What are your investment goals?
My investment goals are very simple – to cover my expenses from dividend income generated from my portfolio. In order to translate goals into reality however, it is important to walk through, and think through the steps it would take to achieve them. Without more specific action plans, goals remain pipe dreams.
For example, I will need $1,000,000 to invest today, if I needed $30,000 in dividend income, and the average opportunity I could find yielded 3%.
Seth Klarman: Investing Is Art First, Craft Second And Science Third
Few people have $1 million in savings just laying around however.
If I broke down that savings goal into smaller and more manageable action steps however, this gargantuan task of achieving financial independence might not seem so impossible. In the case of investing for retirement, the important inputs within the control of the investor include the amount of money they can allocate each period, the amount of costs they incur. The other important inputs include time that this money needs to compound for through dividend reinvestment, the rates at which the capital is invested and reinvested.
1) If you think about it, if I managed to save $10,000/year, I will be able to generate something like $300 in forward annual dividend income. Just by saving $10,000 in the first year, I will have accomplished 1% of the goal. If I reinvest those $300 back, I will be able to generate $309 in dividend income in the next year. It is obvious that I would need to keep adding money, and reinvesting dividends for quite some time. At the level of inputs I have discussed above, it would take the investor 46 years of saving and reinvesting that dividend, before reaching their goals of earning $30,000 in annual dividend income. In order to reach the goal quicker, one needs to save more, and invest in companies that grow those dividends, rather than maintain them static. This is the reason why I don’t like relying on fixed income for retirement income – the income never grows, which doesn’t unleash the power of compounding to its fullest potential.
2) By doubling the investment amount to $20,000/year, the time to retirement is shortened to 30 years. It sounds like we are on to something.
3) If someone managed to keep saving $10,000/year in dividend growth stocks yielding 3%/year, and growing that distribution at 5%/year, it would take them approximately 27 years to reach their goal. This is approximately 20 years shorter than the example where dividends didn’t grow. If someone in the first scenario wanted to retire in 27 years using dividend stocks that never raised dividends, they would have had to save $23,000/year. This is more than twice as much as in the first situation. It also means the investor would have had to work twice as hard to earn that money, and endure greater sacrifices, merely because their capital was not invested in the most efficient way possible.
4) If someone managed to keep saving $20,000/year in dividend growth stocks yielding 3% and growing distributions at 5%/year, it would only take them 20 years to accomplish their goal. If someone in the second scenario wanted to retire in 27 years using dividend stocks that never raised dividends, they would have had to save $36,400/year. You can see that dividend growth is extremely valuable, and cuts down on the amount of savings needed to reach the goal.
The important lessons from this exercise are the following:
1) Save as much as you can each year. The more you save, the better your chances or accomplishing your goals
2) Always focus on companies that can grow earnings and dividends. That way, your capital is more efficiently invested. This means that your capital is working harder for you in accomplishing your goals. Otherwise, if you pick poorly selected investments, you will have to work twice as hard at earning more and spending less in order to save more. An investment that can provide both decent yield today, and the prospect for dividend growth is more valuable than the investment that provides simply current yield. The dividend growth investment provides protection against inflation, and results in less capital required to be invested.
3) The other important thing to consider is to keep investment expenses to the minimum. This includes commissions and taxes. This is where it is important to be patient and to reduce turnover to the minimum. It is also important to select good brokers who also have low commissions, and avoid paying recurring and high fees for mutual fund managers or investment advisers. It is also very important to keep tax expenses as low as possible. If you are going to spend 20 years accumulating dividend growth stocks, you want to legally avoid paying taxes on those dividends as much as possible. Otherwise, your time to reach your goal will be extended. This is why I have been increasingly maxing out 401K, IRA’s and HSA accounts, in an effort to keep more of the money I earn, and have it pay the least amount of taxes in the accumulation phase.
4) The fourth thing is to reinvest those dividends selectively. I say selectively rather than automatically, because selective reinvestment keeps the investor focused on entry price and valuation. If you focus on entry price, you are more likely to get a good entry yield for the growth you are paying for. Even a half a percentage point in started yield could do wonders to a dividend portfolio whose goal is to churn an ever increasing stream of dividends. Reinvesting dividends back into the same company without taking into consideration valuation factors does not seem to be helpful in the goal of living off dividend income in the most efficient and effective way.