There is a type of investment that allows you to sit back and relax without having to worry about the hot water cylinder breaking or chasing late rental payments. But isn’t the investment property the best form of passive income? You probably think it is. A lot of people probably think it is. Hopefully, I am able to convince you otherwise.
I want to tell you that the index fund is that easy alternative.
Kiwis romanticise the idea of property as an investment vehicle. Since the 1990s and thanks to the ever increasing housing market, we are now seeing the rate of increase in property value, exceeding that of income1. Knowing that just owning a home beats pouring your soul into your day job, why not invest in property?
After all, it is a tangible asset that you can see, touch, and charge people to live in.
Got a mortgage on that house? Let the rent pay it off and then provide you with a steady stream of passive income after the bank is gone. Until the hot water cylinder decides that’s enough to your joy or your tenants decide to throw a bash-in-the walls party.
I agree that our parents and our parents’ parents have profited greatly thanks to the property market.
But times have changed. Now owning even your first home is near impossible, let alone another investment property.
Taking advantage of the internet, we now have an easier way to invest our money and that does not have to be in a property. The easy alternative is the index fund.
Before you get started
Starting off with investing is like learning to run before you can even crawl. Check this off first:
- Have a rough budget
- Kill your short-term debts
- Have an rainy day fund
A budget, just enough to know your essential spending (i.e. rent, food) and maybe how much is wasted on useless wants, will give you a good idea on how much you can spare to invest.
In addition, having no short term debt obligations (e.g. credit card, hire purchase) will save you a lot in terms of interest on those loans.
Finally, having a rainy day fund will mean if you have a small emergency come up (like a car break down), you won’t have to go into more debt to finance this mishap or take money away from your potential investments. Not only that, a rainy day fund gives you a feeling of security and less worry.
I cover this in more depth in my previous post.
When I say passive income, we need to explore two concepts:
In the traditional accounting sense, income increases your net worth. Net worth is your assets, which is what you own, less your liability, which is what you owe.
When we say passive income, this is where your net worth increases while you sleep. In other words, it is income generated by doing little to nothing.
With investing, the income you receive may not necessarily be more cash in the bank but this will be increased net worth as the investment grows in value, increasing the value of your assets.
As a disclaimer, I am not a professional financial advisor. This is all opinion and here your education. I would suggest seeing a financial advisor for any financial questions and doing your own research.
What is an Index Fund?
Shortly put, an index fund is a collection of individuals’ money invested into shares of a company. This fund buys and sells by following a market index.
Before we dive deeper I want to mention some terms first:
- Managed fund
- Passively managed fund
- Exchange-traded fund or ETF (NB: for ease, we will consider this synonymous with passive managed fund)
A stock is a share ownership of a company that is publicly traded on a stock exchange.
A stock can provide income in two ways:
- Appreciation of stock value
Dividends are profit made by the company which is paid to stockholders. Another way a stock can provide value is where other individuals are willing to pay more for the stock than you initially bought.
A managed fund is a collection of money from lots of individuals, pooled together. This money is then invested into a collection of stocks from different companies.
The advantage of investing in multiple companies rather than one is that you build diversification. If you invest in only one company, there is a chance that this company may fail or perform poorly causing its value to decrease. Instead of having all your eggs in one basket, a managed fund will enable you to invest in multiple companies. The chance of multiple businesses failing is much smaller than one company failing, reducing your risk.
For example, the Vanguard Total World World Stock ETF invests in thousands of companies from all over the world. By investing in companies globally this reduces risk even further as you are not limited by the economics of a single country or geography.
Passively Managed Fund
A fund can be managed passively using a computer or actively using a team of experts. With all managed funds comes a fee. A payment for the services provided in investing your money. An actively managed fund, since it involves a team of experts, tends to have higher fees as opposed to a passively managed fund.
An index fund is a form of a passively managed fund. This is all down to a computer tracking a market index.
A market index in a way allows investors to quantify a performance of a particular market. An example of an index is the S&P/NZX50, which tracks the performance of the top 50 companies on the New Zealand stock exchange.
An increase in this index means that the market as a whole (the top 50 New Zealand companies in this example) are performing well. When this index drops, this reflects in reduced performance of these companies. This is the case with the In the case of the recent Coronavirus pandemic or even the global financial crisis of 2008, where whole countries economies floundered, reflecting in reduced performances of business across the world.
But am I not better with using a team of experts to make the best investments?
Predicting the market is very difficult or at least impossible. The fact is the less actively managed fund the better2.
We have already established that passively managed funds have less fees. We also know that actively managed funds do not perform better than passively managed funds. Then, does it make sense to pay for something that doesn’t necessarily perform better?
How do Index Funds make you Rich?
Now, that you have the minimum viable knowledge of what an index fund is and how it works, you can now see how it can make you rich.
Overall, we are expecting an average return from an index fund of 6%3. This would be a combination of dividends and share price appreciation. This is what we expect over a long period of time (e.g. 10+ years). In reality, this can fluctuate from day-to-day being greater than 6% or far less.
6% may not seem like much tomorrow, but thanks to the effect of compounding and small regular investments, over time, your money will grow exponentially. And this exponential growth can be regarded as passive income.
Despite the dips in the market due to the financial crisis like the global financial crisis of 2008 and Coronovirus pandemic, over a long period of time, the market will increase, as human ability increases through innovation.
The key is to start early. Also, the key is to keep going through the downtimes without panic selling your investment and making a true loss. You need to have that end goal in mind when investing.
This is why it is important to make sure you know how much you can afford to invest on a regular period, no debts, and a rainy day fund in cases of pay reduction or emergencies as mentioned before.
When times do get tough, and they will, you will be able to keep investing for longer, for the long term.
I hoping know you understand that index funds are:
- Low cost, using passive strategy
- Well diversified, investing in multiple company
- In the long-term and with compounding, money can grow
- Simple and easy to understand
What is Investment Property?
The investment property is regarded as the king of passive income (if you have no knowledge of index funds, that is) A house you own but do not live in; you allow individuals, or tenants, to stay in exchange for a regular fee called rent.
After the novelty of purchasing your first home has worn off, it is time to utilise the capital and purchase that investment property.
After setting up your investment property, income is earned in two ways:
- Capital gains
Rent (similar to dividends from shares) is collected over a regular period, normally every week. A less tangible form of income that an investment property provides is through capital gains (similar to the increased value of a share in a company). Over time and in general, the land value will increase, resulting in the investment property as a whole increasing in value.
Investment Property realities
On paper, rent and capital gains can act as excellent forms of passive income. Only if the income is truly passive…
You have done all the hard work, paying into your current home, looking for the right property and signing all the papers. You have had important meetings with the lawyer and the real estate agent.
You should be able to relax on your arm chair and watch the money flood in. Right?
Sadly, the hard work doesn’t stop there for an investment property owner. Owning an investment property is quite not passive.
The next stage is selecting the right tenants to fill the space. You better make sure they pay regularly and that they do not cause any fuss. You have to trust people who you do not know well to look after your space. That requires a lot of trust.
Also, do not forget maintenance on your property. If something breaks, then you must fix it and it comes out of your own wallet.
In some cases, the rent will cover the mortgage. This works well but remember the mortgage is the minimum you pay while rent is the maximum. If you are able to charge more rent than your current mortgage, then it would be a good idea to put the excess you make into rental to an emergency fund in case something does wrong in your investment property.
If the tenant decides to move out, you can still pay your mortgage while you find the right tenant instead of desperately trying to fill in the spot.
You can also find someone to manage the property for you and pick the right tenants, but this will eat away at your returns. Just like hiring an active manager for a managed fund, when you can do the job yourself.
You may have a good tenant. I’m at the expectation level that most people are good. A good tenant won’t be staying at your property forever, and there are bound to be a few rotten apples among the bushel – and the taste of that rotten apple sure does linger.
Bad tenants aren’t just bad. Not only will they cause financial harm, but they can inflict a lot of emotional harm as well with stress. You won’t remember the nice tenants, it’s the bad experience that will tend to stick so you best be prepared.
When it comes to cashing out, an investment property will take months to sell. Not only this, you have to share some of your earnings with the real estate agent if you decide not to sell privately.
Sounds like a lot of work right? It is. Holding an investment property really works for individuals with a particular skill set. After all this is more of a side hustle than a form of passive income. And avoiding any sort of work is the whole point of passive income.
With an index fund, most of the work can be done in front of the computer. Researching the right index funds takes a few hours, making sure it is well diversified, low-fee, and fits in your investment timeline. After you have reached your investment goal, cashing out of your index fund is a lot easier than an investment property by clicking a button.
Who would suit Investment Property?
The key attributes that a successful investment property holder should have:
- You enjoy catering for a tenant and offering a great service in where they live
- You are handy with tools or you know people who will fix things for cheaper than the market rate.
- You have excellent people skills – you can somehow judge good tenants from the bad tenants. If there is conflict, you have the ability to maintain calm and ability to resolve differences
- You are comfortable handing these responsibilities to someone else, with one of your largest assets.
If these are part of your skills or this is what you at least enjoy, then this would be useful in the realm of holding an investment property.
For me, I would struggle at most of the items on this list and so investment property may not be for me. I am more suited for sitting in front of a keyboard and clicking a few buttons.
How to invest in Index Funds?
Investing in index funds simply involves using a computer. Also, you do not have to be a millionaire. All you need is good knowledge of how much money you need for your essentials, what you spend guilt-free, and what you want to put away for the long term.
A good start is 10% of your take home income. Start small and increase accordingly.
There are many platforms to investing. The two popular ones from my experience include:
I use InvestNow since it has no membership fees as opposed to Sharesies. However, Sharesies has an easier user interface and can be used on a smartphone. Sharesies also allows investment in individual stocks of New Zealand companies.
I aim to invest 10% of my take home income every time I get paid into index funds that are low fee. This is done through an automatic payment.
These funds include:
- AMP Capital Australasian Property Index Fund
- AMP Capital NZ Shares Index Fund
- Smartshares Global Aggregate Bond ETF (AGG)
- Vanguard International Shares Select Exclusions Index Fund
Please note that I have no affiliation to these platforms or fund managers.
Investment property has been viewed as the ultimate form of passive income. Previous generations have made huge gains financially by having an investment property.
Kiwi’s are now finding it difficult to purchase their first home let alone an investment property. On top of this, investment property is no easy task requiring a lot of set up which costs time and money. This continues in maintaining the property literally but also finding the right tenants and being able to navigate any disputes.
Now that we have access to the internet, investing in index funds has become easier. You do not have to be a millionaire either; all you need to have is a good grasp of where you money is going, little to no debt, and an emergency fund in place.
I am hoping after reading this you have gained some knowledge on index funds and how it can help you live a happy life. If you would like to comment please do so and if you like what I write please keep updated by subscribing to my newsletter.