Thursday, July 26, 2018

How to retire in 10 years with dividend stocks

The goal of every dividend investor is to generate a sufficient stream of passive dividend income, that would adequately cover their expenses. In order to achieve this goal however, investors need to select a strategy and fine-tune it over time to reflect current market conditions. In most of my articles I tend to focus on investing that would generate dividends for several decades to come. But how would someone who wants to retire in one decade afford to retire? Follow the guidelines in this article, and you might end up being one of the lucky ones who can afford to quit the rat race in a decade.

The first guideline is to contribute regularly to your dividend portfolio. This is important, because it allows our investor to dollar cost average their way over many years. This would provide them with the opportunity to build their portfolio brick by brick, without purchasing everything as a lump sum. Many articles on retirement focus on lump sum investing, which is not relevant to most future retirees.

The second guideline is to focus on dividend growth stocks, which are companies that regularly raise distributions. Since our dividend investor is likely to live off distributions for decades to come, they need to overcome the risk of inflation. As a result, they need to invest in stocks that can afford to regularly increase dividends, thus ensuring an inflation adjusted stream of income. Luckily, David Fish has the dividend champions list, which can be accessed from here. Investors can use this list as a starting point to identify dividend growth stocks, and apply their screening criteria.

The third guideline is to buy quality dividend stocks at attractive valuations. This is the step where the savings added to the brokerage account need to be invested. Investors should develop a set of standard screening criteria, in order to narrow down the list of dividend champions or achievers to a more manageable level. I typically look for companies yielding more than 2.50%, which have raised dividends for at least ten years in a row and trade at less than 20 times earnings. I then further avoid companies with high dividend payout ratios, depending on their industry and business form. After I do this, I research each stock in detail, in order to determine if it has what it takes to keep raising earnings and dividends over time. This is the most subjective part of the process. However, if you create a properly diversified portfolio of income stocks as outlined in the next step, you have a very good chance of success, even if you picked average companies.

The fourth rule is to focus on creating a diversified income portfolio, in order to reduce risk. In order to protect yourself, your goal is to have your income stream come from as many companies as possible. Leave the task of outperforming the market each year to the people who want to manage other people’s money or who are trying to sell you expensive newsletters. Your goal is to create an income stream that grows over time, which will support you in your retirement. As a result, in order to have a defensible income stream, you need to own at least 30 individual income stocks representative from as many industries as possible. Ideally, you would own three stocks from each of the ten sectors identified by Standard and Poor's, which comprise the S&P 500 index. In reality however, it might be difficult to achieve this strict diversification. However, since you are building your portfolio over a long period of time, you will likely be able to purchase quality stocks from different sectors, which would be priced right at different times over the next decade.

The fifth rule is to reinvest dividends selectively in these quality income stocks over the next decade. Until you reach your target dividend income, you need to use the power of dividend growth, new capital contributions and dividends received to plow back into your portfolio and turbocharge your dividend income. I typically avoid reinvesting dividends automatically. Instead, I wait for my dividends to accumulate, and then either add to an existing position, or initiate a new position in an attractively valued stock. While some might say I am missing out on compounding my income while waiting for my dividends to accumulate and buy a stock, I disagree. Re-investing dividends in an overvalued stock is a much worse offense than simply patiently accumulating cash in my book, and deploying it in the best values at the moment. This is another tool that will increase your odds of growing your dividend income stream faster.

Now that I outlined a list of few basic guidelines to follow, I will show how an individual can retire in ten years. Let’s assume that our individual manages to save $1,000/month for the next 120 months (10 years). The first month they only manage to save $1000. Let us also assume that our investor invests his or her hard earned money in dividend stocks yielding 4%, that grow distributions by 6%/year. Let's also assume that share prices grow by 6%/year as well (Such linear growth in share prices does not work in reality, but is only used for the model) If the distributions are paid monthly, and are reinvested back in stocks yielding 4% and growing distributions at 6%, our investor will generate approximately $659/month after 10 years. Now granted, they only saved $1000/month for ten years. However, if they saved $2,000/month instead, their dividend income will rise to $1,317/month in 10 years. If your dividend crossover point is around $1,300, then after ten years of meticulously saving and investing $2,000/month, you will be able to retire. The table below shows how investing $2,000/month in dividend paying stocks that yield 4% and grow dividends by 6%/year, can result in monthly incomes exceeding $1,300/month in 10 years, and $2,000/month in 13 years.

You can open the spreadsheet from a new location from here.

As you can see, the second column shows number of shares purchased with the $2000 savings every month, plus the amount of dividends received as well. After the first year, the $2000 buys less than 2000 shares, because the share price goes up in lockstep with the dividend growth.

This spreadsheet is a guideline on the forces that will help someone reach financial independence. Your dividend crossover point will be dependent the amount you can save, amounts you need, returns you can generate, and time to retirement. By carefully managing those variable, the retiree will be able to devise a proper plan that will help them accomplish their ultimate goals of attaining freedom over their time.

Relevant Articles:

What are your dividend investing goals?
Dividend Growth Stocks – The best kept secret on Wall Street
Dividend Growth Investing is a Perfect Strategy for Young Investors
Dividend Growth Strategy for Retirement Income