The goal of this post is to get everyone to think about stable cash-flow in their personal portfolios.
Anyone looking to become financially independent will tell you they are trying to have their ‘passive income’ exceed their expenses. But what is passive income?
Unfortunately, not all investment returns are ‘income,’ and understanding how to think about your investment ‘income’ is critical as you plan for the future.
There are several categories that your invested income can fall into:
- Income-generating and immediately accessible (the sweet spot)
- Income-generating in a retirement account
- Non-income generating
Calculating passive income
Most investors will look at their investment portfolio, multiply by some expected safe withdrawal rate, and compare that to their expenses.
As an aside, a lot of people think 4% is a reasonable safe withdrawal rate…While that may hold if you have your money locked in at 4% treasury rates, thats probably not the case if treasury rates are 2-3% as they were until only just recently. Check out more here for a great article by Financial Samurai on why the 4% safe withdrawal rule is outdated. Anyways, back to the point.
Let’s take an example:
A couple (both 40 years old) has $85K in annual expenses (so needs ~$100K in pre-tax income to cover their expenses) and has $5M invested. They want to know if they could retire today. Here is their investment mix:
- $3M in their 401K fully invested in the S&P 500
- $1M in a brokerage invested in growth tech stocks (paying almost no dividends)
- $1M in low-risk, long-dated bonds that are returning ~3%
At first glance, it may seem like they should have hit financial independence – they have ~$5M invested and only need a ~2% withdrawal rate over inflation to meet their expense needs.
However, much of their income is either inaccessible or not generating cash-flow, which will be an issue for them as they go to pay their bills.
- The $3M invested in a 401K can’t be accessed until they are >59.5 years old without paying a penalty
- The $1M invested in tech stocks will not pay much in dividends and will likely be quite volatile. It may be up 20% one year and down 10% the next. As a result, there is a good deal of path dependency if they had to sell their holdings to pay their expenses (I would also never recommend thinking of capital appreciation as income…it’s not income until you have cashed out, and there are no guarantees when it comes to an assets appreciating)
- The $1M in bonds is their only real income producing asset, generating ~$30K a year. As a result, they will be in a cash deficit despite having so much invested
It is still valuable to invest in non-income generating assets
It is still very valuable to invest in non-income generating assets like growth stocks (esp. when you are young) is because the expected return (note I didn’t say income) is high, relatively speaking, which will allow you to accrue a large net worth that can be put to work for you generating income later. Returns compound, which will amplify this additional expected return over time.
Part of this tradeoff between expected return and income is why something like rental income is so attractive. The expected return is high (in a large part because you are so leveraged), and it’s generating cash flow. The tough part is that this income really isn’t passive, and you have to figure out how to reinvest the money while you don’t need it.
What is interesting is purely quantitatively you could probably make more by investing in non-income generating assets until you retire and then being particular about only selling off the required amount in retirement to pay your expenses.
Let’s see why – If I am generating $100K a year in passive income in addition to $100K from my job, but only have expenses of $100K, I am paying a higher tax rate on $100K of income than I need. If instead, I have $100K of income to pay down my expenses, and then the $100K in investment return exclusively comes in appreciation, in retirement, I can liquidate just that $100K to pay my expenses and pay a much lower tax rate on the liquidated earnings.
That being said, given the uncertainty in capital appreciation, you will be unlikely to feel confident in your ability to pay stable expenses with a volatile portfolio.
As a caveat – I am NOT saying to stick all your money in treasuries as a 25-year-old. But don’t forgot to keep an eye on cash flow in your portfolio.
How to think about cash flow in your investing
My strategy for accruing cash flow over time:
- Accrue net worth while I have a stable W-2 income and can take risks. This has included investing in growth stocks / the S&P and taking some bets on sectors I am bullish on
- Look for good opportunities to generate real cash flow over time by buying rental assets, businesses, etc.
- Try and build some side businesses that can generate income and will give me something fun to work on and own in the long run (e.g., a blog / personal service business / other side hustle)
Also, start to think about retirement savings vs. non-retirement savings. You should prioritize retirement savings initially due to the tax advantages (and by the way, a Roth 401K / IRA will become more valuable if tax increases are passed), however, that won’t help you achieve your cash flow needs in the short term as you generally can’t access your returns before a certain age without paying a steep penalty.
If you want to achieve early financial independence, you will need to build your non-retirement nest egg to a sufficient size to support your lifestyle. This may seem like an insurmountable barrier, but by focusing on the three main pillars of solid financial health, you can put yourself in a good spot to get there:
- Earning: Selling time
- Saving: Expense optimization
- Investing: Automating your investing
What your thoughts on how to generate cash flow in your portfolio?
RWM
