Wednesday, March 6, 2024

Start investing with the end goal in mind

Planning your retirement is one of the most challenging exercises in the world. There are plenty of ways, methods and advisors, who try to influence your choice with formulas and narratives. Some of these methods may work, while others will fail most of the time. Everyone’s situation is different of course, which further complicates things. The investment path and environment will vary from individual to individual as well. For example, your experiences will be different if you started retirement in 2012, versus starting retirement in 2007 or 1929.

Some lucky investors have the benefit of pensions in addition to social security. This alone can be enough to quit your job, albeit in your late 50s or early 60s.

Others plan to rely on a combination of investments, and withdraw a portion for so many years. There are hundreds of articles, papers and opinions on the best way to live off investments. I have read a portion of them, but have decided to largely focus elsewhere.

For my retirement, I plan to live off the dividends generated from my equity portfolio.

Dividend payments are more stable than share prices and the potential for capital gains, which makes them an ideal source of income for retirement. Historically, US dividend growth has exceeded the rate of inflation. This means that dividend income not only maintains purchasing power, but increases it over time.

I go a step further by focusing on companies that can grow those dividends, have adequate dividend payout ratios and are available at attractive valuations. By assembling a portfolio of carefully selected dividend growth stocks, I can easily see how much income my retirement portfolio generates right from day one. When I compare my dividend income to my expenses, I know exactly where I am on my journey towards financial independence or retirement. This is the so called the divided crossover point.

Dividends also take into consideration current valuation available to investors today. A lot of retirees rely on historically backtested studies that show how they will not outlive their money by withdrawing 4% of their portfolios annually. Unfortunately, some of these studies are using data from historical periods that may not be directly comparable with todays situation. If the data was for periods where bond yields were above 4% and dividend yields were above 4%, it may make sense that withdrawing 4% from a portfolio was sustainable ( even when prices largely went nowhere, such as the period between 1965 and 1982). The question is whether it makes sense to withdraw 4% from a portfolio today, during a time when bond yields are closer to 2% and equity dividend yields are closer to 2% as well.

These studies attempt to make up the difference by hoping for quick annual gains in principle. Unfortunately, it is difficult to predict what share or bond prices will do in the short run when you need to sell. While the yields themselves will vary, the dividend payments will not. Relative to share prices, dividend payments look like an ocean of stability. They make retirement planning to be a breeze.

I have decided to focus on dividend income, since it is easier to predict. For example, I am reasonably certain that Johnson & Johnson will pay at least $3.60/share in annual dividend income over the next 12 months. Chances are high that this dividend king will continue growing the dividend at least once during the same time as well. However, I have no idea whether the stock price will go above $150/share or below $100/share. If you plan to sell shares to pay for retirement expenses, it makes a difference whether you sell at a high price or at a low price. Unfortunately, no one can predict share prices. On the other hand, predicting dividend incomes is much easier. This is why I focus on dividend income for my retirement planning, and ignore share price fluctuations. I think like a business owner.

Again, I focus on analyzing each individual business, in order to determine if it can safely pay and grow dividends per share over time. I also focus on underlying valuations, in order to lock in a set rate of dividend yield today. I also go a step further, by trying to build out a diversified portfolio consisting of as many companies as possible that meet my basic criteria. Besides diversification by sector, I also try to diversity over time, in order to build my positions in these companies more gradually.

The focus on dividend income makes the transition from earning a paycheck to retirement much easier. When you work, you receive a paycheck once or twice per month. When you create a dividend portfolio, you generate dividend income that replaces those paychecks. In effect, with dividemd investing you are creating your own paycheck to live off in retirement.

Compared to my paycheck however, dividend income is more reliable because it is generated from at  least 30 – 60 global businesses, and not a single client ( employer). My job is to diversify, build over time, buy at the right valuation and ensure that the underlying profit machine is humming along nicely. When you start with the end in mind, and you keep at it, you can track your progress until you reach your own dividend crossover point.

To put things in perspective, I believe that it is relatively easy to create a diversified portfolio today with a starting yield of roughly 3%. This portfolio will have adequate sector allocations, and could be built out over a period of several months to an year, in order to take advantage of dollar cost averaging and the variety of different opportunities available at different periods. If you place $1,000 in such a portfolio, it can easily generate $30 in annual dividend income today. If history is any guide, this dividend income will increase over time at or above the rate of inflation.

An investor who needs $30,000 in retirement income can get there by potentially investing $1,000,000. Few investors have this type of cash ready to be deployed however. The mindset of viewing income and expenses through the lens of dividend income investing however, can change you. The investor can see that if they only require $24,000 in annual retirement income, they need a nest egg with $800,000 today. However, if they need $36,000 to live off in retirement, they will need a nest egg worth $1,200,000.

For each extra dollar of extra expenses in retirement, our investor will have to save $33 extra dollars. These 33 extra dollars, invested at a 3% starting yield will generate one dollar in dividend income for ever. If you increase expenses by $10,000/year, prepare to come up with an extra $333,000. This can take quite a few years of hard work to accumulate.

Alternatively, if our investor manages to cut expenses, they can rest assured that for reducing each dollar in annual expenses, they need to save and invest $33 less. If you decrease expenses by $10,000/year, you can retire with a nest egg that is $333,000 less than originally expected. If you are the average person, the fact that you need to save a lower amount for retirement means that you can also retire earlier.

As I mentioned above, few investors have $1,000,000 to invest right from the start. However, if you choose to invest regularly over a set period of time, you can get there within a reasonable period of time. The inputs will vary from individual to individual of course, because different investors can invest different amounts every month. The conditions will vary as well.  For example, when I invested in 2008 - 2010, it was much easier to find quality companies yielding 4% than it is today.  However, if you keep investing regularly, keep reinvesting dividends, and manage to put money to work in a diversified portfolio of quality blue chip dividend payers, you may reach that goal in a reasonable amount of time.

For example, lets look at how long it would take you to reach $30,000 in annual dividend income if you invest $3,000 per month in dividend growth stocks. Let's assume an average yield of 3% and an average dividend growth of 6%/year. We will assume automatic reinvesting of dividends.

At this rate, it would take the investor roughly 14 years to reach their goals. This is not bad.
If money is tight, and our investor can only afford to put $2,000 to work each month, they can reach their goal within roughly 17.50 years. If the investor can put only $1,000 to work every month, they will be able to generate $30,000 in annual dividend income after 24 years. I used the spreadsheet in this article to calculate the different scenarios.

In this article, I showed that it pays to focus on the end goal in mind when investing for retirement. The first step involves coming up with a target monthly dividend income to pay for retirement expenses. The next step involves creating a dividend strategy that allows the investor to build a dividend portfolio that showers them with a growing stream of dividend income. Depending on current condition, investors can see how each dollar they invest generates a certain amount of dividend income. As a result, investors can see their progress towards the coveted dividend crossover point after every new investment they make, after every dividend increase and after every single action to reinvest dividends. By investing regularly, keeping investment costs low, and sticking to their strategy through thick or thin, our investors have a very high chance of hitting their retirement objectives.

Thank you for reading!

Relevant Articles:

Dividend Investing Resources I Use
Financial Independence Is Easier to Model with Dividends
- What drives future investment returns?
Generate a retirement paycheck with these dividend stocks

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