Friday, January 15, 2016

Your most important asset

In the first two weeks of this year, the stock market has been down a lot. For someone who invests for dividends, I am relatively agnostic about stock price fluctuations. As long as the dividend is paid, I can afford to hold on to my portfolio. I can also afford to take advantage of lower prices when I have fresh new money coming in, which are ready to be invested.

The money I have invested in my portfolio are a result of my ability to earn income. It was reassuring that during a turbulent week for most investors, I was able to receive some fresh cash deposited in my checking accounts, in addition to any cash dividends I obtained as well. This got me thinking that my ability to earn income is an important asset in itself. In the accumulation phase, this ability to earn income and to save money is very important.

If you had asked me a few years ago what my most important asset was, I would have told you that the most important asset was my dividend portfolio. Upon further reflecting, I have come to the conclusion that my dividend portfolio is very important to me. However, it is not my most important asset.

The most important goal is the ability generate income without much effort on my time. However, this requires an upfront investment in time or capital. It also requires some maintenance as well. The passive income generator is my dividend portfolio of course. It took me eight years to reach $15,000 in forward dividend income. In a few more years, I will reach my dividend crossover point, after which I won’t have expend units of time for units of currency. Until I get there however, I would have had to spend something like 10 – 11 years accumulating capital ( plus something like 5 years after high-school to obtain relevant degrees and certifications).

The reality is that my most important asset is my ability to generate income over time. After all, my primary cash generator is the engine that provides fuel for my investment endeavors and also pays my bills until I reach the dividend crossover point. I view myself as a DGI Inc, where I am in charge of increasing my earnings capacity. The goal is to generate the most earnings for the least amount of effort and time possible. This is achieved through streamlining, growing, and learning skills that generate higher profits for each unit of time.

For most people, their most important asset is their job skill set. This is why it is important to always do a good job, keep a wide network of contacts and to keep that job ( or look for another one in the field). This primary job is important, as it provides you capital to invest. If you want to retire early, you will have to pay the opportunity cost of not earning income. This is not a problem if you have the passive income to pay for your expenses. However, if you are still in the accumulation phase, it makes sense to keep grinding at a job until you reach your dividend crossover point. Switching careers is fine, as is the ability to do side projects for cash.

This is why it is important to dedicate the most of your time and attention to your job, and not as much to investments in the accumulation stage. This is because you will get the best return on each unit of time you allocate with a job, and not with the investment. That doesn’t mean that learning about investments is a waste – in fact it is very important. If you have spare time, you should learn the basics of investment. Investing is important, because you get to learn how to generate money with money, and therefore ultimately free you from having to work. But as we reiterated above a couple of times, without that initial cash generator ( your job) and the time to accumulate capital, you will not be able to get to the investing phase.

For example, if you have a low net worth, you need your job/business venture in order to build out your investable assets. It is not possible to retire on a portfolio worth less than $100,000. And as we all know, the first $100,000 is the most difficult. Only after a few years of working and saving to accumulate that capital, and compounding on that capital, can someone reach that magic figure.

For most people out there, it makes sense to find that job that excites you, and figure out how to get the highest return on investment for each unit of time you spend. We all know however that there is a point of diminishing returns with jobs. In addition to that, most jobs are not scalable. No matter where you work, or how easy your job might be, you will have to put in at least 40 hours of working/sitting in a cube/sitting in meetings to get paid.

The expected amount of your lifetime earnings will be largest when you are younger. When you are in yours 20s, your human capital is full of potential. For most individuals in their 20s, they could easily expect to work for another 30 – 40 years. However, if you are in your 50s or 60s, you will likely work for about 10 – 15 more years ( or less). So this is the time at which the expected value of your human capital is much lower. When you are old and can no longer work, you hopefully converted that human capital of yours into financial capital such as stocks, bonds, real estate, pensions etc. This will pay your bills in old age. That’s why I believe that learning about investing is the most important thing a person can do. Obviously, they need to start slow, and need to focus on their primary cash generator first – their job or their business. However, if you never learn how to invest that money, you will suffer financially once you are low on human capital.

In the initial stages for youngsters like myself, it may pay better to spend your time learning a new job skill or getting an advanced degree, rather than analyzing the 10-K for Johnson & Johnson (JNJ). If you are able to charge more for your time as a result of this new job skill, you will be better off than learning about Johnson & Johnson in detail.

Let’s assume that you earn $50,000/year and can save $20,000/year. ( for a couple, just double the dollars). This translates into a rate of $25/hour. Let’s assume that you can spend either buy index funds that yield 2% and can generate some capital gains in the average year or you can build your own dividend portfolio that yields 3% - 4% today and can generate some capital gains ( expected total returns for stocks are possibly around 9% - 10%/year, however the amount and timing of capital gains is largely uncertain and unpredictable). Let’s assume that building your dividend portfolio takes 100 hours per year, versus 20 hours for the index portfolio. This means that you are spending 80 hours per year more. The opportunity cost of this time is $2,000/year. Now if you can earn an excess return of $2,000 from that portfolio, then the activity would have been worth it.

Of course, if you manage to acquire skills to increase your rate to $30/hour, and you maintain your level of spending, your ability to save increases from $20,000/year to $30,000/year. When you can earn more money, it is much easier to save more.

If you have a portfolio worth $150,000, you can potentially generate $4,500 - $6,000 in annual dividend income versus $3,000 for an index fund. When the portfolio reaches six figures, it makes sense from an economic point of view to do your own investing.

For someone with a small portfolio in the low five figures, it probably doesn’t pay initially to pick their own securities, unless they enjoy this challenge. These investors might be better off investing in a dividend ETF such as Schwab US Dividend Equity (SCHD) or ProShares S&P 500 Dividend Aristocrats (NOBL) or even an S&P 500 fund in their 401 (k).

The contra-argument of course is that you are learning a skill that could be very valuable when you accumulate a lot of money in your portfolio. Investing is a highly scalable skill. You have the same level of skill/effort to manage portfolios worth $10,000 to $10 million. For example, if you have a portfolio worth $2 million, it is much easier to add some value to your portfolio assuming you still spend 80 hours more than an index investor and your hourly rate is still $25/hour. For example, off the top of my head you can simply sell your index fund and buy the shares in that index fund directly, thus saving yourself from a $1,000 - $2,000 in unnecessary annual costs. Plus, it would be easier to tax loss harvest when you hold individual securities than when you hold the underlying index portfolio. There are a lot of brokers out there, who will gladly accept your business and offer you free trades as an incentive. Off the top of my head you can also move your portfolio to another broker, and generate a few thousand dollars in benefits to your account from broker referral bonuses.

Of course if someone is willing to pay for your skill, you would have increased your ability to earn income. If someone with money is impressed by you, you may end up managing money and earning much more than before. For other less impressive individuals like myself, I have managed to earn a few bucks from my blog, which certainly adds to the bottom line. I think about investing in my free time ( time not spent with family and work), so I might as well write a blog and get paid a little for it.

Perhaps the solution I am getting to is that it makes sense to give your earnings generation ability the maximum attention in YOU Corporation Inc. Perhaps this is why many employees simply invest through index funds in their 401 (k) or IRA accounts. From an economics standpoint, it makes total rational sense to do it. When the investor is close to retirement age, it makes sense to use the accumulated knowledge, and pensionizing those assets properly. In the case of many of you readers, you have managed to structure a dividend portfolio to live off in retirement.

Perhaps this is the reason why most of my readers are in their 50s, 60s, 70s and 80s ( if you are in your 90s, please let me know in the comments below, so that your age group gets a representation).

In my case, I have spent the majority of my time focusing on obtaining new degrees and certifications, as well as studying investments. I am lucky that I knew what I wanted to pursue, and I am also lucky that I have had an interest in investing for the past 17 – 18 years ( before I ever had money to invest). I have managed to do fine in my portfolio, and I have obtained pretty enormous synergies between my investing and my day job. For example, I took a few advanced graduate courses for my master’s degree, which I aced. This was possible because I could connect a lot of the material my job experience and my experience investing. That graduate degree helped me earn a higher salary.

My investment knowledge in researching and analyzing companies has been transferable in my day job. I have been able to impress the hiring managers with some of the company knowledge I had accumulated during my investing. This translated into better job prospects. Needless to say, my investing has also been beneficial in starting this site and writing about investing, which indirectly has resulted in some advertising dollars coming my way.

My work knowledge has also been very beneficial, because it has helped expand my circle of competence and knowledge of how different industries operate. I am also more skeptical about certain industries or companies than before.

In conclusion, I believe that the ability to earn income is a great asset to have. This ability to earn income and produce savings, provides the capital needed to invest, and provide for old age/retirement/financial independence. The best efforts on your time the accumulation phase could be spent on increasing your earnings capacity at your day job and/or through extra business opportunities. This is why it is important to take on extra responsibilities, learn new skills, network intelligently, and obtain relevant higher degrees and certifications.

However, it is important to also learn the ropes on investing from the get go, so that you do not waste your savings, but rather compound them in an intelligent way. That way, the investor will be able to gradually get to a point where they can formulate an investment plan to reach their goals. As the investor gradually builds up their knowledge, their investment capital is also gradually increasing. The nice thing is that investing is a perfectly scalable activity for most of us with less than 10 -20 million in investable assets. Once the amount of accumulated investments from savings exceeds high five figures, the investor should know enough to put that capital to work ( or alternatively, know how to outsource this decision effectively). The ability to take care of investments and work towards your goals through investing is paramount, as the amount of human capital/ability to earn income decreases once you are in your 50s.

Relevant Articles:

How long does it take to manage a dividend portfolio?
Dividend Investing Knowledge Accumulates Like Compound Interest
Life after Financial Independence
The Perfect Dividend Portfolio
Happy Financial Independence Day

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