March 18, 2013 | Posted in:Passive Income
Financial Independence can be achieved in one of two ways. The first being that you have a pile of money that is so big you won’t ever be able to burn through it by the end of your life.
The second, and more feasible way for most of us to achieve Financial Independence is by creating passive income streams. It’s a very simple idea on paper: Once you have more passive income being generated annually than you are spending annually you have become Financially Independent.
Passive income creation is paramount to any “FI”er that is seeking early retirement. This is the idea that sparked my lovely moniker, Johnny Moneyseed (which is surprisingly not my real name).
Johnny Appleseed (John Chapman) was a businessman in the 1800s. His dream was to plant so many apple trees that no one would ever go hungry. Legend told of Johnny going to many places across the country planting apple seeds along the way.
Mr. Appleseed knew that he could eventually create an “infinite supply” of apples, by repeated planting, cultivating and harvesting of his nurseries.
Mr. Moneyseed does the exact same thing, but with… you guessed it, Money! Money has an amazing ability to produce more of itself, if handled correctly.
For every $100 you plant, you could expect it to produce an additional $5 a year. Of course I’m not talking about planting it in the ground, I’m referring to the stock market. The stock market is the first area of opportunity to generate passive income that I will cover, but it’s not the only one!
Naturally, if I have $50,000 invested, I can safely assume that $2,500 will be produced every year. If reinvested (replanted) instead of being withdrawn (harvested) then the following year our $52,500 balance will produce (yield) $2,625.
You can tell me that I’m wrong about my numbers. You can tell me that there’s no way of predicting the stock market. You can tell me that we’re bound to see another recession, depression, or otherwise that will gobble up my money and make me look like an asshole. If you’re a naysayer, leave your comments below and I’ll address each one individually!
But if you are still willing to hear me out, let’s look at the one of the more common indexes, the S&P 500, as a benchmark for the following example. The words “S&P 500″ may sound familiar, but newscasters tend to focus of the S&P’s little brother instead, the DOW Jones Industrial Average.
In extreme brevity, the S&P 500 tracks 500 U.S. equities and displays a generally accurate depiction of how the entire market is faring.
I’m not going to go all Dave Ramsey on you and try to tell you that the S&P 500 is a sure-fire investment that has gained 12% since it’s inception in the early 1970s. He’s not half-wrong though, because it truly is a beast!
As a point of reference I would like to use the year 1984, because it was a fabulous year. Not only was it the first year that Apple began to sell Macintosh computers, but it was also the year that I was born.
For scientific purposes, if you were to travel back to 1984 in your DeLorean Time Machine and invest $100 into the S&P and then fast-forward back to the future to December 31, 2012 your investment would be worth $791.00. That’s an average climb of about $20 a year. It’s safer to not have such lofty goals, so I’d prefer to sticking to the safe value of $5 for every $100.
Obviously, the more money that we could have invested back then, the more it would produce us today. Unfortunately, you probably don’t have a DeLorean, and even if you do, Doc Brown probably hasn’t made his way to tuning it up for you yet.
The stock market is kind of a weird place. You can’t just say “I want some S&P 500 please” because it’s an index, not a stock. You could buy shares of all 500 companies that it’s comprised of, but the more realistic option is to buy a mutual fund based on the index. Vanguard has a low-cost* mutual fund called the Vanguard 500 Index Fund Investor Shares with the ticker VFINX, which is exactly that.
I wouldn’t recommend creating a portfolio that only consists of VFINX shares, but I also wouldn’t recommend neglecting it’s power. For best results and the highest dividends possible I focus on a technique called Dollar Cost Averaging. That’s just a Fancy term for scheduling recurring investments of a given amount of money regardless of current stock price. For example, every month I may buy $500 worth of VFINX, I don’t care if there’s a recession or the market is hitting all-time highs, because we aren’t looking to time the market, we are looking to create the best average stock price over time.
Recessions, or market lows are actually great times to buy shares, because it’s like the stock market is having a sale! You can buy more shares for a lower price! It can be risky though, because if the stock market bottoms out, you will lose everything (but if that happens, we’re all screwed!).
To become financially independent, with the ability to never have to lift another finger as long as I live, I would have to have a passive income stream of at least $30,000 a year. I had stated that every $100 that I have invested will create $5 every year, so the math to figure out how much I will need to have invested to sustain my minimum threshold is very easy. Just multiply the amount we want to receive every year by 20.
To produce $30,000 a year, I would need to have $600,000 invested.
I’m going to save how we plan on living our life for under $30,000 a year for a later post, so if your mouth is open or you are squinting at your screen saying “Yea right!” Rest assured, I will let you see how inexpensive life can truly be.
*VFINX has an expense ratio of 0.17%. Comparable funds can have expense ratios over 1.0%!
**Past performance of the stock market does not guarantee future returns. But it’s a safer bet than the casino!