I am a dividend growth investor because my research has uncovered that dividend growth stocks perform very well over time. I purchase stocks in solid companies which pay dividends, and regularly increase them each year. This is the strategy I am using to live off dividends in retirement. My research shows that a portfolio of carefully selected dividend stocks will provide a sufficient income stream for me to live on without having to touch principal. The fact the companies I purchase also grow earnings to pay growing distributions each year means that over time stock prices would go higher, thus providing some protection to my capital from inflation.
My neighbor is not a dividend investor. My neighbor purchases index funds and hopes to rely on an asset depletion strategy commonly referred to as the 4 percent rule. You can read more about the original research about it here. Basically, my neighbor is relying on total returns from index funds to fund retirement.
Historically, stocks have produced an annual return of 9% to 10% per year. If one owns $1 million worth of an S&P 500 index fund, their return would be approximately $90,000 to $100,000 per year. Thus, selling $40,000 worth of stock each year would lead to a portfolio value of $1.05 to $1.06 million by the end of the first year.
This was a good strategy for generations of do-it-yourself index investors. Accumulate as much in index funds as possible, then sell off 4% of your initial portfolio value each year, while also adjusting for inflation. The one problem this strategy creates is that it leads to a rapid depletion of the asset base during extended bear market declines or during flat markets. Stocks do not go up or down in a straight fashion each and every year. Investors who retired in the early 2000s and 2007-09 saw this firsthand.
In fact, investors who put $1 million in an S&P 500 mutual fund in 1999 and used the 4 percent rule for withdrawals now have only $360,000 left.
The calculations assume a 3% annual inflation rate and a quarterly distribution. In addition, investors would have sold more than half of the shares they originally owned by August 2011. Given the expected withdrawal of $55,369 in 2011, the portfolio would be depleted in 6.5 years if stocks do not appreciate by 2020.
I have always had an issue with index funds. They are a decent vehicle for accumulating wealth, as they provide ordinary savers with the ability to have exposure to the stock market without understanding much about it. However, the traditional methods of selling off portions of your portfolio each and every year is similar to cutting off the tree branch you are sitting on.
That’s why the idea of creating a dividend portfolio makes perfect sense for investors who are retired and even those who plan to retire some day in the future. Using this strategy, investors only spend the dividend income generated by their investments. Dividend income is more stable in comparison to relying exclusively on price appreciation. If you compare the price returns of my benchmark the S&P 500 index to the dividend returns, you would see why retirees prefer the stability of dividends in retirement.
Dividend investors should carefully select stocks with solid fundamentals that could afford to grow distributions for years to come. They should also have a set of written rules, which would help them in evaluating stocks. You could read more about my entry criteria in this article. Investors also should try to create a diversified portfolio to minimize sector risks on their dividend income.
There are approximately 300 dividend growth stocks in the world. After further screening, the enterprising dividend growth investor would likely find a more manageable list of 40 to 50 securities which could be accumulated at the right prices.
By relying exclusively on spending only the rising income stream, investors would avoid depleting their asset base by selling off shares every year. As a result, dividend investors would not have to sell in a depressed market to pay for their living expenses and risk depleting their assets.
Next: 10 Dividend Stocks Offering a Stable Stream of Income