Tuesday, 29 December 2009

Living Off Dividends

Living off dividends is one of the best goals you can aim for, and it is certainly something I aim to do.

Dividends are payments companies make to shareholders. If you own shares, every so often the company will will drop money into your bank account as dividends. By owning shares, you can provide income for yourself without actually doing any work. Income from work requires time and effort, but you can earn income from shares by sitting back and doing nothing. This passive nature of earning income is why dividends are a form of passive income.

It is important to understand that ownership of shares is not the only way you can earn money from doing nothing. You can receive passive income from savings accounts, term deposits, real estate, bonds, royalties from book sales, and so on. When I say that living off dividends ia a worthwhile goal, I am referring to living off passive income. I talk about dividends because I personally use stock ownership almost exclusively to earn passive income. For the average person, I think it is probably not a good idea to exclusively rely on stocks for passive income. Do as I say, not as I do. You should diversify into less risky income-producing inverstments like term deposits. There are some term deposits out there now that give you 7 per cent per year. I have not invested in these mainly because you need to save up a whopping $25,000 to invest in them.

The main benefit of living off dividends is the freedom it gives you. When you live off interest, rent, and dividends, you live off the fruits of other people's labour, not your own. You don't work for others. They work for you. This gives you incredible independence. Many people who are dependent on work income to fund their mortgage, car payments, etc are essentially slaves to their bosses. If the boss tells you to lick the toilets clean, if you depend on your job to pay for your food, mortage, car payments, etc then you have to lick the toilets clean in order to survive. There is no dignity in being a slave to your boss. However, if you had passive income, you don't need to lick the toilets clean if your boss tells you to do so because you can quit and still comfortably live off dividends. While you are unemployed you can find another job but even if you take a long time finding a job or even if you never find another job, it doesn't matter because you don't need to work for yourself. Others work for you.

Many people say that debt is dangerous. Just to be clear, I am not anti-debt. I think debt can be used as an effective tool to build wealth. If you borrow money and invest in an asset that goes up in value significantly, you can build yourself massive profits. The problem is that there is no asset that is guaranteed to go up significantly all the time. (If such an asset exists, why would anyone bother working. Just borrow money, buy that asset, and then retire.) For the average person, I recommend you stay out of debt. This not only means staying away from the debts that almost everyone thinks are bad such as car loans and credit cards but also the so-called good debts like home loans. I recommend you try to buy a second-hand car and to live with parents if you can. I am different to most people in that I broaden the definition of debt. Most people think of debt as obligations to pay money placed upon them because of some bill that appears in the mail, e.g. credit card bill. My definition of a monetary debt is as follows: "a future obligation to pay." Hence a credit card debt is a debt since you are obligated to pay X dollars by a certain date. The same applies to home loans and car loans. However, using this definition, it becomes logical that hunger and shelter are also debts. All humans have a need to eat food for energy and a need to cover himself for shelter from cold and heat. In order to eat and in order to cover himself, he need to pay. Hence eating and sheltering are future obligations to pay and hence by definition they are debts. We all are born with debts because we all need food and shelter. They are necesities for life. The best way I think you can eliminate these debts is to produce passive income. The more passive income you produce, the less indebted you are and the less indebted you are, the further away you move from a state of slavery. The greater your passive income, the greater your freedom.

If the need to feed and cover yourself is a debt, then image how much more debt you'd be in if you had a child. If you produced a baby, not only do you have to feed yourself but you are also legally obligated to feed your child (if you don't, you will go to prison). Hence having a child is one way of going into immense debt. The problem is worse because if you have a child without being able to pay the debt then you harm not just yourself but you also harm an innocent child.

CNN Money is a critic of living off passive income. In their article Living Off the Interest? Good Luck, they say that living off passive income is a poor strategy because "few people will amass a big enough nest egg to live without touching principal." The problem with many of these analyses is that they assume that your investments will not provide enough income for your lavish lifestyle. The way to live off dividends then is to keep your expenses low and to invest in high-yielding investments.

If you are an Australian resident who wants to produce passive income, I recommend you invest in the Vanguard High Yield Australian Shares Fund (High Yield Fund). The management fees of 0.90% are a little high, but given that this mutual fund gives you monthly distributions (most of the time) and franking credits, I think it's worth it. The High Yield Fund doesn't really track any existing index and so it cannot really be called an index fund but an actively managed fund or maybe a mixture of both. Rather, it takes the ASX200 index, strips AREITS out, and then invests in the companies in the index that pay the highest dividends. Another investment that I think shows good passive income potential is the SPDR S&P/ASX 200 Listed Property Fund (SLF), which in an ETF you can buy on the ASX. As of Christmas 2009, SLF has a 8.03 per cent dividend yield.

Ultimately, dividend investing is an inexact science as it is difficult to predict how dividends will change over time, so it is up to you to select the best investments. The two products I recommend above are just recommendations for those who don't know where to start. They are products that I use myself.

I have about 20,000 units in the High Yield Fund. The graph below shows the historical distribution payments from High Yield Fund if you had 20,000 units in it. The horizontal axis shows the date, the vertical axis is in Australian dollars, the blue line shows the distribution payment, and the red line shows the 12-month moving average of distribution payment.

As you can see, about 30% of the time the fund does not pay a distribution. The 12-month moving average suggests that on average the distirbutions are fairly stable. It would seem reasonable to live off this income stream. There are a few spikes, suggesting that some years there are windfall profits to companies.

According to my estimates, my passive income at the moment is about $254 per month, so I am about halfway to being able to live off passive income. At the moment I am investing 80% of my pay, which I think is the most I can handle without suffering immense pain. I think an individual should save up at least 50 per cent of his pay initially and, when he is comfortable, be more ambitious and slowly increase that savings rate higher if he can till it is, say, 70 or 80 per cent. This way you can most quickly get yourself into a position where you can live off dividends. If you are not living off dividends, you are a slave, and what is the best thing for a slave to do? Escape.

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