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For more on this topic please read Mark's article on how to generate $100,000 in passive income.

Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs. So Mark.

Mark LaMonica: Yes.

Jayamanne: We talk on this podcast a lot about investment wish lists. So what we mean by that is have investments that suit the criteria of your investment policy statement and wait until they come into a reasonable price range to purchase. 

LaMonica: Yeah, I mean, that makes sense to me. 

Jayamanne: What about other kinds of wish lists? Because it is your birthday on Sunday. 

LaMonica: That is true. Well, a little bit of background. So obviously, I've been making this joke that Shani thinks I'm going to die on this podcast for a while. And that's because…

Jayamanne: Which is completely unfounded. 

LaMonica: Well, Shani's been making this joke for about four years now. And the arbitrary age that she picked that I would die is what I turn on Sunday. 

Jayamanne: So we'll see what happens. I mean, let me defend myself here. 

LaMonica: So my wish list is that I don't die.

Jayamanne: Okay.

LaMonica: Which means our wish list may be in conflict. 

Jayamanne: I'm going to defend myself here. You were wearing yourself out at work and you were working out a lot and you were working out through a lot of injuries. And I said, if you don't take better care of yourself, you will die by 45. 

LaMonica: Do you think that I've taken better care of myself?

Jayamanne: No.

LaMonica: Okay, so still. 

Jayamanne: All right. Okay. So we'll see what happens. 

LaMonica: So this may be the last podcast we ever record.

Jayamanne: Maybe.

LaMonica: I want you to move on and find a new podcast partner.

Jayamanne: Wow. That's very generous of you.

LaMonica: You're supposed to say…

Jayamanne: I will never find another podcast partner like you.

LaMonica: Exactly. All right. So let's get into this. Well, I wrote an article, perhaps my last article ever, that led us to today's podcast. And my article was on compounding. 

Jayamanne: And you write a lot of articles. So at some point, if you're going to write about investing, you're probably going to cover compounding. 

LaMonica: Yeah. And that's true. And compounding is, of course, a core concept when it comes to investing. And compounding is one of those terms that I believe is more known than understood. As investors, we want to understand the key concepts to determine if they're something that can be incorporated into our investing approach or just ignored. But today's podcast is not strictly about compounding. It is about how compounding should be incorporated into an income investors approach. 

Jayamanne: And compounding, of course, is earning a return on a return. And one of my favorite analogies of compounding is a snowball rolling down the hill and gathering more and more snow as it goes and it grows in size. And what we are supposed to understand from this analogy is that the key to investing success is not the size of the snowball when you start, but how big the hill is. And of course, the hill represents time. 

LaMonica: And this applies to our examination today of compounding for income investors. And we're going to look at what it takes to generate $100,000 in passive income. 

Jayamanne: And we'll admit that $100,000 is an arbitrary number. But just like there is a fixation on becoming a millionaire, there is also this fixation on a six figure salary. And in this case, a six figure salary in dividends, which is generated passively. 

LaMonica: All right, so let's dig into this a bit. When we talk about compounding, there are three components that impact the total amount of wealth that is generated. That is time, returns and new savings. When we take an income perspective, there are four components that we need to focus on, time, dividend growth, dividend reinvestment and savings. 

Jayamanne: And this is simple math. But what we need to examine is the interplay between these factors because that will influence decision making. And to do this, we will look at the incremental layering in each factor. 

LaMonica: Okay. So let's start with new savings, Shani. That is money you save and invest. This is of course critical when you're a new investor, because you have a small portfolio, and need to get some money to work for you. So let's say you manage to save and invest $10,000 a year for 40 years, and you buy shares yielding 4%. Well, at the end of that 40 year period, you will have $16,000 in income. 

Jayamanne: To be clear, Mark, there is a bit of a difference between $16,000 and $100,000. 

LaMonica: There is, and many people can calculate the difference, but we'll just leave it at a bit of a difference right now. 

Jayamanne: Okay, teasing aside, this is an illustrative of an important point. In this scenario, there is no dividend growth and there is no reinvestment of income. And in many ways, this approximates using long-term bonds or term deposits to generate income. There is no growth in that income. Sure, it changes based on interest rates, but it creates an inherent problem for investors. Without growth in the income, our purchasing power decreases over time due to inflation. And this is why cash and bonds don't generate very high returns in excess of inflation. 

LaMonica: And that is the magic of a dividend. Dividends can grow, which means our existing income can outpace inflation even as we contribute more to our investment account. 

Jayamanne: And there is another factor we can explore now that is dividend reinvestment. So very simply, a dividend reinvestment is buying more shares with the dividends received. Since those shares earn more dividends, you get more income. Now there are dividend reinvestment plans where the dividends are automatically reinvested in more shares of the same company, and they're simply receiving the dividends in cash and then investing it wherever you want. 

LaMonica: And it doesn't really matter which approach you take. But what matters is the yield that the money is invested, whether that is in shares of the same company paying the dividend or a different company. This is a good place to pause and talk about the two options. The argument for an automatic dividend reinvestment is that it removes decision making from an investor. And investors are notoriously bad at making decisions. That decision can be what to invest in or when to invest, with dividend reinvestment that goes away. 

Jayamanne: And in an entirely shocking development, the argument to not use an automatic dividend reinvestment is that it allows the investor the freedom to make the investment decision. Undervalued shares can be purchased or in the case of our example, a share with a higher yield that is still sustainable. 

LaMonica: So there you go. I think there's merit in both arguments. But if I had to pick, and let's be fair, I have, I would pick automatic dividend reinvestment. I get the notion that choice is great, but it isn't like the dividends are automatically invested in random shares. This is a position in your portfolio. A conscious decision was made to purchase the security. A conscious decision is made every day not to sell the position. So I'm an automatic dividend reinvestment type of guy, Shani. 

Jayamanne: All right. So same scenario, $10,000 invested each year for 40 years into an investment yielding 4%. But this time, the income earned each year is reinvested at 4%. After 40 years, the total income is now just over $38,000 a year. 

LaMonica: Okay. So that's much better. So that's more than double our previous total by just reinvesting dividends. So it may not seem like a lot, but over time it matters. And that, of course, is the central tenet of compounding. 

Jayamanne: Well, Mark, we talked earlier about one of the benefits of dividends is that they grow. So let's layer some growth into that and we'll use 5%. So now we have $10,000 saved for 40 years and invested at 4% yield, with dividends reinvested and 5% growth in dividends.

LaMonica: So after 40 years, we now have a grand total of $149,000 in income. 

Jayamanne: All right. We made it, Mark. We broke the $100,000. All it took was some growth. 

LaMonica: Yeah. It would be better, I think, if we broke the $100,000 in income from our Christmas shares. 

Jayamanne: That's true. We'll have to check on those. We'll let you know how they're going.

LaMonica: We will. Okay. So let's talk about something that I think is fairly amazing. $400,000 total was invested. So remember, that's $10,000 for 40 years. But $149,000 in income is being generated in this scenario. Means the portfolio is yielding a remarkable 37% based on the cost or the money that was invested. 

Jayamanne: I'm impressed, Mark, but we've actually forgotten one thing, franking credits. 

LaMonica: And how can you forget franking credits? I'm not sure. Yeah. I mean, if we forgot franking credits, a mob would probably show up with pitch forks to the Investing Compass studio and burn it down. And I am too old to flee from a mob. 

Jayamanne: Have you ever had to flee from a mob before, Mark? 

LaMonica: Not yet. What about you?

Jayamanne: No.

LaMonica: What about that time the flock of birds attacked you? 

Jayamanne: That's true, actually, I have. 

LaMonica: But you didn't flee. You just sat there.

Jayamanne: Yeah. I guess so.

LaMonica: And cried.

Jayamanne: Okay. We're going to assume a 0.5% yield bump from franking credits. And this is fairly conservative, but it accounts for a globally diversified portfolio, which we think is a good idea, since it adds some diversification to the source of income received. And with all the other factors consistent, this leads to total income after 40 years of $194,000 in income. 

LaMonica: And that's a great outcome. But we have, of course, ignored the fact that in the real world, we have to pay taxes. And a mob won't show up to make us pay the taxes, but the police will, right, Shani? So we need to take that into account. So as painful as this may be, we're going to look at a couple of different tax scenarios. So the first is if you're investing in super. So the tax on income received in super prior to preservation age is 15%. We use that tax rate to total income at the end of the 40-year period is $160,000. 

Jayamanne: That's good news, Mark. We're still above that six-figure threshold. If we add a 45% marginal tax rate, it, of course, changes the outcome. We're now at $110,000 in total income. 

LaMonica: Another piece of good news, because we're still above $100,000. But this is fairly conservative. Most people are not at the top marginal tax rate for their entire life. Many people don't ever get to the top marginal tax rate.

Jayamanne: Mark.

LaMonica: Yes, Shani.

Jayamanne: I have a question for you.

LaMonica: Okay. 

Jayamanne: What if you don't have 40 years? 

LaMonica: All right. Well, I guess this is one of those occasions where I wish this was actually videotaped because Shani was looking directly at me when she said, what if you don't have 40 years? But we can run a couple scenarios over 20 years. Now, remember that time is a key factor in compounding. 

Jayamanne: So this is more challenging at both the 15% tax rate and the 45% tax rate. We don't get to $100,000 in income using those same assumptions. So we need to make some adjustments. We need to adjust the yields on the investments from the 4.5% inclusive of franking credits to 5.5%. But a higher yield can lead to lower growth in the dividends. So we will lower the growth rate from 5% to 4%. 

LaMonica: So that does hit our magic number of $100,000. But we do need to make even more adjustments at a 45% marginal tax rate. We leave the dividend growth rate at 4% and the yield at 5.5% over the 20 years. We need to save more and a lot more. So instead of $10,000 a year, we need to save $45,000 a year. 

Jayamanne: The point of this exercise was to demonstrate how compounding for income works so we can make decisions on our own portfolio. And we have some lessons that investors can take based on this exploration. So Mark, why don't you start with our first lesson? 

LaMonica: Okay. So, our first lesson is that trade-offs matter in income investing. The trade-off between higher yields and dividend growth is an important consideration for income investors. And we can use the original 40-year scenario to explore how this works. Increasing the yield on the portfolio by 1% to 5% results in the same amount of passive income at the end of the 40-year period as reducing the annual dividend growth rate by 1.74% to 3.26%. So those trade-offs will vary with different investment timelines, but it provides some guidance to investors to make decisions when selecting individual holdings in a portfolio. Franking credits undoubtedly influence decision-making by Australian investors, and they are valuable. Yet their value can be quantified, and there are cases when a global company without franking credits is a better choice for an investor. So don't ignore dividend growth just for franking credits. A diversified portfolio with a mix of higher yielding shares with less opportunity for dividend growth and lower yielding shares with higher potential dividend growth can be the best approach for growing passive income. 

Jayamanne: Okay, so I'm going to take lesson two, and that is that investors should keep their focus on the future. One mistake that income investors make is falling into dividend traps. The issue with using the dividend yield to decide what shares to buy is that a yield is based on what has happened in the past. As investors, we only care about what happens in the future. The key to success is finding sustainable dividends that grow in the future. 

LaMonica: All right, and the last lesson is to make sure you increase the bang for each buck of savings that you have. My favorite metric for income investors is yield at cost. I like this metric because it shows me exactly how much passive income I am generating off of the money I saved and invested in the past. Simply divide how much income a particular position or my portfolio as a whole generates by the cost basis of the shares in the ETFs I own. Dividends grow and the yield at cost goes up. Dividends are reinvested in the yield at cost goes up. It's another way of seeing the tangible benefits of compounding. 

All right, Shani, we made it to potentially the last podcast ever. Well, for me.

Jayamanne: It's been great, Mark.

LaMonica: Yeah. No, I've enjoyed working with you. I hope that the new person you do this podcast with is, I don't know, I hope this is as good of an experience as you're having with me every week. Thank you guys very much for listening. I appreciate it. 

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