The Dividend Collector

Simply put, investing is all about buying a series of cash flows. More comprehensively, the value of a stock should equate to the present value of all future cash flows to equity-holders using a discount rate that accounts for time and risk.

Typically, an investor would estimate the future cash flows and work backwards to determine an appropriate price for the stock. If the stock is trading below the estimated value, the investor would buy with the expectation the price would eventually reach its fair value. Longer term investors might continue to hold a stock – even if it’s trading at fair value – because they expect to receive a return on their investment.

The problem with the traditional way of evaluating a stock is that price fluctuations can take investors on an emotional roller coaster, leading them to make bad decisions.

Below I present an alternative, somewhat backwards – but otherwise appealing – way to look at a stock by solely looking at the dividends received.

This way to look at a stock is as if you were buying an annuity (from an insurance company) that pays growing cash distributions. While you still own the original capital (and any capital appreciation), which you wouldn’t with an insurance annuity, the key to this analytical approach is to assume you don’t. Essentially, you trade a lump sum today for an infinitely continuous and growing stream of dividends.

Becoming a dividend collector

I think this psychological ploy can help some investors avoid over-trading their accounts by ignoring price fluctuations, instead focusing on dividend income generated by the portfolio. Dividend streams tend to be more stable than stock prices, resulting in less emotional distress. This is because even during bear markets, many companies will continue to pay and even grow their dividends. The dividend collector is far less emotionally sensitive to market movements than the traditional portfolio manager. The dividend collector is also more likely to remain invested for the long term, thus creating greater wealth than someone who trades on emotion.

The investing purists will say that total returns (price fluctuations + dividend income) is what matters. I agree. In the end, you’ll be collecting and reinvesting dividends plus (hopefully) growing your initial investment over time. That’s the beauty though. By ignoring your original capital investment and focusing solely on the dividend stream, any growth in capital becomes a fabulous added bonus at the end of your investment horizon.

Today’s small dividend becomes tomorrow’s big dividend

For simplicity’s sake, assume an initial investment of $100 into a dividend paying stock. Assume the annual dividend on that stock is $2.50, but grows at 6% annually.

(Note: In reality you wouldn’t invest in just one stock. To reduce risk, you’d diversify across a number of dividend paying stocks and research the quality of each of those dividends.)

The chart below illustrates how that annual dividend would rise each year over 20 years.

As the $2.50 dividend grows to $8.02 over 20 years, an initial 2.5% dividend yield today becomes an 8.02% dividend yield based on your original investment.

An investment that pays for itself

Giving up some money today in exchange for an escalating cash payment sounds appealing. But you also have to consider how that money accumulates over that 20 years. Over that period you’ve collected almost $100 worth of dividends ($99.98 to be precise). So you’ve recouped your original investment – presumably to put to work in another asset – and you’re continuing to generate 8.02% on your original investment.

Now take that experience and scale it up to a $1,000,000 fully diversified portfolio of dividend stocks. Under the same assumption, that portfolio has generated almost another million over 20 years plus eventually spits out an income of $80,200 that continues to grow. Realistically though, you’ve also reinvested the accumulated dividends (thus generating additional dividend income) plus your portfolio has likely grown (the added bonus I mentioned above).

Again, I want to stress this isn’t necessarily an academically complete way of looking at an investment. However, I find that focusing on the continuous and growing stream of cash flows generated by an investment helps some people stick to a long-term plan. Consequently, they are better equipped to grow wealth over the long term and avoid emotional sell/buy decisions along the way.


How to Generate Retirement Income

Picture this. It’s September 1981 and you’ve just retired. You want to live a comfortable life so you figure you need to generate a retirement income of about $50,000 in today’s (2019) dollars.

That means you need $18,172.17 in 1981 (chart below).

Inflation-adjusted income required to match a $50k income in today’s dollars.

How do you proceed to generate a sustainable retirement income from your investments?

In 1981 the solution was pretty simple and low-risk. You could buy and hold 10 year US Treasury bonds that, at the time, yielded over 15%. Investment required: $118,587.78!

Of course, $118k in 1981 is worth more than $118k today because of inflation. In today’s inflation-adjusted terms (adjusting for Consumer Price Index) that’s the equivalent to $326,289.62.

Unfortunately, for those retiring today, this retirement income strategy is totally infeasible. This is because the yield on 10 year US Treasury bonds has dramatically declined.

The chart below shows how the 10 year US Treasury yield has declined over the decades. Currently the yield is flirting with all time lows of about 1.5%. These lower yields mean that an investment in US Treasury bonds doesn’t generate the income it used to. Said differently, to generate the required $50,000 annual income today using low-risk US Treasuries, you’d need to invest way more money than you would need to in 1981.

10 year US Treasury Bond Yield

As of September 1, 2019 you’d need to invest almost $3.5 million (chart below) into 10 year US Treasury Bonds to generate a $50,000 annual income. In inflation-adjusted terms, that’s about 10x more than you’d have to invest in 1981.

(Final chart below shows inflation-adjusted investment required to generate the inflation-adjusted equivalent to $50,000 in today’s income.)

Investment in 10 year US Treasuries to generate $50k (in today’s dollars).
Inflation-adjusted investment in 10 year US Treasuries to generate $50k (in today’s dollars).

With Yields So Low, How Can you Generate Retirement Income?

Now you’re probably thinking you wouldn’t rely on just your straight investment income to pay for retirement. You might intend to draw down your capital and rely on a pension. This is what most people do. But I would argue it is not the right strategy.

If you have a good defined benefit (DB) plan pension that replaces at least half your current income, God bless you. You can probably stop reading…that is, unless you think your company has even the slightest risk of going bankrupt sometime between now and the time you die or if you think your company will find a way to weasel out of paying its obligations (because with lower yields it is becoming increasingly difficult for defined benefit plans to remain fully-funded).

On second thought, keep reading even if you have a DB plan.

The Retirement Income Rule of Thumb

The wealthy of the world strive to pay their retirement bills from their returns ON capital…not the return OF capital. In order to build lasting, generational wealth, enough income must be generated from a combination of dividends, interest income and capital gains to cover living expenses.

You may be familiar with the 4% rule of thumb. This rule states that – based on historical market returns – an investor can withdraw up to 4% from their portfolio each year without eroding their capital. In essence, the 4% withdrawal is offset by returns from a combination of dividends, interest income and capital gains that equals to 4% or more.

Generating a satisfactory income aligned with the 4% rule while maintaining a high degree of safety was easily achievable in 1981 – US Treasuries are considered risk free assets. Today, however, the environment is far more challenging.

How do you generate sustainable income from your investment portfolio today? Unfortunately, you might not like the answer.

You can do some or all of the following:

  1. Learn to live with a lower retirement income by living more frugally.
  2. Work longer and delay withdrawing from your portfolio. This allows your portfolio to grow larger and reduces the income-generation burden on your portfolio and the risk you outlive your savings (i.e. longevity risk).
  3. Build a larger portfolio by earning more income and saving a greater proportion of that income throughout your working life.
  4. Take greater risks with your money by investing in assets with higher total returns potential (combination of dividends, interest income and capital gains). The downside is that you might lose more money than you’re comfortable with if things go south.

Of course, you can avoid all this if you have $3.5 million to invest in 10 year US Treasury Bonds. Without $3.5 million to invest in risk-free assets, you must stretch across the risk spectrum to find assets with higher dividend yields, higher interest income and greater capital returns potential. Of course, moving up the returns spectrum requires you to take on more risk.

Beware of Risk

Whatever you do, don’t go chasing higher returns without paying attention to risk. Same goes for higher yields. Not all yields are the same – for example, a company might have a high dividend yield because the market anticipates a dividend cut or worse. (When it comes to dividend yields, I always look at a company’s payout ratio to assess the sustainability of the dividend.)

While you won’t be able to escape greater systematic risk (i.e. market risk) when investing in asset classes with higher total return potential, you can eliminate idiosyncratic risk (company-specific risk) by diversifying across companies. Moreover, systematic risk can be mitigated by investing in a variety of assets classes with low-or-negative correlations.

Don’t make the mistake of ‘diversifying’ across asset classes with similar risk exposures – e.g. dividend paying stocks, corporate bonds, high yield bonds – and thinking you’re set. Many (probably most) asset classes are exposed to the business cycle and risk sentiment, so you need to find a way to balance out your risk exposure using assets that are negatively correlated to these factors, such as sovereign bonds and gold.

But I just said US Treasuries yields are super-low, right? And gold is more of a currency than income-generating asset. True. This simply underscores today’s challenge with generating retirement income from a portfolio.

Once you have to start worrying about risk, it becomes exponentially more difficult to generate retirement income using investments, like you might have in the past. It can be done – investing doesn’t need to be hard – but it’s not like 1981 where any monkey could fund their retirement without taking on risk or making lifestyle tradeoffs.

Today, it is inescapable fact that you’ll need to do some combination of the four options noted above: 1) Live on less, 2) work longer, 3) save more, 4) take on more risk.

See. I told you you won’t like the answer.


8 Life and Money Lessons Shared by the Elderly

I have made decisions in my 20s or 30s that I’m sure I will regret later in life. I’m probably not alone.

A 25 year old making a choice believes he has decades of recovery time if that choice is poor. Yet, the elderly would warn otherwise. Unfortunately, many of us don’t have grandparents around to ask how they would have done things differently.

Fortunately, The New York Times recently ran an article that sought the accumulated wisdom of grandparents everywhere, entitled: “From the Elders to the Kids: What I Wish I’d Known”.

Much of the advice involved money. While the article itself is interesting, the unsolicited comments truly delivered the lessons many of us need to learn and re-learn.

Below are 8 verbatim comments that embody the life-lessons retired folks had for younger generations:

1. You really do not need the latest phone/computer/car/vacation, what you need is to have a security net so that you can kick back some when you are my age. My husband and I have lived well below are means for years. It is just recently we have begun to spend more freely because we do have a large nest egg put away. You will be astounded by how quickly it can increase by just putting a small percentage away every paycheck.

2. You might not make it to 67. My parents were disabled at 50. My turn came at 45. So get it together and start saving YOUNG.

3. I am 73 and am a semi-retired attorney. Best advice I ever gave myself was to get a profession where you can hang out your own shingle if a salaried job disappears. I lost my last “job” at age 47 when my boss lost his election and I have been working solo ever since and loving it.

4. Plan for the future as if the worst might happen, that you might not be able to work as long at a highly paid salary as you’d hoped. Be prepared for disaster.

5. Don’t put off everything you want to do until retirement. I’ve seen lots who are now unable to travel or do what they want due to health and money problems.

6. My best advice is to minimize debt. Debt will cost you far more in the long run than any other financial transaction. Save money, make smart purchase choices. And watch the small expenses- coffees, t-shirts with the latest catchy slogan, subscriptions to publications you seldom read. They add up.

7. Retirement may not turn out the way you thought it would. I ended up selling my home, moving in with my mother, subverting all the plans and things I thought I would be doing in retirement to elder care and taking care of a huge yard on our small farm.

8. Realize that many of your relationships are probably tied to work. Once they are gone, and if you have to move it’s a very difficult task to reform those kinds of relationships, especially if you are unable to get out.

If you know someone young that could benefit from this advice, share this article. Sharing is caring.