Wednesday, December 30, 2015

Should Dividend Growth Investors Dip into Principal?

One of the most popular questions I get asked is whether investors should ever dip into principal. The short answer is almost always:


Anytime someone asks me whether they should ever dip into principal, I ask them the following question back:

"Do you know how long you will live after you retire?"

You are gambling if you want to dip into principal, because you are dealing with large unknowns such as returns over a certain period of time, longevity, inflation etc. If your projections turn out to be wrong, and you turn out to be living off your capital during a time when it is not growing, you are asking for trouble because your risk of running out of assets increases. Instead, I plan to live simply off the income my portfolio generates.

My goal is to get income that increases above the rate of inflation, and to then spend it as I please. Anything left over is reinvested back or put into cash for an emergency fund or debt reduction (if I ever have debt). Annual rates of dividend growth could fluctuate, and you might go from high growth for a few years, followed by a steep decrease of cuts due to a recession. Reinvesting excess dividends back provides flexibility and breathing room in case projections do not turn out as expected. I know everyone’s situation is different, which is why I am mostly discussing why I do not want to eat into principal.

Eating into principle results in reduction in income generating capacity. It is akin to cutting the tree brand you are sitting on, or selling the tree, rather than harvesting the fruit.

You are reducing your flexibility when you dip into principal. At that point, you are relying on the fickle nature of stock market fluctuations. It could work for you if stock prices keep going up. However, since stock prices rarely go up in a straight line fashion, chances are you would end up selling shares in a great company at low valuations. Twenty or thirty years from now, those companies would be worth several times the amount you sold them for on aggregate. To me, that is not an intelligent way to manage my investments.

The bigger problem of course is that you may enter a phase where stock prices are flat or low for extended periods of time. Examples include 1966-1982 and 2000 – 2012. When stock prices are flat or low and you sell 3 – 4% of your holdings each year, you are essentially shooting yourself in the foot. After 10 years you would have taken out 30 – 40% of your portfolio. I would hate to be 75 and see that I have only a decade or so of retirement money left over. This would be a slow psychological death.

The average retirement is about 30 years. For a very lucky portion of you, the retirement might last as much as 40 – 50 years. You do not know what inflation will be over the next 20 – 30 years. You also do not know what interest rates, stock market returns or the world will look like in 20 – 30 years. However, you would like to be retired throughout each period. This is why I only take into consideration the income that is generated from my dividend portfolio. Based on history, I expect that dividend income from a diversified portfolio of US stocks will grow above the rate of inflation over time. I also expect that the amount and timing of that dividend income is relatively predictable. For example, I believe that there is a 99% chance that Johnson & Johnson (JNJ) will pay at least $3/share in annual dividend income in 2016, which will be paid in four installments throughout the year. However, I have no idea what Johnson & Johnson's stock price will be. As you can see, dividend payments are more stable and more reliable than capital gains. This is why astute retirees focus on divided income in retirement - it is that much easier to live off a dividend portfolio.

Retired investors need a return on investment that is always positive, paid in cash, and grows above rate of inflation over time. They want to be relatively certain about the amount and timing of receiving this cash. This is similar to the time when you were working and received a paycheck twice per month or every two weeks. With dividend paying stocks I have companies that pay me once per quarter, every single quarter. For example Johnson & Johnson (JNJ) pays every March, June, September and December. Other companies have different quarterly payout schedules - when I combine them I end up with a dividend check almost every other day. If you are drowning in cash, your financial position is that much more flexible and easier to forecast and rely upon. As an investor, I need to eat every day, not just on days when Dow Jones or the S&P 500 is up, or only in years when the market went up.

I view capital gains as gravy, which will maintain purchasing power of my principal and will result in step up basis for my inheritors (relatives, charities etc). By spending only income, I am maintaining some flexibility in my finances. By liquidating principal, I am making a gamble that could turn very costly if I live too long, my investments stay flat, or inflation is higher than anticipated. If you think that staying behind the store counter at age of 65 is difficult, try doing that at age 80 or 85. Your goal is to stay retired, not to make gambles with the retirement nest egg you worked so hard to accumulate.

The closer I get to my target financial independence date, the more conservative I get in my estimates. My dividend portfolio would have to withstand quite a lot of risks in the next 30 – 40 years, while still providing me with a rising stream of income to pay for my lifestyle. I would go through several recessions, speculative booms, at least a couple deflationary cycles, technological or other obsolescence of certain products my companies sell, corporate failures, wars and even potentially nationalizations. I could also experience fluctuating rates in dividend growth or even flat dividend income for a few years, while inflation is ravaging. The reality is that the future is largely unknown, and could only be estimated based on information I have today. I am pretty sure that the investor in Russian stocks from 1912 could not have expected that within 5 years their stocks would be worthless. However, if they owned US, or British stocks, they would have been better off.

Do you expect to ever dip into principal?

Thank you for reading!

Full Disclosure: Long JNJ

Relevant Articles:

Why dividend investors should never touch principal
Are you drowning in cash?
Dividend income is more stable than capital gains
Why Stock Charts Are Misleading for Dividend Investors?
Dividends versus Homemade Dividends

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