Rule #15 Don't try to "Beat the Market"

Do you know the only thing that gives me pleasure? 

It's to see my dividends coming in. -John D. Rockerfeller

Have you ever heard anyone talk about beating the stock market?  Its what hotshot investors talk about at cocktail parties.  What they mean is that if the stock market has an annual return of 10% in one year, they have had a better return than that 10%.  Very impressive indeed!  They will try to achieve this by building and adjusting a stock portfolio, mutual fund portfolio, or with index funds.  Beating the market is all well and good if the market goes up, but what if the market goes down? If the market has a loss of 5% the next year and the investor only lost 3%, then they have also beaten the market because they have done better than the market has done that year.... but people don't tend to brag about losing money "Yeah! I only lost 3% this year!".  The market (and by market I mean Dow Jones Index, S&P 500 index, or TSX index etc...) has historically returned 8-12% returns annually but those numbers are smoothed out over decades of data, so you certainly couldn't count on a 10% return every single year... as has been the case the last decade.  One thing about measuring returns in the market this way is you only realize these returns when you sell the investment... and that brings on the issue of timing, and few people have mastered that.

I don't really care if I beat the market or not.  Beating the market is not my objective.  I am not in competition with the market, My objective is to build a portfolio that will eventually result in me being financially independent.  Who cares if you beat the market if the market has lousy or negative returns?  If the market loses 25% in a year, I feel no pride in only losing 20% that year.  And if the market were to make 25% in one year, its ridiculous for me to worry that I only returned 22% instead.  I feel this "beat the market" mentality is a waste and makes people take their eyes off the prize, or chase capital returns instead of stable cashflow.  People shop around for stocks or sectors hoping to get a winning year or to follow advisors or mutual funds because they have a few good yearly returns.  That just seems dumb to me.  I prefer a system that provides stable and somewhat more predictable results.

We have our own metrics.  We don't compete with the market, and we sure as hell dont try to beat it.  Our goal is to grow our cash-flow on existing assets by 8% a year... We get this by reinvesting the 3-5%-ish dividends that we get in cash-flow and then plan on a 4+% increase in dividends annually.  We generally don't pay much attention to stock prices once we own the stock because they tend to fluctuate due to world and political events rather than be based on actual company financial metrics.  Tracking growth of cashflow is pretty easy to understand and we don't have to follow the stock prices or compare with how the market is doing.  In fact, since we are reinvesting dividends to buy more stocks for cash-flow, we don't mind when the market takes a dive because it means we can pick up good stocks with even higher yields than before.

Every year for the last 10 years, our cashflow from existing assets has increased.  Every year! And Every year it has gone up above the rate of inflation.  The lowest growth rate was about 5% in 2009 and the highest has been about 15%.  Thats a pretty good record if you ask me.  This year is turning out to be a good one, we expect about a 10% increase in total this year if we keep going the way we're going.  Three quarters of our dividend producing stocks have increased their dividends this year and the rest probably will within the next 3-6 months, and we just keep rolling those dividends back into the portfolio buying more cash-flow-producing stocks, furthering the compounding.  This increase also does not include any new monies that we put to work in this strategy.  Include the new monies, and our conservative leveraging strategy and we're increasing our cashflow above our 8% per year target relatively easily.  Do I care how this all compares to what the stock market performance is doing these days?  No, I don't.

Rule #7 Maximize income in AFTER TAX money.

If, as a big severance package, your company offered you $60000 in any of the following income streams: pension income, capital gains income, employment income, or dividend income, what kind of income would you choose?  Did you think about the taxes?  Most people don't.

I hate paying income taxes. I wont go into it in any detail because it gets political... and I only talk politics if I have a beer in front of me, and I don't right now, so you are spared the rant.  But with that said, we all hate paying taxes, especially on income.  Doesn't it make sense then to try and minimize the amount of tax one pays on your income?  Sure it does. This is called tax avoidance and it is perfectly legal... structuring your income in such a way as to be tax efficient.  I was introduced to this way of thinking about a decade ago when I came across a blog talking about the virtues of dividends... Canadian Corporation Dividends in particular.  There is something called the Canadian Enhanced Dividend Credit, and I won't bore you with details of it, only to say that it results in a lowering of the marginal income tax rate on those dividends.  You can find out more about it here.  

For those who don't know what a dividend is, its a when a company shares a portion of its earnings with shareholders by sending them a cheque... usually quarterly throughout the year.  Those companies have already paid taxes on those earnings, so you don't have to pay as much taxes as you would if it was standard employment income.  Let's have a look at a couple scenarios, where income could be from one of these different streams...  Employment, Capital Gains, RRSP or RRIF withdrawal (remember its taxed when you take it out), Dividends from American Corporations, Dividends from Canadian Corporations (those eligible), and other income.  "Other Income" could come in the form of a pension, rental property, royalties, typical government benefits, some income from REITS, servers tips etcetera.... all of which are taxed at the same rate as employment income.  I don't include business income as I have no experience with owning my own business, nor do I know the intricacies that go with it. 

The two scenarios are $60000 and $100000 in annual income.  The income tax regime is Federal and Ontario, Canada.  The basis of the calculations is from the taxtips.ca calculator page where you can run your own scenarios.

So the Total in-pocket amount is the most important column because thats the one that tells you how much you get to keep.  Notice the big difference in taxes from the Investment rows such as Capital Gains and Canadian Dividends (eligible) in comparison to the Employment, RRSP/RIF Withdrawal, and Other Income rows.  Markedly different isn't it. If you made $60000 in Canadian Dividends you would get to keep 97.6% of it, vs the 80% you'd get to keep in employment income.  Note that as an employee you would also be required (don't get me started) to pay CPP and EI premiums which will run you another $3000 a year or so in tax obligations that you wouldn't have to pay if you made your income from dividends or capital gains.  Again with $100000 income, the investment income rows fair substantially better in tax treatment.  When I recognized this a decade ago, I started thinking that there was a type of income that I wanted more of, and other kinds of income that I wanted less of.  It was one of those "Eureka!" moments for me.

So... 

Guess what kind of income I prefer. Then guess what I look for when I'm building an investment portfolio.