Wednesday, November 11, 2015

Entering Wealth Preservation Mode

In my previous article, I discussed the concept of the dividend snowball as it applies to my dividend portfolio and dividend income. The powerful concept of the dividend snowball means that a portfolio generating $15,000 in annual dividend income could easily double dividend income to $30,000/year in a decade or less. This calculation assumes that no new capital is allocated to that dividend machine, and dividends were reinvested. Just for the sake of reference, I achieved the first $15,000 in annual dividend income in a little over eight years of savings and investing.

Now that I am getting very close to the dividend crossover point, and financial independence, it is time to make sure my financial house is in order. As the amount of money at stake increases, my desire for risk starts decreasing. This is why I have been thinking lately about including layers of protection around my nest egg that will protect it from future downside. Wealth preservation is as important as building wealth in the first place. If you have won the game ( or will have won it by the end of the decade), it is important to stop playing so hard and to make sure the downside is protected from risks.

One thing I haven’t discussed before is the fact that I would be eligible for Social Security a little over three decades from now. If the laws are changed, I may end up eligible for Social Security a little less than four decades from now. Based on my earnings history, it would seem that Social Security could cover as much as half of my expenses in 30 years. If I keep earning money with a W2/1099 income, my social security income would likely increase.

Putting all of the above in perspective, I believe that I may end up with a lot of passive income in the future (if all goes well). This would include dividend income, social security income, and wage/consulting income along the road. This is why I am putting a lot of the capital that I believe will generate this excess dividend income in tax-deferred retirement accounts. I have already discussed before strategies for getting a deduction today, compounding the money tax-free and withdrawing without penalties and paying taxes. I won't discuss this today.

On the other hand, projecting the future is more art than science. While I like to show expectations in a linear form, I do realize that the future is largely unknown and unpredictable. This is why it is important to stress test assumptions and provide additional layers of support, that will help my dividend snowball.

I believe that success in investing is all about being aggressive in the accumulation phase. Once a critical mass is achieved, it would be helpful to also cover any downside. I operate under the assumption that the upside will take care of itself. My job as a capital allocator is to cover my portfolio against risks.

The important factors to protect me against risks include items such as Fixed Income, Housing, and Maintaining Health. It would also be helpful to continue working in some enjoyable capacity, that helps me grow as a person.

For the past five years, I have discussed how I always wanted to have exposure to fixed income. When I discuss fixed income I mean holding directly US Treasury Bonds or US Agency Bonds with varying maturities. I also include Certificates of Deposit (CDs) in my broad definition of fixed income. Having another asset class will provide more security to a long-term portfolio, since it would cover risks that an equity only portfolio cannot cover. This fixed income would provide protection in the event where we see another Great Depression. During the Great Depression, share prices fell by 90%, while dividends declined by 50% - 60% as well. The bond interest increased their purchasing power, due to deflation.

Unfortunately, I have not viewed fixed income as attractively priced over the past five years. Few others have viewed fixed income as attractively valued as well. It is interesting that very few view fixed income instruments as good values today. From a contrarian standpoint, it is possible that the majority is wrong. Either way, I am planning on using new cash to build a long-term CD/bond ladder. Basically, I am aiming to put approximately 3 – 4 years’ worth of expenses in a CD ladder. This translates into something like $54,000 to $96,000 in fixed income. I would do this by purchasing CD’s with 5 – 10 year maturities every single month for a few years. The goal is to have a CD worth about $1,000 maturing every month for about five years, starting out approximately five years from today. Because I believe that I will not use this money, I will likely reinvest the money into another CD at maturity date.

I could achieve this CD ladder by putting an equal amount of funds every month for a period of approximately 5 years. At the end of year 5, I would have my first CD mature, and I would be able to reinvest the amount if I didn't need it.

Alternatively, I could purchase CD's that mature in 5, 6, 7, 8, 9 and 10 years right from the get go. Many brokers offer Certificates of Deposit.  So I have decided to buy 5 year CD's today, but also longer-dated ones to build that ladder faster. I started this exercise a couple of weeks ago, and so far I have a CD maturing every year between 2020 and 2025. The next step is to ensure I have a CD maturing once every six months/twice per year in every year between 2020 and 2025. By the time this ladder is set up in 2018 - 2019 or so, I will have a CD that will mature in each month between 2020 to 2025 ( plus or minus a few months since I am starting late in the year in 2015). A large portion of those CD's will be set up to auto-renew, though a decent portion will also be allocated manually upon expiration. I do not expect this exercise to take more than 10 minutes per month. Those CD's will be set in taxable accounts.

The other important area I need to focus more is my health. I spend too much time in front of a computer. This is bad for the body. I will be working more on exercising. By exercising I mean incorporating exercise into my daily life. This includes always taking the stairs, taking breaks to do brisk walking etc. It also means eating healthy. I have one body that I need to keep working well for several decades into the future. Just like with compounding capital, the habits I form today will bear fruit decades from now. If I eat junk food, I will suffer health problems down the road. However, if I exercise regularly and eat nutritious food, I stand a better chance of maintaining a healthy lifestyle in old age. I break this problem as a capital allocation problem – if I can maintain my health, I will probably spend less on healthcare 30 – 40 years down the road.

Do you have an allocation to fixed income? What percentage of your portfolio is in fixed income?

Thank you for reading.

Relevant Articles:

Margin of Safety in Financial Independence
Stress Testing Your Dividend Portfolio
Does Fixed Income Allocation Make Sense for Dividend investors today?
How to stay motivated on your road to financial independence
My Dividend Goals for 2015 and after

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