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

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