dividend Stock Newsletter

This has been an interesting time for markets. China’s market crashed, and global markets around the world responded with milder crashes and volatile rides.

And yet the US still has a highly valued market.

According to historical valuation assessments of the broad market, such as the Shiller P/E, the U.S. stock market is still valued at a premium compared to its historical mean. This is probably partially the result of the unusually long stretch of low interest rates. And when discounted cash flow analysis, or other versions of that like the dividend discount model, are performed on individual stocks, many of them have been valued at a premium lately.

There are a lot of long term problematic trends. Trends that are decades in the making, larger than individual bull and bear cycles in the market. The U.S. has a weak middle class along with increasing political polarization and public debt, Europe has ongoing problems with their shared currency, debt levels, and unemployment, Russia’s economy is in shambles due to their concentration in the energy sector and the fallen energy prices, China’s stock bubble just burst, and Japan has an aging, shrinking population and the world’s highest national debt level as measured by the debt to GDP ratio. These large drivers of the global economy all have substantial long-term problems. And yet U.S. stock market valuations are historically high.

Needless to say, I’m not surprised to see a market correction, and wouldn’t be surprised to see a bigger one on the way. We’re certainly due for one. And yet, I’ll still be putting money into the market. This season’s newsletter will focus on how to build a dividend portfolio to weather economic storms, including some stock ideas I think look reasonably valued at the moment.

Keys to Defensive, Successful Investing

Investing is simple, but not easy. Many investors buy and sell on emotion, as evidenced by the fact that large cash flows into the market are observed to occur at market peaks, and large cash flows out of the market are observed to occur towards market bottoms. I think that readers of dividend sites like this one tend to do better, fortunately. I’m preaching to the choir a bit in this section.

The healthiest, longest lived populations in the world, such as those living in Okinawa Japan or Icaria Greece, tend to have the simplest, most obvious diets and lifestyles. And most of the world doesn’t follow them, despite their simplicity and pleasure. In places like that, the people eat whole fresh food like wild fish and legumes, plenty of vegetables and fruits and herbs and spices, socialize with family and friends as a cultural priority, drink tea or wine in moderation, get plenty of slow exercise from walking to and from their jobs and neighbors homes and doing manual work, and don’t rush or experience much stress. And many of them are dancing and hiking and laughing and staying mentally sharp into their 90’s and 100’s, while spending a fraction of what we do on health care. It’s not complicated for them.

Successful investing is a lot like that. Simple, but rare. Obvious, yet rarely followed.

Check your Balance
This is a good time to check your asset balance. Do you have the ratio of stocks, bonds, cash, and other investments that you target?

Having a diversified portfolio reduces volatility because by ocassionally rebalancing, you’ll naturally shift money from bonds/cash to stocks when stocks are cheaper, and shift money from stocks to bonds/cash when stocks are expensive, simply due to returning to your target balance from time to time.

Invest Over time
If you determine the suitability of an investment by calculating a fair intrinsic value, don’t worry too much about trying to predict the future. If the price is reasonable now, a few months from now might be even better. Or it might be worse. Neither of us know. By putting money into attractively priced investments on a regular basis, you even out your chances.

There are plenty of people I know that dabble in investing as a hobby rather than as a consistent means of building wealth. What this means is that they maintain a little portfolio of some hot stocks, and enjoy discussing performance with colleagues and friends. Five years later, their portfolios are still small, because individual stock performance is a lot less important than shoveling money into a portfolio month after month.

Stock, Country, and Sector Concentration
Consider how much money you’d be willing to lose in a single investment, and then invest accordingly.

Regardless of how prudent we may be, an investment could go sour. We don’t have access to all the current information, nor do we have the ability to see the future. Plus, a shared event could bring down all stock prices in a sector, such as a reduction in the price of a barrel of oil, or a housing bubble. And a single country could have poor governance or economic stagnation. It’s often a good idea to maintain diversification among companies, sectors, and countries.

As long term investors, we don’t really care about stock prices themselves, because all else being equal, low stock prices just mean more buying opportunities. But we do care about tangible financial damage to a company including things that could lead to dividend cuts, so diversification is important.

Concentration into a few companies, or a major sector, could lead to outperformance compared to a diversified portfolio. But it could also lead to disaster, wiping away a decade of portfolio growth. Deep concentration sometimes makes sense for professional investors, but rarely is ideal for casual investors who are building wealth for their families.

Four Stocks to Consider

Texas Instruments (TXN)
Texas Instruments has fallen from a high of nearly $60 down to under $50 per share, and I believe it may be a solid investment at this price level.

Over the last decade, the company has not had any revenue growth, and a big reason was that they completely exited the wireless market to focus on analog and embedded chips, which was a transition they completed in 2013. Despite the lack of revenue growth, the company has increased free cash flow margins and reduced their share count substantially from share repurchases, resulting in 13% free cash flow per share growth over the last decade. They’ve also increased their dividend for eleven consecutive years now. All of their free cash flow goes to dividends and share repurchases, and only 4% of revenue has to be invested back into the company for capital expenditures.

Looking forward, with no major transitions ahead, Texas Instruments is the largest analog chipmaker in the world and should be set to finally grow. In addition, their transition from 200mm to 300mm wafers should cut their costs significantly, further increasing their profit margin. As they continue giving all the free cash flows back to shareholders, investors should do well.

An issue that some dividend portfolios face is that they lack much investment in the technology sector. Dividend growth companies are rare in the sector, and as an investing demographic, we tend to prefer stability. A company like Coca Cola will be selling pretty much the same products ten years from now as they do now, but Apple will be selling absolutely nothing of what they currently sell in ten years. A company that has to continually reinvent itself is harder to predict for the long holding periods that dividend investors tend to prefer.

But a handful of tech companies are blue chip companies with decent dividend payouts, and Texas Instruments is one of them. The dividend yield is currently 2.8% with a high dividend growth rate, and the overall shareholder yield is over 7%. Analog chips, which measure things like temperature and pressure and convert them into digital information, are hard to design, have very long product lifecycles (years, and sometimes decades), and as a result offer high profit margins for the designers. Embedded systems, like microcontrollers, also have long lifecycles and similar profitability levels. If there’s a tech stock out there that’s good enough for a dividend portfolio, the world’s largest analog maker is a top contender.

Chipmakers exist in a cyclical industry, and competition is significant, so Texas Instruments is not without risk.

Using the last twelve months of dividends ($1.36), along with a conservative estimate of 7% dividend growth going forward (quite low, compared to their 13% free cash flow growth per share over the past decade and their high recent dividend growth rate), and lastly a slightly market beating 10% target rate of return (discount rate), we can arrive at an estimate of fair value:

TXN_Valuation

For investors that use options, Texas Instruments is also a decent stock to write a long term covered put for. If you want to pick up shares of the company at a lower cost basis than what is currently available, you can write puts at a strike price you desire, and get paid to wait. For example, you can write January 2017 puts at a strike price of $47, and receive about $6 per share as a premium for doing so. If, in the next 16.5 months, Texas Instruments goes below $47/share, you’ll have to buy at $47/share, and your actual cost basis would be about $41. On the other hand, if Texas Instruments stays above $47, you’ll have been paid a fairly high rate of return simply to wait, without buying, and then you can use your capital elsewhere, or write another put.

Chevron Corporation (CVX)
Chevron stock was absolutely slammed and has since rebounded a bit.

In my previous newsletter from three months ago, I stated that Chevron stock was fairly valued. Not overvalued or undervalued, but fair. A couple months after I wrote that, crude oil prices dropped like a rock from $60/barrel to $40/barrel, which naturally brought oil stocks down, including Chevron. This is an example of where not putting too much money into one stock, and having a habit of investing money every month, helps ease things a bit. Recently, crude went back up to about $50, easing Chevron’s problems.

Chevron is in a particularly vulnerable state, because they have a high dividend payout for the industry, and they’re right in the middle of an investment cycle where they are spending a lot of money on investments and waiting for large LNG projects to fully come online and start producing major revenue. Having oil prices fall and their profit cut away, is a major blow to the company.

The big question for dividend investors is whether or not the dividend is safe. The company has raised its dividend for 27 consecutive years and now is being looked at as a potential dividend cut. After this stock price drop, the dividend yield is at a lofty 5.3%.

The official position of the company, based on their most recent investor presentation and words from their chief financial officer during the last earnings announcement, is that their number one priority is to cover the dividend with free cash flow by 2017. This is because their major LNG investments are coming online, and capital expenditures are expected to fall dramatically when their period of massive investment will be finished, and the fruits will be harvested. The next year and a half though, until 2017, will be rough. At these oil prices, free cash flow won’t cover the dividend, and so the company is issuing debt to pay for it. Obviously that’s not sustainable.

The company currently has about $30 billion in long term debt, and shareholder equity minus goodwill of about $150 billion. This is a LT debt-to-equality ratio of about 20%, which is a very strong balance sheet. The company currently pays out about $8 billion per year in dividends, so if the company uses debt to fund the dividend for 18 months, that would require about $12 billion. This would boost long term debt to $42 billion for the dividend alone, resulting in a LT debt-to-equity ratio of around 30%, which is still a very strong balance sheet. As a comparison, Conoco Phillips currently has a LT debt-to-equity ratio of about 50%. So, Chevron could fuel its dividend with debt until its LNG operations help it fully cover its dividend with free cash flow in 2017, and still have a stronger balance sheet than Conoco Phillips.

Does Chevron have to cut its dividend? Absolutely not. Will they? Who knows. In a world without dividend champion lists, and investors that rely on dividends for income, cutting the dividend for a year or two and then restarting it at a higher rate when they are in a better position, would be financially prudent. But when reputation matters, the executives seem as though they want to hold onto it.

The way I see Chevron currently, is that gas prices won’t stay this low forever, and five years from now, Chevron at $80/share or Exxon Mobile at $75/share will be seen as steals. But in the near term, a dividend cut is not out of the question, especially for Chevron. I wouldn’t rely on Chevron for current income, but I’d look at it as a potential bargain stock for the long haul.

Toronto-Dominion Bank (TD)
The Canadian housing market is highly priced, and Canadians have record levels of household debt relative to disposable income, at over 160%. This is higher than US household debt levels right before the housing crash in the mid 2000’s, when we were at 130% on average, down to under 110% now after some household deleveraging.

Vancouver is a particularly interesting case, because much of the demand for housing comes from outside their local labor market. A significant chunk of luxury property in the city is purchased by people from mainland China, and many Chinese people just lost a lot of wealth on paper from their stock market crash.

Plus, oil prices have fallen far, and Canada’s economy has a lot of concentration in this sector. If there’s something that could cause a housing bubble to burst, something like this might do it.

Needless to say, some investors are shorting companies that have exposure to the Canadian housing market. I can see why. And yet, I don’t think investors necessarily have to avoid this industry. TD in particular is in a decent position.

The Canadian banking system works in a fundamentally different way than the US banking system. In Canada, it’s a lot harder to simply walk away from a mortgage when the price of a house drops. As a result, even before the U.S. housing crash, Canadians have had a much lower rate of mortgage delinquency than Americans. In addition, many residential mortgages held by Canadian banks are insured by the government, limiting their own losses.

Toronto Dominion bank is one of the largest banks in Canada, and is the sixth largest bank in North America. Their business model involves borrowing money mainly from depositors and lending that money at higher interest rates to customers for mortgages, auto loans, and other types of loans. The bank has expanded strongly into the United States along the east coast, resulting in the bank having 15 million Canadian customers and 8 million American customers and growing. The bank’s focus is on retail banking, aiming to offer top quality customer service compared to competitors. At a time when banking is starting to shift from physical to online banking, TD is going against that trend by focusing on expanding their physical footprint and offering longer banking hours than competitors.

Compared to their peers, TD has a larger portion of their Canadian mortgages insured. Slightly over 2/3rds of their Canadian residential mortgages are insured. For that other third, the average mortgage-to-value of the loans is 70%, meaning that a fairly large housing correction would have to occur before those mortgages would be underwater. Unfortunately by some estimates, the Canadian housing market may indeed be that far overvalued, with that far to fall. Overall though, it can be said that TD is in a stronger position than American banks were before the US housing crisis, and is also in a stronger position than many of the other large banks in Canada. The credit agencies currently assign TD bank with high credit ratings (Aa1, AA-, and AA respectively by Moody’s, S&P, and DBRS), and those credit agencies are taking into account the risks embedded in the current Canadian housing market.

Historically, TD’s performance has been excellent. The company has had 12% average dividend growth over the past 20 years, and currently has a solid 3.8% dividend yield. Over the past 10 years, the bank’s revenue has climbed from under 12 billion CAD to over 30 billion CAD, while EPS has grown at a similar rate, despite some share dilution.

Their most recent investor presentation states that the bank expects to increase adjusted EPS by 7-10% per year over the medium term. In combination with a nearly 4% dividend yield, this is a good potential investment. However, given the state of household debt and housing prices in Canada, I’ll use a more conservative growth estimate in my dividend growth expectation.

Here’s the estimated fair value, in CAD, using a 6% long term dividend growth rate and a 10% discount rate:

TD_Valuation

That’s in CAD on the TSE, not in USD on the NYSE. Currently, the price is about equal to the estimated fair value. And that’s using a dividend growth rate that is below the low end of the company’s estimated EPS growth rate; 6% compared to 7-10%, because I’d prefer to be pessimistic on this. If you believe the company will hit its estimates, or if you’re willing to settle for a lower 8% or 9% rate of return, the fair value to you would be substantially higher than the current price.

Overall, I believe TD represents a fair buy at this time. There are risks in the Canadian housing market, but the stock is trading at a price that seems to take that into account. TD has protection in the form insurance for a majority of its residential mortgage portfolio as well as diversification into the US lending market.

Aflac Incorporated (AFL)
Aflac sells supplemental health insurance in the United States and Japan. While primary health insurance companies will cover various specific procedures, usually by paying the health care provider rather than the policyholder, Aflac’s main business model instead is to pay cash to policyholders that file claims for certain health problems, like cancer. This way, when customers face income loss or other financial problems due to a health problem, Aflac provides them with cash to get through those difficult times while their primary health insurance company covers the actual medical expenses.

The company experienced strong top line growth between 2005 and 2012, climbing from $14.3 billion in revenue to $25.3 billion in revenue. During that time, the dollar was weakening compared to the yen, giving the company a strong tailwind. Then, from 2012 to now, the revenue has fallen from that height of $25.3 billion to $21.7 billion, this time due to the dollar strengthening compared to the yen, giving the company a major headwind. EPS has followed a similar pattern over that period of time.

So, this has been a tough few years for Aflac. The positive part of the story, however, is that their core business is doing very well when exchange rates are excluded. Between 2005 and 2014, the amount of premiums they have generated in Japan has increased every single year, from about 1 trillion yen in 2005 to about 1.6 trillion yen in 2014. The story is similar for their US business; premiums have increased from $3.7 billion to over $5.6 billion during that period, and every single year saw an increase in premiums compared to the previous year.

Japan has an aging population, and the universal health care system is conservative in its payouts. Japan has the longest life expectancy in the world and pays considerably less than half of what the US pays per capita on health care each year. This gives Aflac plenty of room for continued growth for the forseeable future, because their role as a supplemental insurer should only grow stronger.

The long-term bearishness of Japan’s economy, along with their very high national debt, is a risk to be aware of. However, Japan’s debt is held in its own currency to its own citizens, giving the country considerable flexibility in avoiding default in most foreseeable scenarios.

Although predicting exchange rates is not something I care to do, the fact that the dollar has already had a four-year surge relative to the yen (going from fewer than 80 yen per dollar in 2012 to over 120 yen per dollar currently in late 2015), and the dollar has surged relative to foreign currencies in general, implies that the company probably doesn’t have too much to worry about from continued currency headwinds over the long term, at least. I believe the worst of their currency troubles are probably behind them, and if not, the company is doing fine anyway, albeit with reduced profitability, and they can safely ride out the currency problems.

Aflack stock currently trades for a P/E of just under 10. They have raised their dividend for 32 consecutive years, but their payout ratio is on the low side, and the dividend yield is about 2.7%. They also repurchase a lot of shares, and between 2005 and the current quarter, their total share count has fallen from 508 million to 444 million. This is a business model I like; a large portion of the returns comes from the dividend and from the company reducing its share count by buying cheap shares, while also enjoying moderate premium growth and a growing customer base in two countries.

Aflac’s dividend has historically risen at a double-digit rate, but during the recent problem with currency exchange rates, Aflac’s dividend growth rate has fallen below 6%. In 2015, the company expects to repurchase $1.3 billion worth of stock, which is 5% of the market cap. The board of directors this past month increased the authorization for the amount that the company can repurchase, up to 56 million shares, or over 12% of the existing number of shares outstanding. Repurchasing the shares is one way to accelerate dividend growth, because reducing the share count allows the company to continue to pay out more and more per share. With shares so cheap, the company gets a good rate of return on their purchases, although I’d like to see a moderately higher dividend payout ratio, personally.

Given historical dividend growth rates, recent growth rates, share repurchase rates, core company performance, and an assumption of reducing currency problems over the next 5 years, I’ll use 7% dividend growth as an estimate for the long term. The estimated fair value ends up being around $55:

AFL_Valuation

As you can see, with the fairly low yield, the estimated fair value is very sensitive to adjustments in the estimated dividend growth rate and the discount rate. Overall, with a low P/E, a long history of dividend growth, a modest current dividend yield, and a fairly safe business, I believe Aflac represents a decent purchase at these prices levels, especially with many other stocks being valued at much higher earnings multiples.

 Dividend Insights Newsletter

We respect your email privacy

The Comprehensive Guide to Index Funds

Index Fund GuideA balanced portfolio of index funds is one of the smartest and easiest ways for most people to invest and build wealth.

It takes a few hours per year to manage, which means you should get a good compounded rate of return on your money while you’re out living your life. I consider it the other smart long-term investment strategy besides value investing, and one that’s suitable for a wider range of people.

This article is going to provide a comprehensive overview on why and how to invest in index funds. It’s about how to invest in index funds purely, or how to combine them with individual stocks. We’re talking 4,500 words here, so you might want to bookmark this page. Alternatively, you can use the following links to jump directly to the sections that you want know about.

Sections:
-What is an Index Fund?
-The Advantages of Index Funds
-The Disadvantages of Index Funds
-The Easy Way to Rebalance an Indexed Portfolio
-The Optimal Way to Rebalance an Indexed Portfolio
-Specific Index Funds to Consider Investing In
-How to Combine Index Funds and Individual Stocks
-The Best Books on Index Funds
-Why 90%+ of People Should Invest in Index Funds


 

What is an Index Fund?

Build Wealth with Index FundsAn Index Fund is a specific type of Mutual Fund, so it’s best to start there.

Shares of stock represent small portions of the ownership of a company. With a mutual fund, a fund manager collects the money from a bunch of investors together and buys shares of many companies with the common pool of money. So when you own a piece of a mutual fund, you own a piece of a big pool of stocks and/or other investments.

In an actively managed mutual fund, the fund manager is trying to meet a certain goal, such as wealth preservation or to try to beat the market.

In a passive mutual fund, called an index fund, the collective wealth of the investors is passively managed by the fund manager to match a certain index, such as the S&P 500. In other words, the index fund doesn’t try to beat the market; it is the market. Rather than trying to select individual stocks, the fund manager invests in all stocks that meet certain criteria.

There are several types of index funds. The most well-known ones follow the S&P 500, which is a set of 500 of the largest and most profitable corporations in the United States. But there are index funds that follow Bond indexes, funds that follow international markets, funds that follow the stocks of a specific country, funds that follow REITs, funds that follow specific sectors (such as Technology, or Healthcare), and all sorts of other funds.

The primary thing index funds have in common is that the fund manager isn’t trying to do anything other than match an index. He’s buying stock from most or all of the companies that meet the criteria of that particular index.


 

The Advantages of Index Funds

Depending how far back we go in history to use as the reference, the average long-term rate of return of the S&P 500 is around 9% per year. After inflation, it’s approximately a 6% real rate of return of purchasing power.

To provide a tangible example, if you put $1,000 per month away into an index fund that grows at an average rate of 9% per year with 3% average inflation, then you’ll have approximately $850,000 in 20 years, and this value adjusted for inflation would be $480,000. At the 40-year mark, these figures rise to $5.6 million in value, and $1.8 million in inflation-adjusted value. You could double or triple these intermediate and end-values by doubling or tripling your monthly investment.

Growth from Index Funds

More realistically, the returns are going to be somewhat volatile. Here was the actual growth of a hypothetical $10,000 invested between 1975 and 2010:

Index Fund S&P Growth

Notice that the growth spiked at the turn of the century during the dot com bubble, and then moved flat and volatile over the next decade. This was because equities became overvalued during that period, and then had 10 years worth of reductions in stock valuations followed by the financial crisis.

Drawing a trend line over the long-term outcome takes some of the weirdness away. It ends up looking like the first chart, actually:
Index Fund S&P Growth 2

Low Fees
The biggest advantage of index funds is their low fees. Actively managed funds have much higher fees, and after fees, most of them provide lower returns than the market. By keeping fees low and merely trying to match the market rather than beat it, index funds statistically beat out actively managed mutual funds.

(The most successful investor in the world, Warren Buffett, recommends Index Funds to most investors for this reason.)

The Efficient Market Hypothesis suggests that all publicly-known information is already factored into stock prices, and that therefore nobody can deliberately beat the market. (It’s luck if they do, according to the hypothesis). To what degree you accept that hypothesis is up to you, but be aware of it.

No Investing Experience Needed
Index funds require no stock picking and little business knowledge, and therefore are useful for everyone that has money to save and invest.

Save Your Time
Out of all investing methods, index funds require the least of your valuable time. Depending on exactly what sort of index funds you pick, when it comes to basic portfolio maintenance, you’ll spend anywhere from a few minutes per year, to a few hours per year, to perhaps a couple of hours per month, tops. This is the closest to set-it-and-forget-it investing you can have.


 

The Disadvantages of Index Funds

Although there are many advantages of index funds, there are a few drawbacks as well.

You Forfeit Shareholder Voting Rights
Shareholders of stock get to voice their opinion on various company matters, ranging from approving or disapproving executive compensation, to voting on specific corporate matters such as whether a company should have a nondiscrimination policy that protects gay employees or whether a company should more easily disclose its political contributions or not. Those were some examples of questions that were brought to a shareholder vote for one of my holdings. Most shareholder votes are nonbinding, but their ultimate power is the ability to elect or not elect directors to the board of the company.

If you invest only in index funds, then you give up your shareholder voting rights to the index fund manager, since they own the equities rather than you. Most fund managers don’t vote quite how you’d likely want to vote if you owned the shares because they represent the interests of millions of shareholders and therefore abstain from many types of votes.

No Investing Experience Needed
This was listed in the advantages section, but it’s a double-edged sword. Investing in index funds means you never have to look at a corporate report, never have to learn Discounted Cash Flow Analysis, never have to keep up on what corporations are doing.

Gaining some knowledge on how businesses work down to the shareholder level can give you knowledge of politics and economics, can help you dominate an interview, gives you some financial knowledge for your own trials of entrepreneurship, and generally leads to financial well-roundedness.

You Abstain from Outperformance
An index fund will beat most actively managed mutual funds due to the huge difference in fees. Most people, including professionals, who try to pick stocks fail to beat the market.

Some of them don’t. Instead, some of them massively outperform the market.

The problem is that it’s next to impossible to know ahead of time which fund manager will outperform the market, and it’s difficult to predict your own future stock-picking ability if you go that route.

An index fund will essentially match the market. If you’re a value investor that believes that you can beat the market by at least a percentage or two per year (which can add up to hundreds of thousands of dollars over the long run), then you might have a better shot with appropriately valued individual stocks.


 

The Easy Way to Rebalance an Indexed Portfolio

The second chart in this article showcased how volatile even a broad market index can be. The proposed solution to this is Modern Portfolio Theory (MPT).

MPT argues that the only free lunch is diversification. For any desired rate of return, you can reduce the risk by diversifying. For any level of risk, you can increase the rate of return by diversifying.

When it comes to index funds, this primarily means asset allocation between stocks and bonds, but can also include cash, REITs, MLPs, etc. And within the stock segment, it means diversification between equities in your own country and equities from other countries. For example, if you’re based in the U.S., and your portfolio consists of a U.S. stock index fund, an international stock index fund, and a U.S. bond fund, along with sufficient cash and some real estate, then you’d be considered rather diversified.

This diversification reduces your volatility at the expense of reducing your overall rate of return, at least over the long term. To passively rebalance your portfolio, you simply pick a target balance and stick to it.

For example, if you decide that your percentage of bonds will equal your age, and that your equities will be split evenly between U.S. stock and foreign stocks, then a 30 year old person would have an index portfolio consisting of three funds: 35% in U.S. equities, 35% in foreign equities, and 30% in bonds. This plan makes your portfolio become less volatile as you age, so that you maximize your rate of return when you’re young, and yet you don’t experience a large decrease when you’re older.

In this scenario, you’d automatically buy stock when stocks are cheap, and sell stocks when stocks are high, which is ideal.

To simplify the scenario, let’s just say your portfolio consists of stocks and bonds, in a 70%/30% balance. If this year, stocks rise by a huge amount, then your portfolio might shift towards 80%/20% in favor of stocks. So, to maintain the balance, you’d use your investment money to buy more of the bond funds to balance that out. And in the event that that’s not enough, you’d sell some of your stock to buy bounds, and regain the 70%/30% target.

If next year, stocks fall by a large amount, then your portfolio might shift towards 60%/40% in favor of stocks. So, to maintain the balance, you’d use your investment money to buy more of the stock funds to balance that out. If that’s not enough, then you’d sell some of your bonds to buy stock, and regain the 70%/30% target.

Index Fund Rebalancing

This doesn’t entail market timing, because you’re not making any predictions about the future. You’re just maintaining the 70%/30% stock/bond allocation whenever it becomes unbalanced by a few percentage points. The same is true for a three-fund portfolio that consists of domestic equities, foreign equities, and bonds; you’d simply direct capital towards the funds that are below your target balance due to their recent underperformance, and/or draw funds away from the funds that are over-represented in the portfolio due to their recent outperformance.

To give an idea of how different types of balances would do, the following chart shows the historical performance of stock/bond allocations between 1975 and 2010. For simplicity, the “stock” section is the S&P 500, when in reality, you’d likely want to split it between U.S. equities and foreign equities. Nonetheless, it presents a long real scenario of the kinds of returns you would have had with different balances of equities and bonds.

The following chart shows the growth of a $10,000 investment in 1975 in three different scenarios: 100% stock, 75%/25% stock/bond, and 50%/50% stock/bond:

Index Fund Asset Allocation

As can be seen, the volatility and total returns increased as the equity exposure increased.

However, these differences are somewhat reduced in a more realistic scenario where new money is invested each year, which would be typical during a working career. In the next chart, each portfolio starts with $10,000 in 1975, but then new money is added each year. More money is added each year to represent a combination of inflation and increased earnings power, so $2k is put in during the first year, then $4k the next year, then $6k the next year, then $8k the year after that, and so on.

Index Fund Returns

In this scenario, there are two main things to notice. First, adding more money over time resulted in a much larger portfolio value over time. Second, it made it so that even the difference between 100% stock and 50%/50% stock/bond was minimal over the long term. The latter was less volatile but provided almost the same rate of return.

The research for these returns originally appears in a bit more detail in the Dividend Toolkit.

The takeaway here is to maintain a balanced portfolio. Your precise allocation depends on your goals, but mixing stocks and bonds, and rebalancing during market movements, reduces your volatility and keeps your overall rate of return decent. This type of rebalancing takes literally a couple of hours per year. Whenever you add more money to your portfolio (such as once per month perhaps), simply add it to the funds that are below your target allocation to balance them out. If the segments of your portfolio are perhaps 5% or more out of balance despite your additions of new money, then consider selling a portion of the over-represented fund to buy more of the under-represented fund to achieve balance.

Simple.


 

The Optimal Way to Rebalance an Indexed Portfolio

It can be tempting to try to optimize these rebalancing efforts. For example, during the dotcom boom, it was clear to rational investors or economists such as Warren Buffett and Peter Shiller that the market was overvalued. It could be objectively proven with reasonable stock valuation methods including the Dividend Discount Model and other methods.

Likewise, during certain periods such as the market bottom in 2009, it was clear to many value investors that the market was very undervalued.

In these circumstances, wouldn’t it be optimal to change the balance accordingly? During the top of the dotcom bubble, wouldn’t it be rational to reduce stock exposure to well under the normal target? And during deep market bottoms, wouldn’t it be rational to increase stock exposure to well over the normal target?

It depends on what your goals are.

If you’d like to be a bit more active with your portfolio, then the Shiller P/E is a good tool to use. The Shiller PE, put forth by Robert Shiller, Yale Economist, is a calculation of the current market valuation. It divides the price of the market by the inflation-adjusted average of the last ten years of earnings to provide a smoothed-out representation of what the current valuation of the market is compared to what it historically has been.

The chart shows that, over a century-long period, the current market valuation is inversely proportional with the expected annualized returns over the next 20 years. In other words, the higher the current market valuation is (as calculated by the Shiller P/E ratio), the less likely it is you’ll get good returns over the next 20 years:

Shiller PE
Image Source

The chart ends in 2005 (20 years after the last mark of 1985), but the accuracy has continued up until the present day. The decade from 2000-2010 was absolutely terrible for equities because the market was ridiculously overvalued in the late 1990’s and early 2000’s.

Given the rather well-evidenced (and inherently logical) premise that highly valued markets offer statistically lower returns, there is a semi-popular investing method that takes this into account.

With this method, an indexed portfolio is rebalanced actively. Rather than sticking to a static stock/bond allocation, such as 70%/30%, the ratio is adjusted based on the Shiller P/E of the market. The higher the Shiller P/E, the lower the stock allocation. And the lower the Shiller P/E, the higher the stock allocation.

The precise method of active rebalancing could be up to you, but here’s an example. Again, I used a simple two-part stock/bond portfolio to explain the point rather than the more realistic US/Foreign/Bond portfolio that would be better to go with.

-When the Shiller P/E of the market is 18, the portfolio shall be 80% stock and 20% bonds.
-For each point that the Shiller P/E rises, the stock percentage shall be decreased by 2%.
-For each point that the Shiller P/E falls, the stock percentage shall be increased by 2%.

So, if the Shiller P/E is 21, the portfolio shall be 76% stock and 24% bonds. If the Shiller P/E is 15, the portfolio shall be 86% stock and 14% bonds. And so on.

This is what the results would have been between 1975 and 2010, compared with the passive portfolios, where “Active” is this actively rebalanced portfolio:

Index Fund Shiller PE

The returns were slightly better, and the volatility was fairly modest. “Active” is probably even an overstatement, because this accounts for a rebalancing only once per year, so it’s about 10 minutes of work per year.

Whether this is a method to go with isn’t conclusive, though.

The overall returns are better, but they’re not that much better.

Given that a) most people won’t stick to the plan and b) the returns aren’t dramatically improved, there’s not a strong reason for everyone to follow that method. Passive rebalancing is perfectly fine. But if you enjoy investing and want to reduce or increase your equity exposure based on the market valuation, it can be a worthwhile approach that likely leads to improved returns and reduced volatility if it’s done with discipline. Personally I wouldn’t recommend it for most people that I encounter, but the information is around for those that want to pursue the method of taking market valuations into account for determining the balance of portfolio assets.


 

Specific Index Funds to Consider Investing In

The business that really started the index fund is Vanguard. And because they were the first mover and with such a strong focus on index funds, they’re the largest player today. Due to their size, they can generally keep expense ratios below any other competitor, and because of their focus, they don’t try to upsell you to actively managed funds. Plus, Vanguard is itself owned by its own funds (in other words, the investors), which really locks down the expenses. (For the record, I’m not in any way associated with Vanguard financially.)

There are a few main ways to invest via Vanguard funds.

Indexed Mutual Funds
These indexes are structured as mutual funds. You can open open an account with them, and the minimum amount to invest depends on the specific fund but is typically several thousand dollars. Here are some of the options:

Total Stock Market Index Fund Investor Shares
This fund invests small, medium, and large publicly traded American companies, and has an expense ratio of only 0.18%.

High Dividend Yield Investor Shares
This fund invests in over 400 companies that pay medium and high dividend yields. The yield is over 3% and the expense ratio is 0.25%.

Total Bond Market Index Fund Admiral Shares
Here’s a good bond fund, diversified across over 5,000 bonds with a 0.10% expense ratio.

Total International Stock Index Fund Investor Shares
For international exposure, this is a good choice. The fund includes over 6,000 companies from around the world, but excludes U.S. companies so that you can pair this with a U.S. index without overlapping. The expense ratio is 0.22%.

If you hold simply a U.S. stock fund, and international stock fund, and a bond fund, your portfolio is pretty diversified. If you live in Canada or the UK or another country, you may want to modify that with greater emphasis on your home country, but the basics are the same.

Funds of Funds
An even simpler method is to invest in a fund of funds. Let Vanguard rebalance your own funds for you. In these structures, Vanguard groups together some of the funds from the previous category into a fund of funds that they keep at a specific balance.

LifeStrategy Growth Fund
This fund is split between the Total Stock Market fund (56%), the Total International Stock Market fund (24%), and the Total Bond Market fund (20%). The expense ratio is 0.17%, and the primary goal here is to grow the wealth with manageable volatility.

LifeStrategy Income Fund
This fund inverses the balance compared to the previous fund, consisting of bonds (80%), U.S. stocks (14%) and international stocks (6%). It’s meant for retirement to keep volatility and risk lower, and the expense ratio is 0.13%. There are two other options that rest between these two funds in terms of stock/bond ratios.

Target Retirement 2040 Fund
This fund is a bit different than the others, because the fund will shift towards bonds over time. As of this writing, it currently consists of 63% U.S. stock, 27% international stock, and 10% bonds. Over time, the bond ratio will grow larger and larger, to reduce volatility as you near retirement. Vanguard offers these funds in five-year increments, so you pick the fund that corresponds to your expected retirement year.

With these funds of funds, you’re sufficiently diversified if you invest in them. Apart from holding property and cash, your job as an investor here is just to shovel as much money into these funds as possible and let Vanguard do the rest. It takes no management from you at all except to check your balances once in a while and keep up with paperwork and taxes (a few hours per year at most), so you can focus your efforts on increasing your income, living life, etc.

Indexed ETFs
These funds are similar to the first group of mutual funds, but they’re wrapped in a structure that is traded on a stock exchange. This is why they are called Exchange Traded Funds (ETFs). You don’t need a Vanguard account for these; you can buy them through any brokerage account just like you would buy any stock.

Total Stock Market ETF (VTI)
Vanguard’s ETF invests in over 3,000 U.S. companies and has an expense ratio of 0.06%.

Total Bond Market ETF (BND)
Vanguard’s Bond Market ETF with an expense ratio of 0.10%.

Total International Stock ETF (VXUS)
Vanguard’s International Stock ETF with a 0.18% expense ratio.

These are the same as their equivalent mutual funds. They’re more flexible, because you can buy and sell them through any broker. There is not currently a fund-of-funds ETF option through Vanguard.


 

How to Combine Index Funds and Individual Stocks

Despite the fact that I run this site that focuses on individual stock selection, I think it’s pretty clear that out of the general population, most people do not have a strong interest in investing, do not find it “fun”, are not willing to put a lot of time into it, and their chances of beating the market over time are not high based on a fairly high degree of market efficiency. Most of my writing is aimed towards the subset of investors that are interested in value investing, which includes myself.

So, to be clear, I think that for 90% of the population, going with a passive and purely indexed approach is the most optimal investing method.

If you’re like me, and for one reason or another you want to own individual stocks as well (because you want to retain your shareholder voting rights rather than wasting them, or you think you can beat the market with a smart investing approach, or you want higher and more consistent dividend income, or another reason), then there are some seamless ways to combine indexes and individual stocks.

The easiest option is to split investments between different accounts. For example, if you have a 401(k), then you can fill that with a few index funds. Then if you have an IRA or a taxable account on the side, you could look into building a portfolio of stocks that pay good dividends, or growth stocks you know well, etc. If the bulk of your wealth is diversified and indexed, then trying your hand at stock picking can keep your risks low.

If you combine things together, then you just have to keep track of your overall diversification. For example, if you have a regular brokerage account filled with indexed ETFs and some individual stocks, then make sure you keep track of what you’re overall diversification is.

For example, let’s say you have $50,000 in a bond ETF, $50,000 in an international stock ETF, and $100,000 in a U.S. stock ETF, and you also own $50,000 worth of individual U.S. stocks split between 10 holdings. In this scenario, the indexed portion of your portfolio is split between 50% U.S. stocks, 25% international stocks, and 25% bonds. The overall split including the individual stocks is 60% U.S. stocks, 20% international stocks, and 20% bonds.

Whatever target balance you’re aiming for, you have to make sure to include your individual stock holdings.

Another way to use index funds is to use some of the more targeted ones to give your portfolio exposure to certain markets. For example, if you own a portfolio mainly consisting of dividend stocks, you may be a bit light in certain industries, like technology. Or you may feel that your overall exposure is a bit too focused on large caps, or not globally diversified to your liking. If that’s the case, then you can hold a technology index fund like the Vanguard Information Technology ETF (VGT), or an index that focuses on small caps, or an international index fund. Or, let’s say you don’t feel comfortable picking stocks in a certain industry, like health care for example. That’s where an index that focuses on the health care industry can give you exposure to that industry and complement the rest of your portfolio.


 

The Best Books on Index Funds

While this article provides as much detail as possible, the length of a blog post becomes ridiculous after a certain point. I may add to and improve this page over time. If you’ve gotten this far, you’ve probably clicked to other sites and back to this article several times, or you scanned rather than read, which is natural.

So if you’d like some further reading on index funds, there are a few books that are good choices.

Millionaire Teacher
This is the #1 personal finance and investing book I’d recommend to people. It’s a good update on the established concepts. The author, Andrew Hallam, is an English teacher that became a millionaire in his 30’s through frugality and index investing. Andrew is personable, so this book is concise, flowing, and quick to read, yet well-researched and thorough.

The Little Book of Common Sense Investing
Written By John Bogle, founder and retired CEO of Vanguard, this book is another concise and good read about index funds.

A Random Walk Down Wall Street
Burton Malkiel looks through various investment strategies and shows that they will underperform a passive investing approach. There have been several editions, and this is one of the original books about indexing, since it even predates index funds.


 

Conclusion: Why 90%+ of People Should Invest in Index Funds

Overall, index investing is one of the most viable wealth-building strategies, especially when combined with cash and real estate.

It’s the investing approach that takes the least amount of time, and although there are some drawbacks, there are plenty of advantages. In the simplest sense, it involves managing a portfolio that looks something like this:

Example of an Index Fund Portfolio

In a more complicated scenario, it means keeping track of a few accounts which may include pure indexes, or indexes combined with individual stocks. If you own individual stocks, then index ETFs can still be quite useful to own assets in certain industries or to balance out your portfolio.

Strategic Dividend Newsletter:
Sign up for the free dividend and income investing newsletter to get market updates, attractively priced stock ideas, resources, investing tips, and exclusive investing strategies. It also occasionally discusses market conditions such as the Shiller P/E and offers investing strategies from professional investors:

 Dividend Insights Newsletter

We respect your email privacy

Financial Freedom: The Accelerated Version

Achieving Financial FreedomThere are only a few essential steps to achieving financial freedom, yet most people do not take them.

This article is going to cover the basics on how to get there, but is also going to focus on one key change in mindset.

Essentially, most of the financial basics will allow you to be financially free in a couple decades or less. To accelerate that timeline, there’s one more kick you can use.

Master this, and you’re set.

What is Financial Freedom?

Being free, financially, means you have enough passive income to support your lifestyle. It could be a frugal lifestyle or a wealthy one; all that matters is that you can maintain it without working.

But an important note is that you can still be working and be financially free, you just don’t have to. Once you don’t need your job anymore, you can still work at it for extra income, and for enrichment. For example, there are physicians on my dividend newsletter. After all that medical school and residency, you can bet they don’t want to retire within 10 years! But they do of course want to be well off and live on their own terms.

Simple math shows that if you have a million dollars (which isn’t all that hard to get), and you extract 4% of it per year (via dividends, rent income, interest, capital gains) and it replenishes itself with better than 4% returns, then you can generate $40,000 in annual income, passively and forever. To get $80,000 instead, you’ll need two million dollars. So if your lifestyle is frugal, you can get by with less than a million saved and invested. For a more luxurious one, you’ll need a few million before you’re financially free.

Therefore, the definition of perpetual financial freedom is that your investments provide you with enough passive income to pay all of your expenses, and this passive income grows at a rate that equals or exceeds the rate of inflation. You never have to touch principle.

So let’s view it as a few different steps:

Step 1) Not Financially Free
You need a job to keep paying your bills. You may have an emergency fund and investments, but basically, your net worth will start decreasing if you lose your job and you can only maintain unemployment for so long.

Step 2) Partially Free
You have a very large pot of savings and investments. Not enough to pay your bills perpetually, but quite a bit. In addition, you have an alternative income stream. If you lost your job, you could keep working for yourself if you had to. Or, you already work for yourself, but you’ve got to keep hustling.

Step 3) Completely Free
You have that million or several million dollar portfolio, meaning that you can extract income from dozens or hundreds of sources to pay your bills, and you never need to work again if you don’t want to. You should still grow yourself and keep your skills relevant, but it’s all for fun at this point. Your wealth should actually grow over time, passively, even if you don’t actively contribute to it anymore.

The Three Variables

Across the full spectrum, from Warren Buffett to a minimum wage worker, wealth folds down to only three variables: income, expenses, and the rate of return on the difference.

Variable 1: Income
To optimize this variable, you either invest in specific types of education to become a highly paid professional, perform excellently at work and get promotions, start your own business that can scale hugely, or build a side income stream onto your existing day job.

Variable 2: Expenses
Optimizing expenses means minimizing them. There are some big wins here, like living in a modest house rather than a large one, keeping costs on automobiles low, living around a good public school system so you can send your kids there rather than to private schools, and traveling smartly rather than falling for tourist traps. Other wins include cutting energy costs, forming healthy habits to avoid unnecessary medical expenses, becoming hands-on around the house or with the car, etc.

Variable 3: Rate of Return
When your income is higher than your expenses, you can save and invest the difference. When this sum of money compounds over years and decades, the exponential rate of return is very meaningful. Someone who sticks to cash and gold won’t have much compounding ability. Likewise, someone who gets into bad habits with stocks and sells out of fear during market bottoms won’t have much compounding ability. The person who invests for the long term in index funds or value stocks has a good system for long-term wealth accumulation. If you take $100,000 and invest it at 6% per year, you only have $320,000 after 20 years. However, if you take the same $100,000 and invest it at 10% per year, you have over $670,000. More than twice as much.

The Basics (You Know These):

To be above average in terms of wealth, there are a series of steps that should be common sense, but generally are not all that common. Let’s get these out of the way before getting to the main point:

Start early.
Try to mitigate student debt by getting a job early and getting scholarships. If you don’t go to college, then obtain a skill set that leads to good work.

Learn the money basics.
Financial education is woefully inadequate in most places. In school you’ll typically learn how to dissect an animal, but not learn almost anything about above-average money management. So you’ll have to step out on your own on this one.

Read Millionaire Teacher, by Andrew Hallam. I’ve communicated with him, and he’s the real deal- an English teacher that became a millionaire in his 30’s through common sense. The book is concise, funny, and useful for a beginner. Regardless of your experience level it’s a solid read, and makes a compelling case for index funds. (This makes an excellent gift for a young adult, or anyone that isn’t particularly interested in picking stocks.)

If you ever invest in an individual stock, go to Berkshire Hathway’s website, and read the annual shareholder letters that Warren Buffett has written. The most successful investor in the world doesn’t write books; he writes annual letters to his investors.

And check out the tutorials on Dividend Stocks, the Dividend Discount Model, and Margins of Safety if you’re planning on ever picking individual stocks. And if you want the complete method, get the Dividend Toolkit.

Earn a good job.
If financial freedom and wealth are valuable to you, it’s key to get a job that pays well. The sciences, engineering, business, or professional paths (doctor, lawyer) are good bets and can be passionate and rewarding careers.

Picking other majors is fine, as long as you keep one thing in mind: college is for exploring but it shouldn’t be aimless, isn’t for everyone, and isn’t something just to do for $100k in student debt. Get a degree for a reason. If you have a job you love that pays moderately well, you can still achieve financial freedom rather quickly. Along these lines, if you enter the workforce without a degree but with an economically useful skill set or your own business, then you can be well-set for a wealthy future by making that a goal.

Learn marketing.
I’m not necessarily talking commercials and sales here; I’m talking persuasion. A fundamental lifelong ability of a top performer is the ability to persuade, motivate, inspire, and guide people to do things.

-Market yourself to a job interviewer. Turn the situation into one where you’re interviewing the company to see if they’re a good fit for you, not the other way around.

-Persuade your supervisor or client to go with your idea. Whether you’re an engineer, business person, lawyer, or anything in between, it’s a fundamentally useful skill to be able to explain your truths concisely and persuasively.

-Use your talents for entrepreneurship, charity, politics, social services, or whatever it is that piques your interest.

Spend less than you earn.
It shouldn’t have to be said, but you need to save a lot of money in order to become financially free. Don’t buy things for show, don’t tie your happiness to your material stuff.

“Give me health and a day, and I’ll make the pomp of Emperors ridiculous.”

-Ralph Waldo Emerson

That’s the one quote I put in the Toolkit. I’ve been asked before what he meant by that as though it’s esoteric, but the man is literally talking about playing around in the forest.

He’s saying go play with your kids, go for a hike, go for a run on the beach, take your significant other out mini golfing, teach yourself a new skill this week, go to the library and read a good book, help out with a charity event, play a sport.

For most people, income is viewed as the amount of money that can be spent. After bills and some basic retirement payments, all the rest is consumed! It’s a constant treadmill of consumerism and work for probably 90+% of people out there.

That doesn’t have to be you if you don’t want it to be. Spend what you need and want, but everything else is a resource. You’re not a person without a plan, where you just spend whatever you get after putting a little bit away. Instead, you know that you can save it up for an awesome opportunity years from now, or retire early, or become financially free. Play chess with your money, not checkers.

Don’t accumulate debt.
Student debt and mortgage debt = acceptable.

Credit card debt = of course not. Pay off your credit cards each month so you pay zero interest.

Save money in the right places.
-Contribute enough to your employer’s 401(k) plan to get full matching.
-Have a large cushion of cash set aside.
-If you’re under the income limit, consider contributing to an IRA.
-Then either put more into your 401(k), or start investing in a taxable account.

Diversify across cash, bonds, equities, and maybe real estate.

Another Key to Achieving Financial Freedom

If you follow those steps, you’ll do okay. You’ll make good money, save a lot of it, get a good rate of return that allows you to be financially comfortable, and eventually financially free, ahead of the curve.

But if you want to kick it up a notch, and it doesn’t matter how old you currently are, here’s another main thing:

Transform your passion from consumption to production.

What I mean by this, is to build or obtain a side income stream. Over the last century or so, developed societies have organized themselves around specialization. People get specialized in one professional area, and then focus on that. If something changes, and they’re no longer needed for that skill, they often don’t know what to do. Industrialization changed the game and led to specialization, and now globalization is changing the game again and highlighting the importance of flexibility.

It’s important to get really good at something. But it’s equally important to be a skilled generalist on the side.

If you have a career that required a very large investment of time and education, requires long hours, and pays very well (lawyer, doctor, executive, chief scientist, business owner), then a second income stream is less relevant. With that scenario, it usually makes more sense to reinvest time into your core work. But if you’ve got another type of job, like an engineer, manager, analyst, tradesman, or another profession, then you likely have a solid paycheck but also ample time on the side. These are good candidates for growing other income streams.

The Simple Math Behind a Second Income Stream

Let’s say you take home $75k after taxes, and spend $50k of it for expenses on yourself and your family. This leaves $25k for saving and investing each year.

Now, let’s say you find a way to add a $25k side income stream to that, after taxes. Now you’re pulling in an extra $25k net, for $100k total net income. If you keep your expenses the same, then you’ll be able to save and invest that entire extra $25k.

What this means is that your income only increased 33% ($75k to $100k), but your savings amount increased 100% ($25k to $50k). So bringing in that manageable extra income doubled your savings amount and essentially halved the amount of time it will take to achieve financial freedom if you keep this up for a while. Depending on how scalable and effective your income stream is, you could eventually even use it to launch full time into entrepreneurship.

How to Not Burn Out

It’s all a matter of habit forming.

What I’m not recommending is that you work 40 hours at your job and then work for another 20-40 hours a week at something you’re not necessarily fond of, and sacrifice your health, social life, and sanity to do it. The ironic thing about civilization is that we built up all this technology and organization, and yet we work more and have less free time than some hunter-gatherer cultures. So the last thing I’d want to recommend is to be a workaholic above and beyond what most people are.

Instead, the trick is to enjoy that side income stream.

After work and family, most people’s free time consists of television, shopping, aimlessly surfing the internet, and a couple hobbies. I certainly can identify areas in my own days that are not very productive. If you take a chunk of that- not all of it, just a chunk- and convert it from consumption to production, then your life can be richer both literally and metaphorically.

When you’re looking back at your life 10, 20, or 30 years from now, you’re not going to be sad that you missed a few shows or spent less time online or didn’t buy that widget you wanted. The things you’ll find important are: a) that you spent time with family and friends doing fun things and b) that you achieved something different, interesting, and worthwhile.

Here are some examples:

-In my state, volunteer firefighters don’t get paid anything. But in my friend’s state, he works as a part time firefighter in addition to his regular engineering job.

-A co-worker of mine who works as an engineer by day, spent some nights driving emergency vehicles. He doesn’t even need the money anymore, but does it because he loves it.

-Some people start unique business ideas. It doesn’t have to be some venture-capital backed plan to rival Facebook; it just has to be something that you enjoy that can bring in four or five figures or more per year, eventually.

-People have had success making high-quality crafts that they can sell on Etsy or in other places.

-A software engineer does some app design or freelance programming on projects that interest her on certain weeknights and weekends.

-Real estate is a common side business. Buying rental properties or fixing up houses for resale can be lucrative methods for building wealth and generating cash flow if you build a good system for it.

-Maybe you have a useful skill, like playing an instrument or performing well on standardized tests. You can turn this into a tutoring business, or teach some small group classes.

-I’ve had success with both freelancing financial writing for larger sites, and financial writing for this site.

The key here is that the hobby itself is production rather than consumption. Rather than viewing this extra income source as a burden, it’s fun. Even if that means leaving some money on the table- the whole point is fulfillment, not just dollars and numbers.

There are 168 hours in a week. A typical person might spend it as follows:

Unproductive Week

So we’ve got 8 hours/day for sleep, a 45 hour workweek (assuming roughly 9 hours a day, five days a week), a solid 4 hours/day for family or friends, 18 hours of random time per week (web surfing, tv watching, hobbies, gym, random stuff, and this could involve family/friends as well), and 3 hours/day of maintenance, which primarily consists of the frictional and necessary stuff: commuting to work, showering, brushing teeth, cooking, going to the doctor, paying bills, shoveling snow from your drive way, getting dressed in the morning, figuring out what’s wrong with your car, etc.

But if you can improve that, you can turn it into something like this:

Financial Freedom Example

There’s the same amount of sleep, work, and time for family and friends, but a few other things have been optimized.

First, less time in general was spent on random stuff: fewer tv shows, fewer video games, less web surfing, and so forth.

Second, some things have been mixed to optimize them. It’s the accumulation of a few “productivity hacks” or changes in how things are viewed. Here are some examples:

-Maybe preparing and eating dinner previously was in the maintenance category, but now you view it as family and friend time because you cook a high quality meal with your significant other, or friends, or parents/kids. You use it as a time to improve your knowledge of cooking, to create a real meal.

-Let’s say a hobby of yours is reading, and you also have a 45 minute commute to work. You can optimize this a bit by listening to audio books as you drive instead of music or a talk show. Because it’s the same path every day, you know it by heart and don’t have to worry about directions; you just have to be an observant and safe driver on a path you know like the back of your hand. I wouldn’t recommend a particularly heavy read, but if it’s a light read, this can work. Now, you’ve combined some hobby time and some maintenance time.

-You got in the habit of getting out of bed within 3 minutes of your alarm clock going off, when it used to take 20 minutes through numerous snooze attempts. Those 20 minutes were neither restful sleep nor productive time, and added up to 2 hours and 20 minutes per week or over 120 hours per year. So they were cut out.

-Maybe your ‘production time’ for building a side income involves your husband, wife, or partner, so it’s a joint effort where you’re spending time focusing on making something happen.

By optimizing the example week, 18 hours of productive time were added into the week, which is more than enough time to create a fun and lucrative side income stream to achieve financial freedom.

For example, if your earning power for this side income stream is only $10/hour, you’re still looking at $180/week, $720/month, or $9,360/year of gross side income.

If you can boost that to $25/hour, now you’re looking at $450/week, $1,800/month, or $23,400/year of gross side income.

For some people, there could be a skill that you can scale rather well, or that is nuanced enough that you can charge more for. If you can get $75/hour, then you’ve got a solid $70,200 per year with 18 hours a week of work on something you enjoy.

The details of how you can work your week will vary based on your age, responsibilities, job, partnership status, children, and so forth. But there’s almost certainly a way that you can increase productive time while also enjoying the week more.

The Takeaway

This method is so powerful because it figuratively kills two birds with one stone.

When offered the basic advice to wealth and financial freedom of “earning more, and spending less”, that sounds boring to people. It is generally thought of as a sacrifice, because people want to do things, and they’re being told to do fewer things, or cheaper things.

But by growing a side income as a fun hobby, you’re simultaneously boosting your income and savings rate, and reducing your consumption. Your reason to spend less on a car or television or random stuff, is not that you need to sacrifice and cut back, but rather, that you change your perspective and view many of these things as time sinks that get in the way of doing more interesting things.

In most of our minds, productive things produce money, and unproductive things do not.

However, the definition I personally use for “productive” is that it is something that as an old man, I’ll look back as being happy I did. So getting enough healthy sleep, getting enough exercise, spending time with people, investing in myself through books, watching my favorite movies, working a good job, using free time for enriching or relaxing activities, and producing value for other people to generate extra income, are all productive.

Things that are generally not productive are excessive television, excessive video games, random web surfing, and unproductive maintenance time.

So if you want to achieve financial freedom earlier, while enjoying everything in your week to a more thorough degree, consider building a side income stream that you enjoy and that allows you to boost your savings amount by 50%, 100%, or more.

photo credit: esther

Strategic Dividend Newsletter:
Sign up for the free dividend and income investing newsletter to get market updates, attractively priced stock ideas, resources, investing tips, and exclusive investing strategies:

 Dividend Insights Newsletter

We respect your email privacy