If you have read about my main financial goals following leaving my corporate career in 2019, you know that one of my goals is to have my investments generate enough cash flow through dividends and other forms of distributions to pay for all of my expenses. I’m in my early forties, so I want the investments in my non-retirement accounts, what I am going to start calling my “Financial Independence Portfolio,” to achieve enough cash flow to pay for my family’s expenses. My by retirement accounts, which I am viewing as my “Financial Abundance Portfolio,” can kick-in and add an extra cash flow to use when the time comes. Hopefully to pay for vacations but perhaps to pay for medical expenses depending on how healthy I remain. Today I will be talking about my Financial Independence Portfolio.
COVID-19 is an opportunity to reshape my Financial Independence Portfolio and add investments that are generating significant cash yields compared to their historical performance. My Financial Independence Portfolio now includes securities that pay dividends, have healthy balance sheets, and have been trading at a meaningful discount to their 52-week highs. I have been building this Financial Independence Portfolio in phases since the bear market earlier this year. Phase 1, which is now largely complete, has been to identify asset classes and securities that I like and to build initial positions in those securities and asset classes. Phase 2 is to add to certain positions within the Portfolio when there is a significant pullback or correction in the market.
My Financial Independence Portfolio, after completing Phase 1, is almost generating enough annual cash to pay for two-thirds of our family’s expenses. In addition, my Financial Independence Portfolio is still 36% in cash so I can readily take advantage of significant pullbacks in the market or a longer recession that pushes down the price of other assets. Based on my expected cash distributions and the remaining cash in my Portfolio it looks like I may be able to generate enough in distributions from my Financial Independence Portfolio to pay for my family’s expenses once the outstanding cash is invested. This may take a few months or a few years depending on when we see a drop in the market.
The Cash is beginning to Flow
As I mentioned above, on a going forward basis my Financial Independence Portfolio should generate annual cash distributions that can pay for about two-thirds of my family’s annual expenses. Some of these investments provide cash distributions on a monthly basis and some provide cash distributions on a quarterly basis. We will not be using these distributions to pay for expenses at this time – the current plan is to reinvest them and continue to build the Portfolio for at least the next few years. My wife is still working and I have picked up some consulting work here and there to pay for things. Things could change but for now the goal is to reinvest distributions from the Portfolio.
Income v. Non-Income Producing Assets
When you are investing really look at income v. non-income producing assets. Warren Buffet has talked about how real estate and gold are both physical assets that can go up in value. However, real estate, such as rental property, generates income every month with its rents. Gold, on the other hand, only appreciates in value when the people that want to buy it believe that it is worth more than when you bought it. I believe gold and other non-income producing assets have their place in many portfolios but they are not the assets that are going to get you to the promise land of Financial Independence.
If you are young the focus on your investments should be on total growth instead of just cash yield. However, even when I was young I typically wanted my investments to generate some cash. As an example, Apple is a growth company but it still is a cash flow positive company and it provides a small dividend to investors. Same with Microsoft – it is a growth company that pays a small dividend. There are plenty of great growth companies that do not pay dividends but the dividend has always given me an extra sense of security (as long as the dividend is being paid out of operating cash flows and not debt or other forms of financing).
Now that I am at the stage of financial independence I try to buy assets that are primarily income producing to me through cash distributions. The underlying business of an investment is typically sound if it can provide cash distributions through its operations. I have bought many of these investments over the last few months at discounts to their historical prices and I can collect cash while I wait for the stock prices to increase in value again. To me, cash flow gives me a sense of security even in a falling market. With these types of companies I still can benefit from capital appreciation in a bull market just not as much as if I owed NVIDIA or other high flying growth stocks. I own some of those in my Financial Abundance Portfolio but in pretty small quantities.
There is additional upside to my Financial Independence Portfolio
The ongoing cash distributions from my Financial Independence Portfolio are regular dividends or distributions that the companies pay and do not include any capital appreciation of the stock or underlying assets. However, I hope that most of these investments will see their prices go up over the next few years. Also, many of these investments have a history of increasing their dividend payments over time which will improve my yield on cost over time. These are upside opportunities I plan for but am not relying upon to pay my bills.
My Financial Independence Portfolio Breakdown
The major investment asset classes that make up my Financial Independence Portfolio are as follows:
- Private Real Estate Debt Fund (31.1% of Portfolio) – Generates stable monthly cash flow, initial investment conservatively secured by real estate, limited upside potential.
- Closed End Funds holding Bonds, Real Estate Equities, and Financials (7.4% or Portfolio) – Generates fairly consistent monthly cash flow, top flight managers in under-valued sectors that have upside, there will be volatility in the stock prices of these securities but I purchased these securities at historical discounts to the value of the assets they hold.
- Preferred Shares (1.4% of Portfolio) – Generates quarterly cash flow at a high yield to cost since I purchased these shares at a discount to their par value, there is some upside to their prices going up in value because they currently provide stable mid-to-high single digit returns in a zero interest rate environment. I have picked preferred shares of companies that pay common dividends and that I believe have a good margin of safety.
- Common Stocks (12.8% or Portfolio) – Consists of stocks that had historically high dividend yields due to March sell-off, long-term upside if/when there is a broader recovery in the stock market, most of these stocks have very good balance sheets to weather further economic turmoil, gives me sector diversification, probably most volatile part of my Portfolio.
- Private Real Estate Equity Investments through Crowdfunding (11.2% or Portfolio) – These are investments in individual real estate transactions that I have reviewed and conducted diligence on and like either for their cash flow potential, capital appreciation, or both. Unlike the Private Real Estate Debt Fund part of my Financial Independence Portfolio, these investments generate quarterly cash flow from some stabilized real estate assets but they also have the potential for capital appreciation over the next 3-5 years.
- Cash (36% of Portfolio) – I assume very little cash distributions from this part of the Portfolio. However, it gives me the ability to add to my investment positions, particularly with the stock positions, if we see a pullback in the stock market due to vaccine candidate failures, political turmoil during the upcoming elections, or the market correcting to the economic reality that this country is facing. One approach I am using to improve the returns on the cash I am holding is selling very conservative put options to generate cash premiums. This strategy is generating a return on my cash that is well above what I would receive in a high-yield-savings account.
- Directly held real estate – I kept this investment out of my Portfolio allocation calculations but I do own a rental property in CA that I manage. I’ve been a landlord since 2005 and currently this investment is slightly cash flow positive. The property has increased in value by close to 50% since I’ve held it but on an annualized basis that’s not a great return. My wife and I will likely hold onto this property until we decide to sell it and do a 1031 exchange into something else down the road.
Weaknesses in my Portfolio
On a broad scale, I identified a few big weaknesses in the portfolio I have put together.
- No hedge using gold or other commodities. I have discussed the benefits of holding some gold in this environment –see here– but during the reallocation of my Portfolio I failed to keep my positions in gold and other commodity-related securities. I plan to initiate and maintain some positions in gold or other commodities in the third quarter.
- No international exposure. My Portfolio is a U.S. biased portfolio which is probably a good thing right now but it is a long-term mistake. My confidence in evaluating emerging markets, etc., is not great so I will probably add a few ETFs to my portfolio to gain some exposure. I will only add a small international position but I feel having no international exposure leaves me overly reliant on U.S. companies and real estate.
- It requires active management. I own over 50 different investments right now in this Portfolio which, if properly managed, takes time to keep track of and adjust as necessary. This is definitely not the buy and hold forever strategy to financial independence but I am not doing day trading either. I will hold many of these investments for a long-time assuming no changes to the reasons why I first made an investment.
My Recommendations to Building a Strong Financial Independence Portfolio
- Focus on investing in income-producing assets when trying to maintain financial independence. Temporary loss of capital is less painful if you are still getting paid a dividend every month or quarter.
- Do not rely on capital appreciation to support your financial independence. The best way to secure financial independence is create enough dividends and other form of regular cash payments from your investments to pay for your expenses. Capital appreciation is that cherry on top of the cake once you establish financial independence – cash flow and long-term capital preservation is the cornerstone to financial independence.
- Buy investments when their dividend yield is above their historical averages only because their stock values have gone down in the short-term due to a market correction. Sometimes individual stocks go down for a good reason but in March, as an example, everything went down regardless of the quality of the underlying company. Many quality value stocks are still down and can be bought at good prices. Be patient and buy at good prices – every few years stocks go on sale.
- Diversify your portfolio among various asset classes. See here for my reasons to diversify not just among different companies but among different types of assets.
- Pay attention to what smart investors are doing and see how you can apply it to your investment decisions. As an example, Warren Buffett just bought shares in a gold company (probably viewed it as undervalued, it generates a dividend, and it creates a natural gold hedge for Berkshire), doubled his investment in a REIT I own (no brainer to add to my position – it was something I wanted to do already but this gave me an extra push to do so), and sold a lot of bank stocks but increased his Bank of America holdings (this to me is a move-up in quality by Mr. Buffett when financial stocks in general are trading at a discount to asset values). I know enough about investing to parse through what other smart people are doing so I can make better decisions with my own investments.
I am going to break down each asset class in my investment portfolio so you can consider these investments for your own portfolio. I am not making any specific recommendations but these articles will give you some investments to consider and do further research on.