Wednesday, June 11, 2014

Margin of Safety in Financial Independence

Financial independence is the point at which your annual dividend income meets or exceeds your annual expenditures. At this point, the dividend investor does not need to have a job, although they could decide to keep doing their work if they enjoy it. The best part is that the investor does not need to work for money again in their life, and can choose to spend their time as they please. They could do volunteer work, take care of younger or elder family members, travel, read or write, or even watch soap operas all the time. If they enjoy their work, they could continue doing that, or they might decide to start their own independent business. The sky is the limit when you have taken care of the downside, by having a dividend portfolio generate an ever rising amount of cash every year, which covers your expenses.

I believe that a dividend portfolio will generate rising income for decades, and solid capital gains in the process of 30 years or more. Even at a total return of 7%/year, $1 million today will grow to $8 million over that time period. That of course assume that dividends are spent, and very little is reinvested back. Some companies will be sold, acquired, merged or fail, but in general this will be a very passive portfolio. I am pretty optimistic about my portfolio after I reach financial independence and believe I will ultimately end up earning much more in dividends than what I would ever earn from paid employment. Once I select a quality dividend paying company, my only downside is the price I paid for the stock. My upside is the sum of all future dividends I will receive until the end of time. The rest is unrealized capital gains, which would result in a step-up basis for whoever inherits the DGI nest egg. However, I am also operating under the belief that the upside will take care of itself. Therefore, I need to spend my time to protect my downside risks. As a result, I believe in generating redundancies in my portfolio, in order to ensure that I stay financially independent. This is where the concept of margin of safety in Financial Independence comes from.

I took the idea of redundancies from the concept of engineering, where bridges are constructed, so that they can carry several times their projected peak load. They have built in overlaps and redundancies just in case peak loads increase over time, and also to withstand a long period of normal wear and tear.

For my portfolio, I want to ensure I it withstands as much pressure without breaking. Thus, i expect to have multiple layers of redundancies built into my portfolio.

- I buy stocks that have many products/services with revenues derived from many continents/countries. This diversity in revenue streams ensures that company is not overly reliant on a single product for which demand softens.

- I buy stocks from different industries, and I try to be diversified so that a total collapse of one of these companies doesn't derail my plans. I seek safety in numbers and believe that a portfolio should include at least 30 – 40 individual components for diversification purposes.

- I focus on companies that regularly hike dividends, and have an established track record of doing so. This provides an extra layer protection that my dividend income will keep up with inflation over time.

- I make sure dividend payments are adequately covered for any new companies I buy, so that short term fluctuations in earnings per share do not leave dividends in danger. In addition, I make sure that dividend growth is not largely achieved by the expansion in the payout ratio.

- I also plan to retire when dividend income covers expenses by a nice margin of up to 1.30- 1.50 times expenses. I am placing the money that generates the excess dividends in tax-deferred accounts, so that they grow uninterrupted if I never use them. In addition, putting money in tax-deferred accounts further diversifies my asset base, and would shelter this portion of networth from taxes for several decades from now.

- I hold my stocks through several brokerages, in order to make sure I would always be under the SIPC covered amounts, and protect myself in case of broker failures

On a personal note, I also try to keep 3 – 6 months of expenses in my checking account. I do these funds just in case, even though I do not really need an emergency fund. I do not need an emergency fund, because I am disciplined about my spending. In addition, my dividend portfolio is an emergency fund of itself, since it would throw off enough cash to support me for 12 months. Currently, this figure is close to 7 months worth of expenses being covered by dividend income. Plus, I view my dividend portfolio as an emergency fund that has enough resources to pay for somewhere around 240 months’ worth of expenses.

In addition to that, I also have a line of credit equivalent to 2 years expenses I can draw on, in case my cash reserves are depleted. I honestly doubt that I would ever use the cash or line of credit for emergency purposes, but then you never know what the future holds for.

Next, I also expect that I will be able to collect some Social Security benefits in the future, when I become eligible for them. I strongly doubt that Social Security will ever be destroyed, although I wouldn’t be surprised if it gets modified in the future. I view Social Security income as similar to an investment in an inflation-protected annuity or inflation protected treasury bond.

The one weak spot in my retirement planning is the absolutely low amount of fixed income allocation I have. In order to withstand the next Great Depression or Japan of the past 20 years, I would need to have exposure to domestic government bonds. If we get deflation, this would jeopardize corporate profits and the ability to maintain dividend payments for a lot of companies. My allocation to fixed income is currently less than 1% today. I do not believe that the current environment offers good prospects for buyers of US Treasuries, which is why I have abstained from investing there. I simply do not want to invest my money in an asset whose principal and income are certain to lose purchasing power over time. However, I am monitoring the situation, and would gladly change my mind if attractive offers are present.

Relevant Articles:

Dividend Investing Is Not As Risky As It Is Portrayed
Dividends Offer an Instant Rebate on Your Purchase Price
How to define risk in dividend paying stocks?
Stress Testing Your Dividend Portfolio
Where are the original Dividend Aristocrats now?

7 comments:

  1. Fascinating stuff. I'm a new reader contemplating dividend income as a core part of my personal RRSP. It will never get to the level of what you describe due to starting far too late in life but could produce a nice crop of cash in the future. Thanx for sharing your thoughts!

    ReplyDelete
    Replies
    1. Anon,

      The best time to plant a tree was 20 years ago. The second best time is today.

      Good luck in your dividend investing journey!

      DGI

      Delete
  2. "I do not need an emergency fund, because I am disciplined about my spending" - Best line ever. The power to save is just as powerful of a tool as the skill to invest. Great article. Good luck with your goals of financial independence!

    Thanks, Sam

    ReplyDelete
    Replies
    1. Sam,

      Thank you for stopping by. Good luck in your dividend investing journey!

      DGI

      Delete
  3. Even at a total return of 7%/year, $1 million today will grow to $8 million over that time period

    It seems to me that 7% is much too much to expect, the population of the USA is not growing that much and world GDP is only growing at about 3%. I would like to get at least 3% + inflation and IMO anything better than 4% + inflation would be great.

    ReplyDelete
    Replies
    1. Hi Jim,

      Actually, 7% annual returns is pretty conservative for equities over a 30 year period. Historically, diversified portfolios have returned 10%year over a 30 - 40 year period. Between 1920 - 2005, earnings per share increased by 5.30%/year for Dow Jones, so did dividends per share. If you add in average dividend yield of 4.20%, you come up with almost 9.50%. A company can also increase EPS if it merely buys back stock. If you bought WFC at 12.50 times earnings ( earnings yield of 8%), and it pays a 3% yield, it can spend the remainder buying back stock, which could result in 4% decrease in shares and 4% EPS growth. That way, the bank can generate no growth in net income, but its remaining shareholders can generate returns of 7-8% per year on average, almost forever. Plus, over time the bank can generate efficiencies through use of technology, and because it learns how to do things with fewer resources. If you as an employee do something for several years, you learn how to be more efficient. Now translate this into an organization, which constantly looks for way to improve, and you can see how it can increase earnings. Of course, this assumes no growth in net income. Over time, income increases.

      We actually live in a world economy which is increasing, number of middle class people is increasing, people are living longer, people are living better. People in Eastern Europe, Asia, and Latin America are living much better today than they did 20 years ago. I think they would live much better in 20 years, have more disposable income, and bring a lot of growth. I believe the future is great for the long-term investor today, as long as they don't overpay for their investments.

      Good luck in your dividend investing journey!

      DGI

      Delete
  4. Quick question: When you're calculating your "retirement margin" (1.30- 1.50 times expenses), are you rolling in an estimated income tax into your annual expenses?

    ReplyDelete

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