Author Topic: Need some clarification!!!  (Read 2841 times)

Driko

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Need some clarification!!!
« on: September 23, 2015, 01:47:16 AM »
So I have done a lot of searching and I haven't really found anything that directly answers the question for my situation. I have read MMM and others talk about gaining 7% back on investments a year. Many talk about eventually being able to live off that 7% due to compounding. I am under the impression that most stocks and etfs do not pay much of a dividend at all which is the only way I could think of a stock to compound? If vanguards high yield dividend is like 3% where does this 7% number come from? I would assume it doesnt come from selling shares as that would just turn stock into liquid assets and then that 7% would be gone once it is spent.

I have about 40-60 thousand per year I would like to invest in a taxable account and I am trying to figure out the best place for it. I was thinking vanguards REIT and high dividend yield etfs, but 3% just doesnt seem that much. I know many people have been saying to invest in etfs that track the index like VTI but all that does is grow in value right? I guess I am trying to understand the compounding that MMM and others talk about? Where should I invest my money so that it compounds and keeps compounding. I also have a fairly high risk tolerance, I am in this for the long haul, but Id like to know that eventually the compounding will be enough for me to live on. I just need help being pointed in the right direction. Thank you!

MDM

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Re: Need some clarification!!!
« Reply #1 on: September 23, 2015, 01:56:48 AM »
... invest in etfs that track the index like VTI but all that does is grow in value right? I guess I am trying to understand the compounding that MMM and others talk about?

"Growing in value" = "compounding".

Might be worth your time to read through http://jlcollinsnh.com/stock-series/

Also, dividends do not compound unless they are reinvested.

See also https://en.wikipedia.org/wiki/Compound_interest.  Although stocks don't "pay interest", the value growth tends to follow a similarly shaped curve on average.

Driko

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Re: Need some clarification!!!
« Reply #2 on: September 23, 2015, 02:29:12 AM »
So basically you are saying I should invest in a benchmark index like VTI and eventually it will grow to such a value that I just sell off what I need to live off per year? I've heard MMM and others talk about dividends like they made it sound like they were living off them so I was just under the impression they had a million worth of shares in dividend stocks and that is more than enough to live off of.  My roth has dividend stocks that it reinvests, but thats only 5500 a year. I am trying to come out with a strategy that will set me up for life since I have a fairly large amount to invest per year.

plainjane

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Re: Need some clarification!!!
« Reply #3 on: September 23, 2015, 06:42:12 AM »
There are a bunch of ways to do it, and different people on the boards have different preferred approaches.  Some people invest in a benchmark index and then sell off what they need.  Some people buy into individual dividend stocks and live off of those.  Some people buy real estate and live off of the rents.  Some people have a pension.  Some people do a combination.

I'd guess that most people in dividend stocks are looking for a measure of growth in the stock value (so they can sell some if required), and a dividend on top of that (which they either reinvest or live off of depending on which phase they are in). 

Driko

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Re: Need some clarification!!!
« Reply #4 on: September 23, 2015, 09:22:50 AM »
So I was planning to have vanguards REIT and high yield dividend make up most of my roth. My 401k has a vanguard mutual fund that tries to mimick the sp500. Are the reit and high dividend yield etf best for my roth? or should I go with something like VOO or VTI? I figured the dividends would eventually be able to buy more shares since the roth is limited to how much you can put in each year. Thanks again for all the advice!

nereo

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Re: Need some clarification!!!
« Reply #5 on: September 23, 2015, 09:45:59 AM »
So I was planning to have vanguards REIT and high yield dividend make up most of my roth. My 401k has a vanguard mutual fund that tries to mimick the sp500. Are the reit and high dividend yield etf best for my roth? or should I go with something like VOO or VTI? I figured the dividends would eventually be able to buy more shares since the roth is limited to how much you can put in each year. Thanks again for all the advice!

It sounds like you are falling into the "Dividends are magical" trap (my own term for it).  Dividends are great, but they are no better than a stock increasing in price by the same amount (minor tax implications aside).

Quick lesson:  Let's suppose there is publicly traded company called Driko's (stock symbol "D").  Dricko's generates a profit each year and is slowly growing.  Management can decide to do a few things with those profits.  It can return money directly to shareholders as a dividend, it can invest in the business (either R&D or growth expansion) or it can hoard money. 
If it gives shareholders dividends = to profits than the stock price won't go up or down very much.  If it chooses to expand its business than (hopefully) the share price will go up since profits will (hopefully) continue to increase.
All things being equal, the dividend paying stock will not go up as much each year because it has to pay out a large chunk of its profits to investors as dividends.
 It gets a bit more complex because share price based on what people will pay now based on what they think it will be worth some point in the future - but the idea is pretty simple.

So - should you invest in an index or stocks that pay high dividends, or ones that will (hopefully) increase in share price?  The real answer is: it doesn't matter.  It's two sides of the same coin. All else being equal stocks that pay dividends will not see their share prices increase as much as stocks that don't.  So - in order to live off your portfolio, you will either need to cash out the dividends, or sell some of your stock each year.  Don't worry, stocks go up in price and they occasionally split, so as long as you don't take out too much each year you will never run out of stock to sell.  Ideally what you sell should be "replaced" by increases in share price and dividends.

Back to your question regarding how we can plan on our investments earning 7%/year?  This amount is based on the real-adjusted (i.e. factoring in inflation) returns of the SP500 index over the last 100 years.  Pick any historical 30-year period you like, any one at all (e.g. Feb 1971 to Feb 2001) and the annual returns will be between 4.7% and 9.2%.  The median annual return after inflation is just over 7%.

So if the median is ~7% after inflation, why don't we just choose to live off 7% withdraw rates (WRs)? The simple answer is volatility - even the median returns are 7%, there are bad years and good years, and if you start withdrawing 7% and have a few bad years up front, you'll run out of money.  In fact, withdrawing 7% every year would leave you bankrupt almost two-thirds of the time over the last century.  There was a rather elegant study done to test what the best withdraw rate is - fondly referred to simply as "The Trinity STudy" - and they found that a withdraw rate around 4% would be successful over 90% of the time.  For that reason many choose to us the "4%-rule", although there are certainly lots of people who choose something even more conservative, while others are ok with a bit more risk.

Driko

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Re: Need some clarification!!!
« Reply #6 on: September 24, 2015, 12:11:42 AM »
Thanks for the great post and information! I really appreciate it!

FI40

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Re: Need some clarification!!!
« Reply #7 on: September 24, 2015, 11:38:01 AM »
In regards to dividend growth investing - one thing to note as well is that sticking to stocks that pay a dividend means you're overweight in mature companies that are closer to market saturation and/or have a very established and time-tested business model. Also certain types of businesses like utilities, reits, consumer staples are conducive to shelling out a steady dividend rather than reinvesting in themselves.

I'm not saying this is a bad thing, just information. To be sure, there are good arguments for both straight up indexing and dividend growth investing. To me it seems DGI should be safer, but should also return less in the long run. I'm not sure if the data bears that out or not.

Tyler

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Re: Need some clarification!!!
« Reply #8 on: September 24, 2015, 04:09:27 PM »
So I have done a lot of searching and I haven't really found anything that directly answers the question for my situation. I have read MMM and others talk about gaining 7% back on investments a year. Many talk about eventually being able to live off that 7% due to compounding. I am under the impression that most stocks and etfs do not pay much of a dividend at all which is the only way I could think of a stock to compound? If vanguards high yield dividend is like 3% where does this 7% number come from?

The short story is that there are two ways for a stock to make money.  The first is dividends, where you get paid a certain amount of money for each share you own.  The second is capital gains, where the value of the share goes up.  The most important number to look at is the total return that includes both dividends and capital gains.  That's where the 7% "average return" number comes from.

Nereo explains the long story quote well.  I'll throw a special +1 to his point on volatility, as the average return does not tell the full story. 

nobodyspecial

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Re: Need some clarification!!!
« Reply #9 on: September 25, 2015, 09:06:14 AM »
To me it seems DGI should be safer, but should also return less in the long run. I'm not sure if the data bears that out or not.
Over the long term the market should do better from growth of new companies and new technologies.

But those boring monopoly energy, telecoms, transport (perhaps not energy) companies are very stable through boom and bust and continue paying dividends. You could reasonably think of them as the equivalent to bonds.