This is a question about whether we are missing some deeper factors in a very simple wealth building idea:
Assuming an individual has $200,000 in investments and it is generating 5% dividends a year. Is it right to simply assume that the person will receive $10,000 of passive income a year which amounts to $833.33 a month ? Or should the calculation be more complex than this?
I tried to understand this question and so here is my interpretation.
My reader is trying to find out if the formula is REALLY that simple.
So here is my take.
If you have a $200,000 worth of financial asset that can continue to generate returns of 5%/yr . it will be able to gain $10,000/yr. This is equivalent to $833.33/mth.
So that is not wrong.
The Volatility of Returns
Unfortunately, it is difficult to find a financial asset that can CONSISTENTLY generate this with LOW VOLATILITY.
For most financial assets, your returns, or Total Returns is made up of Capital Appreciation/Depreciation + Cash Flow Yield
If you are using most financial assets, the returns, the prices gyrate up and down. If you measure the returns from year 10 to year 0, you might get 5%/yr.
However, in that span you may get -10%, +20%, +5% etc. It is not a consistent 5%.
The financial assets that are volatile include:
- Investment properties
- Unit Trusts
- Exchange Traded Funds
The Cash Flow yield is not consistent most of the time as well. In order to provide that cash flow, the underlying assets within the financial assets needs to generate 5-7% in cash flow, then the financial assets can give you 4-6% and not impact their business adversely.
We all know that business goes through good times and bad. Thus the cash flow yield is not consistent as well.
- Your rental income is not consistent
- Your dividend income is not consistent
- Your interest income, bond interest income is consistent as long as you hold on to that bond, but you might reinvest at a different interest rate, so it is also not consistent
- Your business income is not consistent
The Inflation Factor
The other aspect is that yes, the math works out, but the purchasing power over time might shrink.
This is because inflation can be high or low, and it tends to erode your purchasing power.
So your $833.33/mth today will buy more things than the $833.33/mth in the future.
If you are planning to de-accumulate (a more complex word that is similar to withdrawing) your wealth machine to create cash flow for financial independence or retirement, how do you resolve this?
One thing is that your total return, which i mentioned previously, needs to be higher than 5%.
If your total return is 8%, this is made up of a cash flow yield of 5%, and a capital appreciation of 3%.
If you are able to get this 5% + 3% consistently annually, it means that you can take distribution of 5%, and your asset base can grow at 3% to keep up with inflation.
This is if inflation is consistent at 3%.
Linking back to my explanation of volatility, you know you get gyrating returns in real life. Only wen you measure from year X to year 0 then you get the average return.
Related: This is my article on how much you need to achieve financial security, independence or retirement. It further explains this total returns equation and how much you need.
So is this all a lie?
The truth is that actual implementation is a little nuance. We focus on the process of generating the total returns and see our asset value go up and down.
However, there are a lot of truth to certain systems we create like how to conservative withdraw an adequate amount to spend, and how do you vary the amount you withdraw to ensure your money lasts longer.
Knowing the $200,000 x 5% = $10,000 equation helps a lot in your planning to find out roughly how much you need.
But we need to ensure that this model is realistic.
Certainly this is more realistic as we have seen different stocks, REITs, overseas properties giving this kind of cash flow yield.
With a realistic model, it gives you more conviction with the kind of numbers you derive in your exploration.
The last thing that I want is to be some finance guru and tell you that you can find some dividend stocks that provide a dividend yield of 8%, so you can realistically generate $16,000/yr in cash flow. I know this is not realistic. However, if we become more conservative in our model, using 4%-5%, I am sure we can safely plan with this figure.
Ultimately, the actual implement-ion requires us to learn more and answer more of our questions.
A more detail implementation would be that you have a portfolio of REITs that is able to generate a 6-7%/yr in dividend yield over time, and a 2%/yr growth. You proceed to spend 6% of this during good times, and 4% during bad times, adjusting in a systematic manner.