Help with approach to retirement funding - SWR, dividend vs bogleheads investing

[savingtofreedom]

I have been hard at work trying to finalize a doable budget, cutting expenses, and using cash to funds more investments and moving some high ER investments to Vanguard.  During this process I have read all kinds of helpful information on the internet and I am at a point of analysis paralysis.  There are a multitude of different approaches to fund your retirement and the two that appeal to me the most are the following:

 1) Bogleheads style - 3 fund approach - total stock market index, international index, bonds - right now I am in different iteration of mostly the US stock market - need to buy some more international and was kind of waiting on bonds because of all of the hoopla I hear about the upcoming bond blowup (which may be total BS - I don't really know any better)

  2) Dividend friendly stocks (have been reading Joshua Kennon's blog) and logically if you pick winners this sounds great - if you pick losers - sucks for you

I will likely do a mix of those above.  Here are some questions I still don't have a good grasp on.

Let's say that my goal portfolio is 1,000,000.   In order to take between a 3 or 4% SWR can I do this without harming principal?   My thought was this is only possible via living off dividends which I makes me find option 2 more appealing.  If I use option 1 - I have to sell some of my assets.  Is the thought that my portfolio will return value greater than the 3 or 4% SWR??  I am sure that will happen some years but some years it will not. 

I would very much appreciate it if someone could explain this further.  Links to related articles or discussions would also be appreciated.

Thanks!!

[Another Reader]

First, Mr. Kennon suggests investing in index funds for the average investor that does not have the time or inclination to understand the businesses behind the stocks they buy.  He states this on numerous occasions throughout the blog.  He also describes stocks he invests in and why he thinks they are good businesses.  He often uses these stocks to demonstrate the power of compound growth.

Second, his idea of the withdrawal rate on a large dividend portfolio are the dividends, which amount to about 2.5 percent IIRC.

Third, FIREcalc and the various Monte Carlo simulations assume drawdown (decumulation) is acceptable.  The simulations ask the question, will the portfolio run out of money over the periods used?   In some simulations, you will end up with more, some less, and some may fail within the 30 year window, depending on your rate assumption.  Going in, you do not know if you will draw down.

For the perspective of an individual building a dividend portfolio, try www.dividendgrowthinvestor.com.

In my opinion, building a large enough portfolio to withdraw from at a decent SWR without risking decumulation requires a very long investment horizon even at a high savings rate, the ability to build high-yielding businesses (Mr. Kennon's approach), or leveraging through real estate.  I'm a conservative person, YMMV.

[kyleaaa]

There is no logical difference between taking dividends as cash and selling off shares to fund living expenses. One FEELS better than the other, but it isn't. If you didn't spend those dividends, what would you do with them? You'd reinvest them. Traditionally, selling shares has been more tax-efficient than taking dividends, so that approach has been the most often recommended one but now with dividend and capital gains rates being the same, it doesn't much matter.

Dividend investing is just a value tilting strategy, nothing more. And it isn't a particularly efficient one. The total return approach is technically more efficient but, on the other hand, many people just FEEL better only spending cash flow. So that's a consideration. Research has shown that nobody can consistently pick the "good" stocks, by the way. Not even Joshua Kennon. Whether or not you end up on the winning or losing side is essentially a coin toss.

Most research backs the three-fund approach.

[savingtofreedom]

Another Reader - thanks for the info and blog recommendations.  My husband may be working longer than me which could help us out in terms of increasing the portfolio value. 

Klyleaa - can you explain this further with numeric examples - I think this is where I may be getting confused.  If the market tanks and your portfolio loses 40% of its value, the dividends may (obviously this can change based economic conditions) still pay out on a per share basis - correct?  So I could still get the same income in a downturn from a dividend portfolio versus a 3-fund approach where my SWR would end up being much higher in a downturn. 

Obviously with the dividend approach - picking winners is very difficult and not likely possible - I fully get that.  I still want to make sure I understand the differences in the approaches. 

[kyleaaa]

Klyleaa - can you explain this further with numeric examples - I think this is where I may be getting confused.  If the market tanks and your portfolio loses 40% of its value, the dividends may (obviously this can change based economic conditions) still pay out on a per share basis - correct?  So I could still get the same income in a downturn from a dividend portfolio versus a 3-fund approach where my SWR would end up being much higher in a downturn. 

Obviously with the dividend approach - picking winners is very difficult and not likely possible - I fully get that.  I still want to make sure I understand the differences in the approaches.

Well, dividends fell steeply during the financial crisis and to my knowledge still haven't recovered fully, so you're kidding yourself if you think only spending the dividends will provide a steady income stream.

Suppose you own shares in a company. At the end of the year, the company can either distribute a dividend to you, the shareholder, or they can reinvest the money back into the company in order to grow even more next year. As the owner, you would prefer the company NOT distribute any dividends to you due to tax reasons UNLESS you needed 100% of the dividends to pay living expenses. If that were the case, you should theoretically have no preference. You can either take the money as a dividend or you can sell off a few shares to generate the same amount of money. You don't care because you get the same amount of income and the company has the same amount of retained capital either way. If the stock market drops by 40% and those companies still pay a dividend, you have the exact same amount of capital invested in those companies as if they paid no dividend and you just sold off shares. It's like having a single $10 bill versus 10 $1 bills. It makes no difference.

Put another way, if your dividend portfolio is yielding 4% and you spend ONLY what you receive in dividends, it's logically equivalent to selling 4% of your shares every year in a portfolio that pays no dividends. It may feel different, but the probability of you running out of money is exactly the same in both scenarios.

[Another Reader]

Dividends from some companies, especially banks and other financial companies, fell precipitously or were eliminated in 2008-09.  Most blue chip companies other than financials did not reduce dividends significantly.  I suggest you look at the payout history of the stocks mentioned in Mr. Kennon's blog and on Dividend Growth Investor.  Dividends are generally based on the business income, not the stock price. 

[savingtofreedom]

Kyleaaa - thanks for the explanation.  Based on your feedback and my minimal level of ability in this manner - the Boglehead approach seems like the way to go for now.  As you mentioned the tax implications of a dividend only approach would be not ideal in a taxable account. 

Another Reader - To your point - more research is in order.

[Mr Mark]

At the early stages of the journey, don't worry about it. Simple vanguard index funds, say even just 1 balanced fund  to start with, and keep saving.

The trick is not really in the Investing. It's first in getting that saving rate up. Worry about SWR etc once you're at a few 100k...

[savingtofreedom]

Mr. Mark - we are at more than 100K - that is the issue.  Our savings rate is probably going to be 60%.  We were frugal before but wasted more money. I would like to set myself up for my own retirement in 7 years or less.  I am hoping husband will work for another 15 or so years - he is ok with that plan as long as he is working for the same company.

[Alex in Virginia]

There is no logical difference between taking dividends as cash and selling off shares to fund living expenses. One FEELS better than the other, but it isn't.

As a strict dividend yield investor, I couldn't disagree with you more about there being no actual real difference between taking dividends and selling off shares.  It's exactly like saying that there's no difference between harvesting eggs from your chickens and killing the chickens.  Or between milking your cows or butchering them.  Or that there's no difference between eating your ear corn or your seed corn.

If you take and spend the dividends, you STILL have the stock shares to give you more dividends quarter after quarter.  If you sell the shares, you've got a big fat nothing left afterwards.

And, it often happens that a stock's price may be below where you bought it even though the company is still cranking out the same dividend as before.  You take the dividend, you're being paid to wait for the price to go back up.  You sell the shares, you just locked in a loss.  Brilliant...NOT.

Well, dividends fell steeply during the financial crisis and to my knowledge still haven't recovered fully, so you're kidding yourself if you think only spending the dividends will provide a steady income stream.

No, no, no.  Dividends from financial companies fell, but not those from other companies.  As usual in a panic, ALL stock prices fell, which allowed me to grab humongous dividend yields from all those companies that had not and would not lower their dividends.  And, yes, I get a very nice steady income stream from my dividends -- a stream that just keeps increasing, even when a company here or there out of the 25-30 I hold hits a bad bump along the road.

If you didn't spend those dividends, what would you do with them? You'd reinvest them.

And so???  If you don't need to spend the money on living expenses, and you reinvest those dividends, then guess what?  You end up with MORE shares, which will yield you even more dividends.  Virtuous, virtuous compounding of returns!  Your little green employees making more little green employees that then make more little green employees, etc, etc, etc.

Dividends make that possible.  It's not imaginary.  It's not just a feel-good thing.

Alex in Virginia

[savingtofreedom]

Thanks Alex in Virginia.

This is why I am confused - is there a study that illustrates your perspective and my initial basic understanding of dividend investing essentially that if I retain dividends stocks through a downturn I may still get a some amount of dividends per share (with the understanding that some may stop due to financial issues).  That does sound like a potentially better deal then having to sell.

When I look at the graphs that illustrate the drops in the S&P 500 I can't help but think that this will happen many more times over my lifetime - which i fine as I plan to hold for the longterm.  But due to luck I could get screwed when those drops happen and they could be pretty damaging to my retirement savings and SWR rate.  Today I am primarily in index funds that mirror the S&P 500.  As I look to allocate more cash to additional investments I was considering performing heavy research into how to value stocks to purchase as dividend producing assets.  But I wanted to make sure that was a worthwhile effort.  The index investing is pretty easy conceptually.

Now I totally understand that picking dividend producing stocks that are here for the long term is a completely different challenge.

If I was of a different temperament and had a more DIY husband I would probably invest in Real Estate.

[brewer12345]

There is no difference between returns from dividends or capital appreciation: they both spend the same.

OP, go play with firecalc and look at the path of returns that would have happened historically.  Firecalc assumes you just withdraw whatever amount you specify and does not make a distinction between interest, dividends and cap gains.  Some years are down years and firecalc in the base version assumes you still take your specified amount.  What the tool helps show is how your portfolio would have done during different periods in history.  It shows basically that about 4% inflation adjusted every year is good for 30+ years without running out of money.  There are refinements and assumptions you can tweak, and the future could be worse than any time in prior history, but as a side-of-the-barn target, 4% a year is a good idea of what you can draw.

[kyleaaa]

As a strict dividend yield investor, I couldn't disagree with you more about there being no actual real difference between taking dividends and selling off shares.  It's exactly like saying that there's no difference between harvesting eggs from your chickens and killing the chickens.  Or between milking your cows or butchering them.  Or that there's no difference between eating your ear corn or your seed corn.

If you take and spend the dividends, you STILL have the stock shares to give you more dividends quarter after quarter.  If you sell the shares, you've got a big fat nothing left afterwards.

This is analogy I hear a lot and it's completely illogical. Your wealth still compounds at the same rate in your scenario whether you take the dividends in cash or receive no dividends and sell off an equivalent amount of shares. It's not at all like killing a chicken or cow. Your ending wealth is the same regardless of which you choose. The only difference is that when you invest in high-yielding stocks, you give up tax flexibility. The difference isn't as pronounced now that the tax rates on capital gains and dividends have been the same over the last decade but if you do the math, I assure you it works out to be exactly equivalent pre-tax.

Study after study after study after study on dividend investing has shown it to be sub-optimal. It's just an inefficient and inconsistent form of value tilting. In effect, what you're doing is lowering your SWR to the amount of your yield. That's fine, except you could do that just as easily, pay less taxes, and likely end up with more money in the end using a total return approach.

[Alex in Virginia]

There is no difference between returns from dividends or capital appreciation: they both spend the same.

It's not that, Brewer.  It's what you are left with after you've spent the returns. 

You put $10,000 into 1000 shares of a stock that goes up 4%, so now it's worth $10,400 and you take your 4% ($400) by selling 38 shares +/- at $104. Great. So, afterwards, what you have left is 962 shares that could just as easily give back that 4% bump-up as keep going up. (And what if the price of that stock had NOT gone up during the year?  There would be NO return to collect.)

You put that same $10,000 into 1000 shares of another stock that pays a 4% annual dividend.  Let's just say the price of that stock goes down 4%.  It makes no difference to the dividend.  You get $400 in dividends anyway.  Afterwards, you still have the 1000 shares of stock.  And whether Mr. Market takes the price of that stock up or down, you're still in line to collect another $400 in dividends the following year.

I know, I know, we could just keep going round and round on this.  And it won't do any good.  Total return people and dividend yield people just have to agree to disagree because there's something we each see very very differently and something in the other fellow's understanding that we don't see at all.

Cheers!

Alex in Virginia

[arebelspy]

The fact of the matter is though Alex, the math just doesn't work as you claim.  Total return and dividend end up the same. 

To anyone wondering about this: do the research yourself.  There's lots of articles out there, and they basically show that the company that pays the dividend will grow less, such that you can sell the one that didn't pay the dividend to earn that same amount of money and still have the same amount of shares you would with the dividend stock.

I actually personally think it ends up a little better for total return, personally, due to dividend yields being driven down due to popularity over the past few years and search for yield, but that's just a guess, and I wouldn't invest based on that.

The power of dividends comes from reinvesting in down markets - if you have other ways to invest more or rebalance, it's moot.

[the fixer]

To the OP:

I withhold judgment of the various people on this forum who espouse different investing strategies. There are lots of ways to make money, but it can be hard to compare one with another. It certainly does get confusing trying to evaluate dividend growth investing, real estate, lending club, stock picking, etc. especially when you're conflicted between seeing individuals claiming great returns versus studies showing average returns don't do that well for the strategy compared to just holding a diversified portfolio of index funds.

The way I deal with all of it is this: before I get heavily involved in any of these, I ask myself if I think I understand the approach better than the average person participating in it:

• Can I pick stocks better than the average Wall St analyst?
• Can I time the dividend market better than the average investor?
• Can I evaluate personal loan criteria and protect myself from taxes better than the average Lending Club investor?

I don't think I can do any of these things, so it's very likely I'll be one of those suckers who does poorly. Then I forget about the idea and just stick with my index funds. It's a plan that works, with minimal risk and effort for the level of return I'm getting.

Over our lifetimes we will continue to get bombarded by people claiming to have great new ways for us to invest our money, so being able to evaluate it and filter out at least 90% of the ideas we're presented with is critical for us to keep making money and not get led astray.

[Nords]

I know, I know, we could just keep going round and round on this.  And it won't do any good.  Total return people and dividend yield people just have to agree to disagree because there's something we each see very very differently and something in the other fellow's understanding that we don't see at all.

You would think that the math works the same for both groups of people.

This perpetual debate is familiar to all Berkshire Hathaway shareholders.  Buffett devotes two pages of the 2012 annual report to it, starting on page 21 of the PDF (page 19 of the paper report) and concluding two pages later.  Let me excerpt the conclusion:

Let me end this math exercise – and I can hear you cheering as I put away the dentist drill – by using my own case to illustrate how a shareholder’s regular disposals of shares can be accompanied by an increased investment in his or her business.
For the last seven years, I have annually given away about 4 1⁄4% of my Berkshire shares. Through this process, my original position of 712,497,000 B-equivalent shares (split-adjusted) has decreased to 528,525,623 shares. Clearly my ownership percentage of the company has significantly decreased.  Yet my investment in the business has actually increased: The book value of my current interest in Berkshire considerably exceeds the book value attributable to my holdings of seven years ago. (The actual figures are $28.2 billion for 2005 and $40.2 billion for 2012.) In other words, I now have far more money working for me at Berkshire even though my ownership of the company has materially decreased. It’s also true that my share of both Berkshire’s intrinsic business value and the company’s normal earning power is far greater than it was in 2005.
Over time, I expect this accretion of value to continue – albeit in a decidedly irregular fashion – even as I now annually give away more than 4 1⁄2% of my shares (the increase having occurred because I’ve recently doubled my lifetime pledges to certain foundations).

I think an implicit assumption in Buffett's process is that you should buy stock in companies that don't suck.  If the share price continues to drop then you might prefer to have the dividends instead, but I doubt you'd ever get your principal back. 

By the way, Early-Retirement.org tracked several diehard dividend investors through the 2008-09 recession.  (I should clarify that it was probably the successful dividend investors, because at least one unsuccessful investor just sorta stopped posting until well after the recovery was in progress.)  The diversified dividend investors saw their income drop by about 10%, and it quickly recovered in 2009-10.  The Dividend Growth Investor blogger also survived just fine even though he was picking individual stocks.

Personally I was buying the DVY ETF with both hands in 2008-09 and ended up with a 5.9% yield on purchase.  The counter-argument to that number was that the yield was based on trailing earnings, and at that point in the recession people were estimating future earnings to be somewhere between "zero" and "apocalypse".

[savingtofreedom]

The fixer - I hear what you are saying and agree that logically 3 fund boglehead approach makes the most sense.

I have some cash in my new Vanguard account that right now I am sitting on waiting to see what happens to this:



VTSAX -  is at an all time high.  I can just wait and see it if drops a little bit each month and put some more money there.  I am worried I am buying high but I know that I cannot time the market.  It will probably drop at some point - who knows how long that might be and how far it will drop.

That's why I found the dividend investing slightly more appealing as there may be a handful of stocks that may be priced lower for some reason or other - again buying one that is worth buying for the long haul would be totally luck at this point.

Hi Nords - I am not sure I totally get what you are saying in your post.  Can you elaborate further please.

[kyleaaa]

VTSAX -  is at an all time high.  I can just wait and see it if drops a little bit each month and put some more money there.  I am worried I am buying high but I know that I cannot time the market.  It will probably drop at some point - who knows how long that might be and how far it will drop.

How did you calculate the probability of the market dropping at some point? I think people irrationally anchor to "record highs" as if they tell you anything at all about the future. By definition in a random walk, they don't.

[jamccain]

While you can't tell if a market is really "high" or not by looking at the DOW averages you can get a picture for when a market if OVERVALUED by looking at P/E.  By determining if a market is under, over, or properly valued you can determine if investing is likely to return a high, middling, or low return.   

For example, if a market is considered overvalued you should expect a low return if initially investing in this market.  If a market is undervalued you should expect a higher return. 

So, what is overvalued?  A P/E in the mid-20's is overvalued in that it cannot mathematically trend much higher outside of a bubble.  The market, as of today, is approaching a P/E in the mid-20's.  Ideally, you want a P/E below ten, but that only happens every few decades.  The 2008 crisis brought the P/E to the low teens. 

Personally, I have sold off, due to drawing the conclusion the current market is overvalued based on P/E, and am waiting for the market to return to a more favorable P/E in the low to mid-teen's...which will likely happen when the Fed starts to raise rates...whenever that is. 

Most people would bash such a strategy as trying to time the market...this isn't timing the market. 

"Bad investors think of ways to make money.  Good investors think of ways to not lose money.  Those 17 words are the most important words an investor can know" - Steven Sears

[Mr Mark]

While you can't tell if a market is really "high" or not by looking at the DOW averages you can get a picture for when a market if OVERVALUED by looking at P/E.  By determining if a market is under, over, or properly valued you can determine if investing is likely to return a high, middling, or low return.   

For example, if a market is considered overvalued you should expect a low return if initially investing in this market.  If a market is undervalued you should expect a higher return. 

So, what is overvalued?  A P/E in the mid-20's is overvalued in that it cannot mathematically trend much higher outside of a bubble.  The market, as of today, is approaching a P/E in the mid-20's.  Ideally, you want a P/E below ten, but that only happens every few decades.  The 2008 crisis brought the P/E to the low teens. 

Personally, I have sold off, due to drawing the conclusion the current market is overvalued based on P/E, and am waiting for the market to return to a more favorable P/E in the low to mid-teen's...which will likely happen when the Fed starts to raise rates...whenever that is. 

Most people would bash such a strategy as trying to time the market...this isn't timing the market. 

"Bad investors think of ways to make money.  Good investors think of ways to not lose money.  Those 17 words are the most important words an investor can know" - Steven Sears

I say good luck with that. And yes it is market timing.

You're referring to the shiller pe, which is very backwards looking. Better to look at sp500 earnings per share or actual PE ratio...   IMHO   

Anyhoooo, I am not all in cash timing the market. I like global growth and the dividends it produces.

If you are super keen, perhaps look at a time when the market drops below say, a 30 day moving average or something. But you may miss out on further gains ( ie the next big dip may still be above current prices) and you will miss out on dividends while you wait.

I still would advise regular investments in balanced low fee funds, and if you have a lump sum, feed it in over a coupleof weeks however you want.

The sky is not falling.

[Nords]

That's why I found the dividend investing slightly more appealing as there may be a handful of stocks that may be priced lower for some reason or other - again buying one that is worth buying for the long haul would be totally luck at this point.
Hi Nords - I am not sure I totally get what you are saying in your post.  Can you elaborate further please.

I'm saying that the math is against dividend investing.  It's less tax-efficient for starters, and if you read Buffett's analysis it makes sense to sell for capital gains instead of to invest for dividends.

The reason people favor dividends is because it enforces a measure of discipline on a company.  Most businesses do a lousy job of deploying their capital, and an even worse job of buying back their own shares.  (Buffett & Berkshire are notable exceptions.)  In addition, a company that does not pay dividends can be tempted to use all sorts of cheating aggressive accounting methods to make it seem as though they're responsibly using capital... right up until they run out of cash.

So dividends impose a minimal standard of fiscal truth upon a company.  (Especially international companies with murkier accounting standards than the U.S.)  To pay a dividend, they have to earn money and use it responsibly.  To keep their share price up, they have to periodically raise that dividend.  Dividends are about the only tool that investors have to really measure the fiscal health of a company. 

I wouldn't invest all of my money in a single stock like Berkshire Hathaway, and I wouldn't invest all of my money in dividend stocks either.  I'd come up with an asset allocation plan, diversify among those assets, put it in autopilot, stop worrying about market valuations, and get on with my life.