You want to become more independent of your paid job. Excellent! How does that work? You spend less than you earn and invest the difference in building ‘passive’ income streams. In other words, part of your income you don’t put into consumption or keep in cash, but use it to acquire assets, i.e. financial assets. These should increase in value over the long term and / or continuously spit off income.
There are more and less active ways in which you can create wealth and income streams. If you’re considering starting a business – a very active path – you might want to read this post. If you want to build up income streams by investing in stocks or real estate, there are more active and less active options within each asset class as well.
I’m putting some basic information on stocks together in this post that you can refer to when starting out on the subject. As always, a disclaimer upfront: I’m not a financial advisor and I don’t give individual investment advice. On this blog, I only share my own knowledge, my experiences and my understanding of economic links. Before you make an investment decision, you should inform yourself broadly and make up your own mind.
How can you build income streams with stocks?
Why do many investors believe they can use equities to build up net-worth? Are all of them speculators or gamblers as a lot of people seem to think? Is the stock market a casino?
Unfortunately, the level of knowledge regarding stocks, and subsequently the shareholder rate (share of people holding shares directly or via investment funds) is very low in Germany.
That’s not really rational, because stocks are basically just shares in publicly listed companies. And those companies are part of the national and global economy.
Risk diversification versus job income
So if you assume that there will be future economic activity and optimally long-term growth, it makes a lot of sense to profit from this – independently of your current job. If you’re not employed by the government, your job will be dependent on a prosperous economy anyway in most cases.
So it is actually more speculative / risky to make yourself too dependent from your employer or your industry long term. Investing in shares of companies or sectors that have nothing to do with your own job is fundamentally a risk diversification.
But if you want to become financially independent, you do not just want to build a theoretical counterweight to your job. You want to build income streams that supplement or even completely replace your earned income. This can work in two different ways when investing in stocks, ideally they go together.
Historically and globally, the stock markets have always gone up over the long term (on the chart, set “Max”). There have been – sometimes drastic – drops in share prices. And there were also phases with long sideway trails. But these level off in the long-term view.
So there is a fair chance that you will be able to grow your net-worth substantially, if you invest and stay invested in the stock market long-term. Profits can then be realized which will provide you with an (indirect) income. This is also the basic idea of the 4% rule.
The second possible income an investment in equities can provide is the distribution of dividends. Not all companies pay dividends. Normally, dividends are paid as part of the profit. Particularly companies going for aggressive growth, e.g. in the tech sector, often decide to reinvest the profits completely or to a very large extent into the company. High dividends tend to be paid by ‘boring’ businesses in the consumer goods, banking, energy or telecommunications sectors.
There is no right or wrong here either. The total return results from price increase AND dividend. And on average this will revert to the mean, i.e. the historical average. So there is a certain likelihood that companies with high dividend payouts will have lower future growth rates than companies that are investing their returns into future growth. But that is not a guarantee, because in new (growth) markets future developments are very difficult to predict.
As an investor, you need to understand the business models of the different types of companies and the opportunities and risks involved. And that brings me to the next point. Because this is especially true if you want to invest in individual stocks.
Building net worth and income streams with individual stocks is a very active process. You have to research the numbers of the individual company thoroughly, and have a good understanding of with the industry itself, the competitors, etc.. And that should not be finished after you bought the stock.
I assume that you are interested in a long-term strategy, and want to keep your stocks for a long time. This is about investing, not about trading. But still, a single company can fail to perform successfully in the long run, up to a point where it makes more sense to sell its shares again.
Determining the “fair” value of a company is very difficult
Personally, I have a very sobering view on the investment in individual companies. During my professional life, I’ve had vast opportunities to see that it is virtually impossible to arrive at a truly realistic assessment of a company’s current state business and “fair” value buy the information that gets published.
Unfortunately, in my experience, this also goes for the findings of many professional analysts as well. And you do have to take in account that they are not necessarily independent. So when you read analysts reports you need to be aware of their institute’s relationship with the company under scrutiny. As always, it makes sense to ask yourself ‘cui bono’ and whether the goals of the beneficiary coincide with your own goals.
Actively managed investment funds
This also applies to actively managed investment funds. These funds invest in several companies, e.g. only in blue chips (high capitalization companies) or certain industries. Depending on how diversified they are, the risk of default is reduced compared to investing in individual companies.
Active management will incur fees and charges. These have become more transparent in Germany in recent years due to some new regulations. But fee structures can still be complex and difficult to understand in their implications for the private investor.
Basically, it is okay of course that a good investment management is also remunerated well. Whether the fees are reasonable, you should decide based on the results. That’s something I’ve learned the hard way in my investing ventures during the past 20 years.
The problem of recurring costs
During the 2000s we also bought investment funds recommended by the bank. And we thought ourselves smart because our funds were 50%discounted load or no-load at all. Unfortunately, we did not even think about what the ongoing fees of 2%+ per annum mean for the total return. Particularly in bull markets – like most markets have been in for the past years – where share prices continuously go up, this is less noticeable because your gains look very positive anyway.
However, taking into account the level of fees, it is not surprising that between 85 and almost 100% of fund managers fail to beat their benchmark index, depending on the segment analyzed. But beating the index is what you are paying the fees for, right?.
You can try to choose one of the out-performing funds, of course. That is made even more difficult by the fact that above-average performance of the past does not guarantee above-average performance in the future. The odds are higher that good performance is followed by bad performance, which is just what makes it so difficult to continuously beat the index.
ETFs (Exchange Traded Funds)
If like me, you find individual stock picking too time-intensive, risky or too little diversified for long-term investment, but don’t want to buy actively managed index funds either, you have another option. There are funds that track national or regional indices, such as the DAX or the STOXX Europe 600 or even global indices such as the MSCI World. These funds are offered in Germany under the name Exchange Traded Funds, abbreviated ETFs.
There are different methods regarding the actual inventory of the ETF. The simplest one which I also prefer, is called physical replication. In other words, the fund actually buys the stocks according to their weight in the index. The weights are updated at certain intervals. So this is a largely passive investment (passive = no manager actively picks individual stocks or times buying and selling).
Thus, the performance of the index fund is essentially the performance of the underlying index. So you cannot outperform the index, as you could do with a single stock. On the other hand, the investment never performs worse than the market.
Very low fees
Since there is no active management, the ongoing fees are very low and there is no load. ETFs on broad and popular indices such as the S&P 500 are currently offered in Germany at below 0.1% annual fees. They are very easy to trade via an online brokerage account. Many banks also offer ETF savings plans.
You need to watch out a bit, though. ETFs have gained tremendous popularity in recent years. They are used a lot in professional asset management, at a much higher volume than by end consumers. But based on the success, quite complex and exotic ETF products are now being promoted as well.
The bank always wins …
Why? Because the issuers can realize higher fees compared to the simple ETFs. There are also ‘ETF funds of funds’, where you pay someone to put together an ETF portfolio for you. So you pile management fees on top of the low ETF-fees again, and the ETF-mix in that fund might not be the simple indexes but indexes on individual economic sectors or more complex investment methods that you might not want to invest in if you fully understood them.
All this completely contradicts the basic idea of the ETF, and that’s where I think the benefits are lost. If you want to pursue a philosophy of ‘passive’ investment, you can easily build a global portfolio with just a few ETFs yourself. Actually, you only need a single ‘World’ -ETF. If you want to follow a slightly more differentiated strategy like me, one ETF is not quite enough. But before you end up in ‘paralysis by analysis’, you can just get started with a ‘World’ -ETF and start benefiting from compounding. You can then dig deeper and diversify your ETF portfolio step by step from there when you’re ready.
Since there are already loads of good resources on the topic, I will not write my own posts on general ETF strategies. But if you have specific questions, feel free to get in touch.
If you want to engage more intensively with growing your net-worth and income streams by investing in stocks, and in particular inETFs (no affiliate links), here are some recommendations:
Two blogs, one in English and one in German:
J.L. Collins, Stock Series
Der Finanzwesir, start with ‚Auf der Jagd nach dem perfekten ETF, Teil 1-3‘
And a book (in German as well):
Gerd Kommer, ‚Souverän invstieren für Einsteiger. Wie Sie mit ETFs ein Vermögen bilden.‘
And here’s another frugal tip: If you want to read books I recommend, check out your local library – they might even be interested in customer’s suggestions on what new books to buy.
Financial Independence Rocks!