Passive Income is for Chumps
From time-to-time prospective clients would approach me and ask how they can build “passive income.” This is a serious red flag. The idea that you can get paid a “passive income” highlights a deep misconception on how investment markets operate. You cannot get paid something for nothing. That is not how the world works. Passive income is a phrase used by salesmen to take advantage of some of the more indolent parts of our brains that want something for nothing. This is the same part of our brain that lotteries exploit to convince people that riches could be on the other side of their next lottery purchase. Despite logic compelling us to recognize the rouse for what it truly is, we still doggedly cling to the fantasy of easy money. The sooner we accept that passive income should never be our focus, the better off we will be.
Of course, the prospect of being able to derive an income without the hassle of a nine to five is undoubtedly appealing. Replacing your salary by some means, that doesn’t require an exchange of labor for money, is certainly possible. If it weren’t then there would be no such thing as retirement. However, the pursuit of income as a primary goal is not the most optimal approach. In fact, prioritizing income can hinder your financial health.
When people say “passive income,” they are either referring to investment income or income derived through some type of entrepreneurial means. It is a tantalizing phrase because it suggests you can make money without the need to work. However, this is a false premise as both entrepreneurial income and investment income both require an exorbitant amount of work. Firstly, entrepreneurial income is the profit left over after the cost of running a business. Generating this type of income requires inordinate amount of risk and an inordinate amount of effort with no guarantee of adequate compensation. According to PayScale data, the average small business owner in Australia makes about $74,000 annually, whereas recent treasury data indicates the average Australian's income now surpasses $100,000. This means that, on average, small business owners are investing more time, assuming greater risks, and earning 26% less than their employed counterparts. Furthermore, with 95% of new businesses failing within their first year, it's clear that such income is far from the "passive" dream many envision.
This narrows our search for passive income to earnings derived through investing. This type of income is what most people mean as “passive.” However, in order to generate a meaningful income through investments, individuals would need significant upfront capital in the first instance. This capital must be accumulated through work, whether by you or, in fortunate cases, received as an inheritance from family members. There is no way around it, accumulating such wealth inevitably involves considerable effort. And once your resource is invested, you still are not getting paid something for nothing. Unlike labor income where you exchange your time for money, investments compensate investors with returns for taking on risk. The return you get is a reward for bearing risk. Bearing risk is not nothing! This is a reality that becomes starkly apparent to any retiree experiencing their first market downturn. The stress and uncertainty brought on by market volatility underscores that managing investment risks can be a critical and at times active task.
When it comes to investments there are two components of returns - the capital growth component, and the income component. The total return on an investment is the aggregate of these two components. In the case of shares, the capital growth component is the change in share price and the income component are the share dividends. What is important to distinguish is the fact that while income may well be a component of return, it is not a determinant of return. In 1992, Eugene Fama and Kenneth French authored a seminal paper, "The Cross Section of Expected Stock Returns," which significantly advanced our comprehension of financial markets and the dynamics of stock returns. This groundbreaking work introduced the three-factor model, identifying market risk, size (smaller companies) effect, and value (book-to-market ratio) effect as key determinants of stock performance across global markets. Subsequent research expanded on this model to include factors like profitability and momentum. Notably, the presence of dividends has never been identified as a driver of returns. The success of dividend-paying stocks is not attributed to their dividend payments per se but to their alignment with one or more of these identified risk factors.
Merton Miller and Franko Modigliani, who are most renowned for their M&M theorem which proved that the market value of a company is independent from it’s capital structure, also have released research that proved investors should be ambivalent when it comes share dividends in their paper titled “Dividend Policy, Growth, and the Valuation of Shares.” There should be no preference towards whether an investor receives a dividend or not. This is because any dividend paid to shareholders will reduce the amount of cash held by the company, this in turn reduces the companies balance sheet which, in an efficient market with rational investors, will reduce the price investors are willing to pay for the underlying assets by the same amount.
To put it into perspective, imagine a company's stock is valued at $100 per share and it announces a profit of $10 per share. If it reinvests all the profits, the stock value would be expected to climb to $110 per share, reflecting the increase in company assets. Conversely, if it decides to pay out a $5 dividend per share, shareholders end up with a dual benefit: their stock is now valued at $105, plus they've pocketed $5 in dividends. In both scenarios, the shareholder's total value amounts to $110.
Despite this, investors often feel that dividends as a “passive income” are a type of “free money.” People will typically demonstrate an aversion to selling shares that have gone down in value, as they doggedly cling to memories of past glories when the share price was trading higher. However, they would not think twice about spending a dividend.
Dividends are also counted towards your total income at tax time. Conversely, unrealized capital gains are not. While the tax office affords some concessions in their treatment of dividends in the way of franking credits, these tax advantages do not outweigh the consequences of dividend investing which leads to a higher concentration of domestic stocks. Australia comprises just 2% of the global equity landscape so already your investment universe is considerably restricted. Further, just 10 companies account for 60% of dividends paid on the ASX 200. Clearly, any advantage that imputation credits may afford dividend investors are significantly outweighed by reduced diversification. The alternative globally diversified low-cost index approach, without preference towards dividends, allows investors to take money off the table as required while conceivably being in a more tax advantaged position by utilizing capital gain discounts and planning share redemptions in financial years when projected taxable income is lower. Unlike dividend-centric investing, this strategy avoids the pitfall of concentration risk and provides a broader exposure to market premiums, which in turn would lead to higher returns over the long term.
The journey to financial security and growth is seldom a passive one; it requires active decision-making and a well-thought-out strategy. Importantly, a realistic perspective on what income truly is and where it comes from will help us not get distracted by unimportant details. We need to set aside the seductive myth of effortless earnings and focus instead on building robust, diversified portfolios that have been informed through academic rigor to withstand the ebbs and flows of economic cycles. By embracing a holistic approach to investing, one that considers the true drivers of returns and their accompanying risks, we position ourselves not just for transient income but for lasting success.