Investing for passive income is a great way to build long-term wealth. In this article, we will look at the basic formula for achieving long-term financial success laid out by two of the world’s most successful, wealthy, and famous investors of all time: Berkshire Hathaway’s (BRK.A)(BRK.B) Warren Buffett and Charlie Munger. We will then compare and contrast two popular and highly effective approaches for implementing it: The more passive, lower risk, and lower reward method of investing in dividend ETFs vs. the more active, higher risk, and higher reward method of investing in individual dividend stocks.
The Munger-Buffett Passive Income Formula
Charlie Munger said that the first step is to accumulate $100,000:
The first $100,000 is a *****, but you gotta do it. I don’t care what you have to do – if it means walking everywhere and not eating anything that wasn’t purchased with a coupon, find a way to get your hands on $100,000.
Why is this financial milestone so important, yet so difficult to reach? It’s because, early on in your saving/investing journey, you aren’t really earning very much passive income from your investments since your principal is too small. However, once your savings reach a certain size, the passive income you earn becomes remarkably large to the point where your nest egg can grow quite rapidly without you really needing to add much additional capital to the pile. Mr. Munger understood this from his own experience and emphasizes working extremely hard up front in order to build a substantial financial snowball as quickly as possible in order to let it do the heavy lifting for you for the rest of your life, enabling you to lighten up your effort a bit if you so choose.
This concept is best illustrated by a snowball, an analogy that Warren Buffett likes to use (so much so that there is even a biography written about him by that title). As he said once:
Life is like a snowball, all you need is wet snow and a really long hill.
The analogy of a snowball is basically that as a snowball rolls downhill, it generally gets bigger as more and more snow from the ground attaches itself to the snowball so that by the time it reaches the bottom of the hill, the snowball is far larger than it was when it first started rolling down the hill. Moreover, the bigger the snowball is, the more snow it can pick up since its surface area is that much bigger and therefore interfaces with more of the ground as it rolls along it. Therefore, the size of the snowball at the beginning of its descent down a hill has an exponential impact on its size by the time it reaches the bottom.
This concept applies similarly to personal finance and investing: Any small increase in the size of your nest egg at the beginning of your investing life has an exponential impact on the size of your wealth by the end of your life due to the power of compound returns.
While the paths to amassing $100,000 in savings are many and often highly dependent on one’s personal circumstances, the approach to investing $100,000 for an effective passive income snowball can be much simpler.
Method #1: Dividend ETFs: More Passive, Lower Risk, Lower Reward
The simplest method for building a passive income snowball is for investors to put $100k into a dividend ETF. They allow you to invest in the broader dividend stock universe with instant diversification, a low knowledge requirement, and professional management. They give you passive exposure to the sector and save you the hassle of having to buy and sell individual securities.
That being said, there are some trade-offs associated with investing in ETFs. First of all, ETFs impose management fees, commonly referred to as the fund’s “expense ratio.” While many passively managed ETFs – which generally follow a blind rules-based investment strategy without relying on qualitative analysis – often charge very low expense ratios, these fees can still reduce the overall returns of the fund. Consequently, this can slow down the long-term compounding effect and potentially lead to underperformance in certain cases where qualitative judgment of markets and individual stocks would have been beneficial. Conversely, actively managed funds, which incorporate human judgment and advanced proprietary algorithms, typically charge high expense ratios, further dampening investors’ long-term total returns.
Another drawback of investing in ETFs is that many of these funds hold positions in hundreds of individual stocks, resulting in a phenomenon known as “diworsification,” a play on the word diversification. Diworsification occurs when investors pursue diversification for the sake of diversification, which can actually worsen the risk-return trade-off in their portfolio.
Moreover, low-cost passive ETFs often do not select specific securities based on factors like their current price, quality, prospects, or management. Instead, they aim to hold every stock within a particular sector, universe, or benchmark, regardless of their quality. This means that investors are also exposed to poorly managed companies, highly leveraged entities, and unsustainable operations.
While less experienced investors may find this broad diversification appealing, we believe that employing a thoughtful analysis of both qualitative and quantitative aspects of each security to select the most opportune investments will yield the best total returns in the long run.
Another issue with many low-cost passive ETFs, particularly those that are market cap-weighted, is that they generate significant demand for large-cap stocks without considering their underlying performance. This artificially inflates the prices of large-cap stocks relative to small-cap stocks.
Lastly, many ETFs, due to their heavy investment in overpriced large-cap stocks, typically offer a very low dividend yield. This limits their attractiveness as passive income instruments.
Although ETFs may not offer the same total return potential as direct ownership of individual stocks, they do come with considerably less risk due to their extensive diversification and – in some cases – professional management. Additionally, they are entirely passive investment instruments. By investing in one or more of these ETFs, investors can enjoy a truly passive investment that is likely to compound at a 7%-12% CAGR for decades to come.
If you’re not looking to hit a financial grand slam in your lifetime and simply want to have a comfortable nest egg that throws off an attractive amount of passive income via dividends when you retire, ETFs like the Schwab U.S. Dividend Equity ETF (SCHD), the Vanguard High Dividend Yield Index Fund ETF Shares (VYM), or the JPMorgan Equity Premium Income ETF (JEPI). If yield is less of a concern and the focus is instead on pursuing maximum long-term capital appreciation, simply buying an S&P 500 ETF (SPY)(VOO) or even a tech-heavy one (QQQ)(ARKK) may do just fine as well.
Method #2: Individual Dividend Stocks: More Active, Higher Risk, Higher Reward
Alternatively, to investing in dividend ETFs, investors can instead invest directly into individual dividend stocks such as Realty Income (O), Enterprise Products Partners (EPD), Ares Capital (ARCC), and Blackstone (BX).
Individual dividend stocks are not as passive as broadly diversified ETFs since success mandates doing considerable due diligence and developing the proper financial skill set. Such investing requires the investor to be willing to spend a considerable amount of time pouring over earnings calls, management presentations, and interviews, studying the broader trends in the industries in which these companies are involved, studying their balance sheets and cash flow statements, capital allocation tactics, macroeconomic fundamentals and trends, and ultimately doing a valuation analysis of the company to determine if its stock is sufficiently undervalued at present to make it worth buying.
Moreover, a typical dividend investing portfolio that has had adequate due diligence performed on it is typically going to be much smaller than the portfolios of the aforementioned ETFs, so it will tend to be less diversified which also brings some risks with it. If any single stock materially underperforms the broader market, has to steeply cut or even eliminate its dividend, or – in a worst-case scenario – goes bankrupt, the portfolio’s overall total returns and income generation will be much more severely impacted than would be the case in a broadly diversified ETF.
That said, picking individual stocks can also bring with it a much higher portfolio dividend yield as well as overall portfolio total returns if handled correctly since investors can hand-select the most promising investments while filtering out the ones that do not look particularly undervalued at the moment.
Investor Takeaway
Charlie Munger and Warren Buffett make a great point that working hard at a young age to build up a sufficient nest egg and then having the sense to use it to build a passive income snowball is extremely important to set you up for financial success. The long-term rewards of doing this are truly exponential in nature.
That said, investors need to be careful in how they structure their passive income snowball because a wrong choice could lead to a miserable lifestyle and/or poor results.
While both of the methods laid out in this article are valid and have been used by many with great success, our view is that if an investor knows what they’re doing and are willing to spend the appropriate time and/or can access good research, investing in individual dividend stocks can be the best approach to using $100,000 to build a passive income snowball.
Read the full article here
