Wednesday, April 2, 2008

Back test Results of one Rule of Thumb

One of my favorite rules of thumb is that a dollar saved in your twenties supplies one dollar in income in your sixties. In order to test the validity of this rule I used historical S&P 500 total return data from Prof Shiller for the period from 1921 – 2008.

I assumed that a person would invest $1000 once in a single year and would not contribute more money later. I would then calculate the total return of the investment as well as its dividend income over the years. I would then pick a year down the road, where the dividend income is above $1000 for the year for the first time ever. For simplicity purposes I ignored the effect of taxes, transaction costs and inflation.

For example, if you invested $1000 in the S&P 500 in 1921, your investment would have produced annual dividend income of over $1000 for the first time in 1952.
The last year for which I was able to achieve dividend income of over $1000 was 1967.
The results of this study confirmed the validity of the rule of thumb that I was testing. I found that the average time it took a $1000 investment to produce $1000 in dividend income for a full year was 35 years. In other words if you contributed $1000 towards your retirement by investing in a broadly diversified stock index fund when you are 23 in 2008, you would expect to achieve $1000 in dividend income on average by the age of 58.

The chart below shows that the longest period to achieve the desired dividend income was 45 years, for those who started in 1928. The shortest it took to achieve $1000 in dividend income from a $1000 investment was only 27 years for those who started in 1941.

The time it takes to achieve $1000 in dividend income from a $1000 investment has been increasing since it hit a bottom in 1941. It would be interesting to see how the decrease in overall dividend yields over the past 20 years has affected this rule of thumb.

















Related Articles:

- The Case for Dividend Investing in Retirement
- Dollar Cost Averaging
- Diversification Matters
- The number one reason why I don't chase High-Yielding stocks

3 comments:

  1. This is a good parameter to look at while evaluating the stock for dividend investing portfolio. One of my parameter is cash flow at 10yr, 15yr, and 20yr horizon. I may add this parameter to see how it stands. Since you looked at S&P500, the time it takes to have same cash flow is relatively higher i.e. 27 yrs to 35 yrs. Looking at some specific dividend stocks it is much less. (22yrs for JNJ, BUD; 19yrs for PFE, BAC; 15yrs for GE).

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  2. Dividend Tree,

    The thing with individual stocks that makes them subjective for this analysis is that you have to take into account the survivorship bias. I do agree though that the companies that you mentioned will probably do better than the broad market averages.

    Thanks a lot for your comments.

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  3. Interesting - 35 years. My analysis about ten years ago indicated 35 years of consistent investing in equities is required to provide a reasonable probability that one would have a big enough pot of money to spin off enough income to live reasonably well and still allow for growth of the principal. I use the word reasonably a lot, but show me someone who can put out an EXACT number for 35 years in the future!
    Given increasing longevity and possibility that current newborns in developed societies could live to be 100, this issue needs to be readdressed. As I tell young people, if each indiviual is theoretically responsible for earning and saving enough income to provide 100 years of living, if one does NOT produce any meaningful income for the first 20+ years of life and wishes to retire after 40-45 years of working, one must invest enough excess funds over that timeframe to pay for the other 55 years of life of unemployment. THAT IS ONE TOUGH NUT TO CRACK!!! Current reality seems to bear this out. One needs a college education to get ahead but comes out loaded with debt to pay off. Then works til 65-67, but still does NOT have enough money to pay for old age and its attendant ills. HELLO.

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