The Making of a Cash FIREhose – Index Funds

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Dividend FIREman subscribes to the “multiple buckets” school of financial independence, with the idea that each “bucket” is designed to provide a separate income stream. I call these buckets “Cash FIREhoses,” because each bucket generates a stream of cash, which will grow larger as time goes by. You can see an overview of my Cash FIREhoses here – at the end of 2017, my total income from all of these Cash FIREhoses was $28,208.

Not nearly enough on which to retire, but not too bad for a guy who had a negative net worth in 2012!

My Boring Old Index Funds Are Throwing Off Some Serious Cash

One of my Cash FIREhoses (and currently my largest Cash FIREhose) is a portfolio of index funds. The total amount in this account as of today is $786,338. This includes roughly $185,000 in gains, which means I have invested $601,338 ($560,813 of my own money over the last 5.5 years or so, plus roughly $40,505 reinvested dividends and interest).

The money is invested in four separate index funds, as follows:

Total US stock market – 38.6% of my total account, 1.61% yield, .04% expenses

Total International stock market – 38.1% of total, 2.68% yield, .11% expenses

Total US bond market – 21.8% of total, 2.42% yield, .05% expenses

Total international bond market – 1.3% of total, 2.21% yield, .12% expenses

Originally I invested only in the first three funds, but after doing some research I recently added the international bond fund. This fund is designed to provide further diversity, and will ultimately be roughly 25% to 30% of my 20% to 25% bond allocation. My overall balance will be 75% to 80% equities, 20% to 25% bonds for the foreseeable future, with the equities split roughly 50/50 between US and international. As I approach FI, and/or if interest rates increase, I may increase the size of the bond allocation with new money, but for now I am keeping this at 75-80/20-25.  I am not too focused on the exact percentage split between equities and bonds, as long as it is between 75/25 and 80/20.

Here are some interesting facts about this account:

-I opened this account in late 2012. ALL of my overall gains in the index fund portfolio have come since February 29, 2016 (in other words, within the last two years). On February 29, 2016, after roughly 3.5 years of investing every month, the portfolio was actually down $2,691. Since then the portfolio is up $185,000.

-Actual dividends and interest in 2017 were $14,717.27 per my last statement. That is an income return of roughly 2.2 percent, not counting investment gains.

-Income (in the form of dividends and interest) from this portfolio has increased steadily as the account value has increased.

2012:   $168.96

2013:   $2,220.57

2014:   $5,376.60

2015:   $7,424.39

2016:   $10,509.58

2017:   $14,717.27

I didn’t start this account as a dividend portfolio, because I was originally a believer in the 4 percent rule. I changed my strategy to be more conservative after reading further studies on potential limitations of the 4 percent rule. I also became disenchanted with the idea of invading my principal. Then I discovered the magical world of dividend investing, “living on the interest,” rental real estate, and other passive income opportunities. After much consideration, I decided to change the focus of this account to a dividend/interest account.

Obviously this means I will need to save a lot more money (almost twice as much) to generate the same cash flow. But I am very pleased with the income potential – a 2.2% return compares favorably to current 10 year treasury yields of about 2.7%, considering that treasuries have no real capital gain potential, which could be significant over a 10 year period in the index stock funds. Note that the dividend yield of the index stock funds could also increase as time goes on, although this factor would be more significant in an individual dividend growth stock portfolio.  Certainly as the value of my stock holdings increase, the dividends should likewise increase.  My bond holdings should benefit from rising interest rates over time as well.

My goal is to build this Cash FIREhose to the point where it will generate a cash stream of $24,000 per year ($2,000 per month). At a current yield of 2.2 percent for this 4-fund portfolio, I would need a value of $1.1 million in this account to pay $24,000 per year. If interest rates increase and I increase my bond allocation, I might be able to reach my goal with less principal. Time will tell, and in the interim I am keeping up my strategy of dollar cost averaging $9,000 per month into this account.

“Dividend FIREman, aren’t you worried about putting so much money into index funds?”

There has been recent criticism of index funds, and given that this is by far my largest investment, I have avidly studied those criticisms. Here are some criticisms that may have merit, but we won’t know for sure until we see what the future brings:

-Indexing is the “in” thing, which irritates the contrarian in me, because the “in thing” usually turns out poorly in the long run.

-What happens if everyone goes into index funds and there is no discernment between good and bad stocks? Are the current large market leaders enjoying higher stock prices simply because of their position as larger weights in the overall market funds (into which vast sums of money are pouring every month), rather than because they are good profitable companies with fair valuations? Are poorly managed or relatively unprofitable companies being lifted up by the fact that “total market” index fund managers must buy their shares as new money flows in? What market efficiencies would there be if everyone indexed?

-What happens when everyone tries to get out of index funds at the same time?  This is something that hasn’t happened before when so many people were invested in index funds (more than 42 percent of fund investors now hold index funds, a percentage that has never been larger in history, and that has almost tripled in the last 10 years).

-There may be a “bubble” in index funds, given the recent stampede of money into those funds.

-Also there may be an opportunity cost associated with deploying this much capital into index funds with lower dividends, given the chance for higher returns in a dividend growth portfolio.

-There is recent academic discussion about bringing antitrust challenges against the largest index funds.  The basic theory is that these funds own so much stock of certain companies and in certain industries that they can effectively set prices and unfairly influence corporate decisionmaking in those industries.  I am not sure about the viability of these theories, but if suits are filed, at a minimum the legal fees associated with defending these challenges will likely increase the cost ratios of these funds. At worst these challenges could result in funds having to reduce their size or limit the scope of their investing, which could undermine the main diversification benefit of “total market” funds.

Despite these issues (most of which are theoretical rather than real at this point), I am sticking with indexing for the foreseeable future, at least until I reach my goal of $1.1 million in this account. I don’t think we will ever see a world where everyone indexes, because there would likely be too much potential for profits relating to active trading in that scenario. As long as there are individual buyers and sellers, there are market makers, and if too few players are setting values and reaping profits, I believe that more players will enter the space.  I like the fact that these funds provide diversified exposure to the whole market, have demonstrated income potential, and have very low expenses. Also, I can always move some or all of this money into a higher yield dividend fund at a later date when I retire.

“Dividend FIREman, how can I create my own Cash FIREhoses?”

If you have read this far, you might be wondering how you can get yourself some of this action. Don’t worry – creating a FIREhose of cash out of index funds is really easy. Here’s what you need:

-Money

-Good place to put it (low costs, diversification, exposure to equities)

-Time

-Nerves of steel

-Patience

Basically you need some capital and you need to create an account with one of the big fund companies (Vanguard, Schwab, and Fidelity are a few of the main players). Link your bank account, make your first deposit, and start investing! Both companies have “total stock market” and “total bond market” funds that are similar to those in my account, and both have very low expense ratios. You just need to do your research and pick the index funds that best suit your investing goals. Remember to consider the expense ratios (high expenses will significantly reduce your returns over the years), and pick passive funds rather than actively managed funds (you will easily be able to tell the difference, because the active funds have much higher expense ratios.  You can also read the fund descriptions, which describe their investing approach).

Once you start the account, you need a plan for dealing with your emotions.   You will be tempted to withdraw money to fund one of the innumerable shiny distractions that our society throws in your face every day (new cars, boats, second homes, home remodeling, expensive vacations, jewelry – the list is endless). You will be tempted to withdraw money when the market drops (and it WILL drop, sometimes precipitously, many times during your lifetime). You will be tempted to make your investments more complicated than they need to be.

But you need to remind yourself to stay this particular course. Make a plan and stick to it.  Six years ago I had a negative net worth. And in the intervening six years there have been many times I have wanted to use the money in this account. But I have doggedly stayed the course, investing every month through good market performance and bad market performance. Even after 3.5 years, when the funds still showed an overall negative balance, I kept investing. Even last month, with the market reaching all time highs, I gritted my teeth and invested my money. You need to do the same thing. During your accumulation years (i.e. now), keep putting money in every month. Don’t take it out for any reason. And watch it grow. Be patient. Give it time. Let compounding interest work its magic.

Conclusions

This financial independence journey has been fun and informative, and it is ongoing. I have chastised my younger self countless times for not starting sooner. But I am living proof that investing works, by investing in yourself, keeping your expenses as low as possible, creating an investment plan, and sticking to it through thick and thin.

Is anyone else planning to use index funds as passive income sources? Do you think I am putting too much money into this account, as opposed to my other passive income investments?  Am I losing too much yield by focusing on complete diversification?  As always I would be delighted to hear your thoughts and comments. Happy investing!

-Dividend FIREman

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2 Comments

  • FIREman, I use a combination of individual stocks, ETFs and open end mutual funds to achieve different investiment objectives and in different accounts (taxable vs tax advantaged). I think there is place for all of these options in most portfolios (maybe not someone just getting started). You hit the real keys: minimize fees, transaction costs and be tax efficient. Tom

    • admin

      Agreed about the overall plan. I will do a future post on ETFs vs. mutual funds. I like the lower costs of the ETFs, but I have refrained from ETFs because I’m concerned that the share values may not always be aligned with the value of the underlying assets (because the ETFs can be traded like stocks all day long). But mutual funds can be traded at the end of each day, so the same issue could arise. Thanks for your comment. Happy investing!

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