WHY PASSIVE INCOME?

One of my biggest missions in life is to show people the value of passive income and how much freedom, independence and choice it can give you, particularly when that passive income keeps growing year after year.

As you know, you can use the $1000 Project to create and build your own passive income supply – if you’re ready to. And having a passive income – allowing your money to work for you, rather than you working for money – appeals to a lot of people on a deep level.

I’m absolutely passionate about my job, and honestly don’t ever get Mondayitis or feel that my work is a monotonous grind. I love the idea of going to work because I choose to, not because I have to. It makes a massive difference to your headspace and attitude when you know that you’re not working to pay the bills, but to build something powerful that will benefit your future and the future of others. That feeling of purpose is so important.

So, building naturally growing passive income is a big part of my personal financial goals in life. I don’t necessarily intend to retire early (I’m way too hyperactive for early retirement!), but I love the idea of having the freedom to decide how I spend my time, and where.

Passive income offers the freedom to work when I want and where I want. Freedom to say yes to my family when they need me. Freedom to take family holidays where and when I want them. Freedom to experience what I want to. Freedom to give unconditionally to charities or help people in need. Freedom to buy the best food and health care for my family, and freedom to leave situations that don’t work for me or my value system.

The main way I’m building my passive income from the $1000 Project is by investing in shares – specifically Australian industrial shares, listed investment companies and some international exchange traded funds. (I’ll explain what these are shortly.) These types of investments suit my long-term goals for building passive income and capital growth opportunities, and I understand and accept their high levels of volatility because history shows it’ll be worth it for great long-term performance.

Where and how you invest is your decision, and you need to understand the risks, benefits and value of investing to you and your goals. I chose to use the $1000 Project to create greater financial security outside of my salary and savings. I wanted to be proactive in creating something to help take care of me financially and give me the freedom and peace of mind I desire.

WHAT ARE SHARES?

In my experience, a lot of people are misinformed about investing in shares, and are almost scared of them. If you don’t understand how they work, you won’t be able to grasp how amazing and beneficial they can be in helping you grow your financial wealth and create more financial harmony in your world.

So in this chapter, I’d like to shine some light on shares so that you can see they aren’t really that scary, and maybe you’ll realise that they could suit you and your goals. I also want to help you realise that managing your money and building an investment portfolio isn’t that hard, especially when you use managed funds, exchange traded funds or listed investment companies. It’s a lot simpler than you think.

To start off, you need to understand the very basics. When you own shares in a company, you own part of a business and are referred to as a ‘shareholder’. Your ownership is documented electronically or on paper, in exactly the same way that your ownership of real estate would be documented through a title deed. Many people claim that shares are just bits of paper or ‘intangible assets’, unlike property – but understand that the businesses you invest in and partly own are just as tangible as a house or flat. The supermarket that I own in my share portfolio – and shop at! – is tangible. The airline that I own in my portfolio – and fly with! – is tangible.

And shares can be incredibly valuable when they’re selected carefully in light of your goals, your risk appetite and your financial strategy. You buy shares with the expectation that the business will continue to develop its products and services, which should increase the value of its shares (and your investment). This is known as ‘capital growth’.

Some of the profits that the business makes each year or half-year are reinvested into the company so that it can continue to grow and produce better and more successful goods and services. However, many companies will also pay you, a shareholder, some of those profits via ‘dividends’, which are normally paid twice per year.

This is a form of passive income – similar to the rent you receive for an investment property, but with sweeter benefits.

Keeping things simple, there are three major groupings in our sharemarket in Australia that you should be aware of – the Industrials Index, the Resources Index and the All Ordinaries Index. (An ‘index’ is a way to measure the share prices of groups of companies – like a thermometer used to monitor the general health of the stocks in that group.)

If you refer to the chart above, you can see how much $100 000 invested in each of these three groups in December 1979 would be worth today. Your resources portfolio would be valued at just over $763 000, your All Ords portfolio would be worth just over $1 115 000 – and impressively, your industrials portfolio would be worth over $1 830 000. And that’s assuming that you spent all the dividends you received.

Looking at these numbers, I’m sure that you’d have preferred not to have bothered with the All Ords or Resources indexes in 1979, and instead to have put your full $300 000 into industrial shares. A far more efficient and effective application of your funds, don’t you think?

Coming back to the conversation around passive income, dividends can be an important part of the $1000 Project journey, if you feel that investing to create passive income sources is going to be your immediate or eventual strategy. Dividends have actually been a bit of a dark horse of the Australian sharemarket, but have contributed impressively towards the total return of the market over time. Take a look at the next chart, which factors in the power of dividends over the long run.

It’s the same as the first chart, showing the $100 000 investment into each of the three indexes – but it shows the result the investments would have achieved if the dividends were reinvested into the portfolio instead of being spent. Let’s just say the term ‘blowout’ is appropriate – and probably an understatement!

Looking at the chart, you can see the Resources Index is up to an impressive $2 225 000, and the All Ords is even better – worth over $5 309 000. And the Industrials Index is worth over $11 000 000!

Yes, look at the chart again . . . you aren’t going cross-eyed. Your industrials portfolio purchased at $100 000 would be worth over 108 times your initial investment. How can that be? $100 000 into $11 000 000 over thirty-seven years?

Well, the answer lies in the fact that shares are two-dimensional, in that they pay income as well as increasing in value. This means that you get a growing passive (dividend) income over time, because the value of the asset increases over time. A $3 stock paying a 15¢ dividend becomes, thirty years later, a $24 stock paying a $1.40 dividend – your last dividend payment could end up being more than 46.5% of your initial investment!

The dividends grow with the value of the asset, which is really powerful when you allow time to let your portfolio grow in value. As an extra bonus, industrial shares often come with tax credits, which I will explain shortly.

Now, some people will say that shares are volatile, but their dividends are actually considered to be less volatile. Without getting too complicated (and possibly boring), the worst annual dividend return (before dividend imputation) was 2.7% in the year to the end of 2008, and the best performance was 6.2% in the year to the end of December 2009, as recorded on the ASX website. So, even in the scariest of economic conditions, for example a Global Financial Crisis, as a shareholder in industrial companies, you can expect at least some dividend return. Collected from a variety of different stocks, these add towards your gross passive income.

I estimate I’ll typically get an average of 4% to 5% p.a. in passive income from my portfolio. Having an approximate idea of what the income will be – and being able to compare it to the previous year – gives me the motivation to keep building it and adding more shares to the portfolio. Eventually, it will compound enough to achieve my financial goal of covering my cost of living, providing me with the financial independence and freedom that I desire. This is so simple and something that you can do too!

WHY SHARES?

One of the reasons I love investing in shares (and in particular Australian industrial shares, if you hadn’t noticed yet), is that it’s so quick and easy to get started. You can buy shares with as little as $500! However, there’s typically a ‘brokerage’ or transaction fee of around $20 to buy each parcel of shares (using a DIY online broker such as CommSec or ANZ Share Investing), so I suggest starting with $1000 worth so that your investment doesn’t get eaten away by these fees.

Compare this to property, where it could take you years and years just to save up a deposit – buying shares means that you can get started on your investment journey much sooner and start building momentum. Also, you don’t need to worry about the exorbitant stamp duty that we have to pay on property in Australia, nor the eroding holding costs such as strata fees, landlord’s insurance, water and council rates.

If you want to sell some of your shares down the track, you can do so relatively easily and quickly as well, and you don’t have to sell the entire portfolio just to release a certain amount of money. By contrast, you can’t sell a third of an investment property – it’s all or nothing.

And when you do sell property, the exit costs are quite high, with legal fees, agents’ commissions, marketing expenses and so on . . . Not to mention that it can take more than a few months to sell by the time you advertise the property, have the inspection campaign, and get through to the exchange of contracts and settlement period. With shares, you just pay a brokerage charge – either a flat dollar amount or a small percentage of your profits – and then the money turns up in your bank account within two business days.

But what I love probably most of all about Australian shares is that most industrial shares come with what are called ‘franking credits’. Franking credits (also known as ‘imputation credits’) are a type of tax credit that allow Australian companies to pass on any tax that they have already paid (at the company tax rate) to the shareholder. The shareholder can then use this prepaid tax as a credit to help reduce their income tax (and potentially receive a tax refund, depending on their marginal tax rate).

Let’s look at an example to show how this works.

Say you earn $400 in passive income from your portfolio of Australian industrial shares via dividends, and a further $400 from your term deposit via the interest you’ve earned. Both investments are earning you the same income: $400 each.

However, the dividend from your shares comes with a franking credit, as tax at the company rate of 30% has been paid to the ATO by the company on your behalf. The interest earned from your term deposit, however, comes with no tax credits.

When you do your taxes, you naturally (and honestly) declare both sources and amounts of passive income; for the dividend income, you add the tax credit back in to your total declared taxable income. I’ve put the figures into a table for you:

In your hand, you’ve received the same income from the shares as from the term deposit – $400. However, after income tax is factored in, the numbers shift. If you had a marginal tax rate of 40%, for example, you’d owe $228 in tax on your dividends, versus $160 on your interest from your term deposit. But you get to use your magic franking credits on the dividend income, and deduct the tax that was previously paid by the company ($171) from the tax you owe ($228) – leaving you only owing the tax office $57. With the interest earned on the term deposit, by comparison, you have to pay the full $160 in tax, as there’s no tax credit. Here’s how it looks in our table:

So, at the end of the day, your net position from investing in shares with dividends that have franking credits is higher: you’re walking away with $103 more.

As you can see, Australian industrial shares with franking credits can be extremely valuable in your portfolio, especially when you look at the after-tax returns – and the amount of money left over in your pocket.

Franking credits are the reason that industrial shares outperform resources and even the All Ords over the long run – these valuable tax credits are typically not available in the resources sector of the sharemarket.

For the $1000 Project portfolio, I’ve removed temptation where possible and enrolled in automatic dividend reinvestment plans for all the companies that have them. This way, I don’t need to remind myself not to accidentally spend any of my precious passive income, and put it to better use for the future. For the companies that don’t offer automatic dividend reinvestment plans, I make sure that I immediately transfer any dividends paid to my separate $1000 Project account, and then buy more stocks once I have another $1000 ready to invest.

At any point, you can decide to stop reinvesting the dividends and simply receive them as payments to your bank account. It’s quick and simple to change this – you have complete freedom and control.

Looking at my growing passive income, I have zero intention of ever selling my $1000 Project share portfolio. It currently provides an annual income (albeit small), and if I can continuously reinvest the dividends for future compounding growth, and add to the portfolio by buying more stocks with my parcels of $1000 at a time, the passive income will grow over the long run and eventually cover my cost of living.

OUTSOURCING SOME OF THE HEAVY LIFTING

The investment strategy that I’m talking about is a very simple ‘buy and hold’ one; the actual picking of the companies for your portfolio can be just as simple.

Now, investing opportunities don’t just exist within the Australian sharemarket – the numbers are equally impressive for most international stock markets. So, to help me diversify and spread my risk (which I’ll discuss further in the next section), I chose to get some expert assistance in the creation of my growing portfolio, including purchasing international shares.

I don’t really feel like I have the expertise or knowledge necessary to pick individual companies to invest in outside of my own country – sometimes I’m not even 100% comfortable picking individual stocks within Australia. So, I often outsource this part of the decision-making process to an expert, by investing in an exchange traded fund (ETF) or even a listed investment company (LIC).

Both exchange traded funds and listed investment companies are prepackaged selections of shares, bundled into a single option that is traded together on the stock exchange. You buy ETFs and LICs like shares, and they pay dividends and have the same objective to grow in value over time as companies do. The key benefit is that you don’t have to worry about choosing what stocks to buy and when: it’s handled for you by whoever issues that particular ETF or LIC.

Each ETF and LIC has an inbuilt portfolio of shares that has been hand-picked by a fund manager, and is already diversified. In my case, an ETF or LIC was a great choice when I wanted to invest in the US market but had no idea of the best company to buy into, and only had a small amount of money to invest initially. An internationally based ETF or LIC allowed me to start building a portfolio with diversified exposure to the US stock market, without the stress.

There are plenty of Australian ETFs and LICs that also offer these benefits if you want to outsource your investment decisions. And in fact, I’ve incorporated a core strategy in the $1000 Project portfolio where I slowly add to my holdings of these styles of investments each time I have another $1000 to invest. Then I cherrypick individual shares to buy if and when I want. This makes investing very simple and a lot less stressful.

Of course, in exchange for doing this heavy lifting and decision-making for you, ETF or LIC portfolio managers charge a predetermined fee. You have no say in which stocks you want and don’t want in the portfolio, or when they are bought and sold. You also don’t have any voting rights in the companies whose shares you own. Even so, ETFs and LICs are a terrific way to build a diversified portfolio if you want to get started but don’t have the time to do all the research.

Another, similar option is managed funds. Just as with ETFs and LICs, a manager selects the stocks for the fund and decides if, when and how much they will purchase. Managed funds aren’t traded on the stock exchange like ETFs and LICs, though, as your money is pooled together with those of other investors. Also, these types of funds aren’t quite as popular or big as ETFs and LICs tend to be, and so the fees are higher – typically between 0.75% p.a. and 2% p.a. An ETF is more economical, with the fee range being more like 0.05% to 1% p.a.

So why would you use a managed fund over an ETF or LIC? Well, one advantage is that most managed funds allow regular investment through an automatic direct debit. You can invest an initial amount (typically the minimum is $5000) and then set up a regular investment plan of, say, $100 per month. This is great for people who want an almost ‘set and forget’ investment strategy, where they don’t need to deal with online broker accounts or stockbrokers, or pay brokerage fees every time they want to add to their portfolio.

Having an investment plan where the funds automatically come out of your account without you having to remember helps to create a great habit. Often, after enough time has passed, you don’t even notice the money coming out, but you still get the comfort of knowing that you’re building your financial future. And you can also set your account up to have your dividends automatically reinvested back into the managed fund, which gives you more opportunities for growth.

Not all ETFs and LICs allow automatic reinvestment, which means that you need to manually buy more yourself; you also have to make sure that you don’t accidentally spend the dividends when they’re deposited into your account. If your account is set up with the dividends going into your everyday spending account, they can soon evaporate into your weekly or monthly spending!

If you’re an organised person and regularly check your bank transactions, transferring the dividends into your $1000 Project account is easy to do. For me, though, I find that life can get distracting, and an ETF or LIC with an automatic reinvestment plan is much easier to manage.

If you want to regularly add money to your ETF or LIC investment, you can set up a separate account where an automatic monthly amount is put aside until there’s enough to invest. (As I mentioned earlier, I recommend waiting until you have $1000 or more, to keep the financial impact of brokerage fees down.)

The most important thing when it comes to picking a managed fund, ETF or LIC – or a stock! – is that you’re clear on what your goals are, what your time frame for investing is, and how much of an appetite for risk you have. This will help you to work out where you should be investing your money to achieve your financial goals. Do your research and always read all the documentation before making a final decision.

HOW MUCH RISK CAN YOU BEAR?

When I first started building my portfolio for the $1000 Project, I could only buy one parcel of $1000 worth of shares at a time. This meant that I carried a lot of investment risk in the early stages, as the value and performance of my portfolio was heavily reliant on just a few different companies.

As time went on, though, I was able to add different shares to the portfolio, and soon I had ten to fifteen different stocks, operating in different industries, and all paying me dividends. Today, I have over eighteen different stocks and my aim is to continue to diversify my portfolio up to between twenty and twenty-five different stocks, before I go on to focus on building the number of units I hold in each company.

Having this range of different companies in my portfolio has really reduced my investment risk – it’s spread across a wider range of businesses and industries, which helps protect me when some go through challenging periods. Whether you’re buying direct equities (shares), ETFs, LICs or managed funds, it’s important to remember that companies don’t perform in a uniform manner. Profits, performance, risks, threats and opportunities vary from one business to another. Having a healthy mix of different shares means that the volatility or share-price pullbacks of a company that’s struggling will be offset by the strength of other companies in your portfolio.

It’s human nature to want maximum return on your money with minimal risk, but some people can handle more risk than others. To help you understand where your limit is and how it should affect your investing habits, I recommend doing a risk profile questionnaire. This is a series of questions about your investing experience, how you’d react to certain conditions and why, how you feel about investing, and so on. There are plenty of these questionnaires available online – one of my favourites is on the Vanguard website vanguardinvestments.com.au.

After you complete an online risk questionnaire, your answers are analysed and you’re given your risk profile. Your profile may vary slightly from questionnaire to questionnaire, but each one will give you a feel as to where your portfolio or asset construction should sit. Risk profiles range from very risk averse (often called ‘cash’ or ‘conservative’ investors) through to more comfortable with risk (‘growth’ or ‘high growth’ investors). There’s no right or wrong profile – they’re purely designed to show which type of investment asset class will work best for you and your goals. And your profile may change as your level of experience and knowledge evolves.

But no matter what your risk profile turns out to be, please go back and look at the two charts on pages 117 and 118 – you can see from the charts why I’ve chosen to focus on shares.

The good news is that once you know your profile, you can start researching and finding different pre-constructed managed funds or ETFs that would be appropriate for you. Then you’re on your way to building your investment portfolio!

RISK AND ASSET CLASSES

Your risk profile will suggest what percentages of different ‘asset classes’ you could aim to have in your investment portfolio in order to match the level of risk you’re comfortable with. This could be, for example, 30% Australian shares, 35% international shares, 10% cash, 12.5% Australian fixed-interest investments and 12.5% international fixed-interest investments.

Asset classes can be divided into two groups:

  1. Income-based assets, which are quite conservative, consistent and carry low risk, but also have low returns over the short to medium term. Examples include cash (as in savings) and fixed-interest investments like term deposits, corporate and government bonds, and so on. The returns are usually very reliable, so great for the nervous investor, but won’t be enormous. Worst of all, these assets are missing the element of capital growth, which makes a big difference over the long run as to whether the income grows or keeps up with you.
  2. Growth assets, which include assets such as property and domestic and international shares. These investments experience high levels of short-to medium-term volatility, so they carry more risk – but in the long term, the returns are generally much higher, particularly when you are properly diversified and manage your investments correctly. And remember, we want the growth assets that we invest in to pay an income, so that we get the best of both worlds.

With investments in growth assets, when market volatility kicks in and you watch your portfolio ride a tsunami of downs upon downs, you need to be able to calmly and rationally ride those waves, and become a professional surfer! You have to focus on the long-term results; you may even be able to capitalise on a downturn by grabbing a few bargains in the sharemarket’s ‘stocktake clearance sale’.

Think about it: how would you react if your favourite shop suddenly started selling its stock at a massive discount? Would you panic and sell all the items you previously purchased from that store? Umm . . . no. You’d probably hightail it to the store and make the most of the opportunity!

Just bear in mind, though, that a tsunami-style stocktake sale like this can go on for as long as two years, sometimes even longer. Which can be a true test of your strength and determination, as well as your trust in yourself and your decision to invest in this asset class. You need to focus on your strategy and stick to it. And don’t forget, if you have dividend-paying shares, even when those share prices are supressed, you will most likely still be earning a passive income from those shares. So they still have your back in the tough times.

More advanced investors tend to view income-based assets as boring and slow in comparison to growth assets, and much prefer the thrill, excitement and opportunity or even efficiency that growth assets provide. But income-based assets have a very valid place in the investing world. They’re often a suitable choice for people who have a shorter investment time frame, for example, as the volatility risk is reduced.

Let’s say you have $20 000 to invest and your goal is to buy a new car in five years’ time. Even though your instincts and risk profile indicate you’re better suited to being a growth or even high-growth investor, you don’t have the benefit of time on your side – you want to be able to spend this money within five years. So, you’d be wiser to keep it invested in something simple and, most importantly, liquid (can be sold quickly), like cash. That way, when you’re ready to purchase the car, the money will be there ready for you, and hopefully will have grown to more than you invested initially, even if only by a little.

If you put that $20 000 in an aggressive high-growth portfolio, and in year four the Australian stock market experiences a correction or pullback for whatever reason, the value of your investments could drop with the market. That $20 000 could be suddenly worth only $16 000 (a loss of $4000), and your time to buy the car is approaching, meaning you have to crystallise that loss by selling the portfolio. If you crystallise your loss, it means that you have formally locked in and confirmed that loss. You haven’t given it the time or benefit of the doubt to recover. So, unless you have a long-term goal at least seven years away – or, even better, a minimum of ten – be careful about including too many growth assets in your portfolio.

Typically, the younger you are, the more time you have to invest, the more opportunities you may want to take to give your funds a chance to grow in value – and the more risk you may be able to bear. The general consensus is that younger people should focus more on long-term wealth opportunities, and should have a portfolio closer to the growth or even high-growth end of the spectrum.

It doesn’t work like this for everyone, though. If you’re completely new to investing, you may want to start with a more balanced approach, and then look to slowly add more growth assets to your portfolio as time goes by and more parcels of $1000 flow in. You can let it evolve and grow organically with your experience and education levels. Remember: the choice is yours, and this is your money, so you need to be comfortable with what you decide to do.

On that note, if you’re doing the $1000 Project initially to fix short-term financial problems such as paying off debt, but you feel inspired and motivated by the simplicity and effectiveness of investing and are eager to get started, the good news is that you can! Start with your superannuation.

Your superannuation is actually your own investment portfolio, which is simply locked by the government so that you can’t spend it. If you’re an employee, your employer is paying 9.5% of your salary every year into this locked investment portfolio for you. And you can decide where it gets invested.

Most likely, your superannuation account will eventually become your primary source of retirement income, so it pays to invest in it and help it grow wisely. Refer back to charts one and two and ask yourself – where would you like your money invested for your future? The build-up for retirement for many Australians is at least thirty to forty years, so you may have the benefit of time, depending on your age and circumstances. And the more money that you have in super, the greater the income you will be able to draw in retirement, or the longer the income will last. Both sound good to me.

So, do yourself a huge favour and involve yourself with where your superannuation is invested today. Don’t settle for the default account because you’re too busy to check. Call your super provider and see where your money is invested and what other options exist. (Again, refer to charts one and two for inspiration if the sharemarket is within your comfort zone.)

In the meantime, use the $1000 Project to achieve your other financial goals and come back to investing later if you want to. Just don’t neglect your super!

HOW TO GET STARTED IN SHARES – 5 EASY STEPS

In summary, if you intend to use the $1000 Project to start investing, you need to follow these steps:

  1. Understand your goals.
  2. Complete a risk profile questionnaire, but remember to assess it while looking at the two charts in this chapter.
  3. Consider different investments, including managed funds, ETFs, LICS and even shares if you feel up for them. Remember, the first three options take away the stress and reduce the time you need to spend researching.
  4. Make a decision and implement it.
  5. Review your portfolio regularly, but focus on the passive income that it’s generating rather than the growth, and look to improve and build this as much you can.

Most importantly – never stop growing your financial knowledge and experience!