Thursday, October 26, 2017

How to Convert a portfolio of index funds to dividend stocks?

In a previous article, I discussed various ways that investors can accumulate their nest egg. One strategy includes putting a portion in one or a few attractively valued dividend growth stocks every single month, and reinvesting dividends selectively. The other strategy involved investing in index funds, using tax advantaged accounts such as 401 (k) for example.

Traditional vehicles for saving such as index funds and target-date funds work well when you accumulate your nest egg, but could present a challenge if you try to live off them. Many retirees prefer to have a stable and growing source of income, which maintains purchasing power over time, and is not dependent on the manic-depressive swings in stock prices. Therefore, investing in dividend growth stocks is the ideal way to generate income from your nest egg in retirement, due to the stability of dividend income. Therefore, if someone were to accumulate their nest egg in other items such as index funds, but wanted to convert to dividend investing, there are two ways that they can achieve that.

The strategies outlined in this article also work for situations where you have a lump sum amount, and you are thinking of investing it.

The first strategy involves selling all funds in your portfolio, and using the proceeds immediately to create a diversified portfolio of quality dividend paying stocks.

This strategy is quick and easy to achieve, as it involves just a few steps. If you want to make the conversion all at once, and not have to worry about how to invest the amounts for months, this is likely the best deal for you. If you could find 20 – 30 quality dividend paying companies, which are also attractively valued, and your money is spread in several sectors, you could be done with this exercise in one day. After that the only thing to worry about would be to monitor the investments, decide what to do with dividend income, and enjoy life.

Back in early 2013, I converted an old 401 (k) into an IRA, and as a result was able to purchase shares in twenty dividend paying companies. It was somewhat challenging to find twenty dividend growth companies all at once that could be considered quality and attractively valued. Depending on the overall stock market environment, it could be very easy to find plenty of value opportunities or it could be very difficult. Between late 2008 and late 2011, it was relatively easy to find plenty of opportunities, and build a diversified portfolio with them. Starting in early 2013, it has gotten pretty tough to do so, especially if you want to avoid concentrating all your bets on several companies in a few sectors like energy for example.

The second strategy involves selling a portion of your funds every month for a period of at least 12 – 24 months, and then using the proceeds to acquire shares of attractively valued dividend paying stocks.

In my experience building dividend portfolios, it is much easier to build a diversified dividend portfolio slowly over time, rather than all at once. This is because different companies from different sectors of the economy are attractively valued at different times. For example, Walgreens (WBA) met my entry criteria between 2011 and early 2013. The stock wasn’t attractively priced again until a brief period in July - August 2013. Since then, it has been slightly overpriced. Until recently.

In addition, if you buy a portfolio over time, you also want to avoid the pressure of finding 20- 30 attractively valued securities at the same time. If you get into the mentality of have to put my money in these stocks regardless of availability of quality companies at a fair price, you might be taking on a large risk to your portfolio. With the slow selling of index funds and replacing with dividend stocks, you stand a better chance of getting exposure to different sectors when they are undervalued, and thus having a higher opportunity for exposure to more quality companies to buy.

This strategy is also ideal if you want to convert your taxable 401 (k) into a tax-free Roth IRA. If you convert the whole 401 (k) into a Roth IRA in a single year, all of the amount in the 401 (k) would be considered taxable income, and would likely push your marginal tax rate to the highest levels. However, by slowly converting your 401 (k) into a Roth IRA over a period of a few years, you can make sure to avoid triggering higher taxable income brackets, which would mean paying less taxes on the conversion.

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