Co-written by Robert and Sam Kovacs
We recently came across an article in the trending section of Seeking Alpha, titled “There’s No Reason Why A 60-Year Old Can’t Invest The Same Way As A 20-year old“, by Rocco Pendola.
This led us to write this article in which we will present our take on investing at 20 vs. investing at 60.
We will first argue that you don’t need a stock-bond split, and you should have an emergency fund ready for the unplanned. But this is where similarities among young and old dividend investors should stop. There is no one size fits all, because of the diversity of resources, goals and needs among dividend investors.
You don’t need a stock-bond split
We do believe there is no reason why one should go from a 90-10 split between stocks and bonds to a 50-50 split as one gets old.
Bonds can be added to the mix, as can preferred shares and other income-generating instruments.
But if dividend investing is done right (more on that later), there is no reason why one wouldn’t want to invest solely in strong dividend-paying stocks to finance retirement expenses.
The stability of the best dividend-paying stocks is on par with what one could expect from bonds. And with yields of safe bonds as low as they are, blue-chip dividend stocks, mixed in with a few other instruments, could offer significantly better, risk-adjusted returns than investing in bonds which yield close to nothing.
Investing and personal finance are intimately connected
Yet, investing in dividend stocks does mean there can be some volatility in income, especially if one’s stocks stop paying dividends, or significantly reduce the amount paid.
From the investing side, you need to keep sufficient diversification to reduce the impact of any single dividend cut. You also need to prune your portfolio to keep only high-quality stocks within it.
A big part of our process of creating dividend growth portfolios involves tying in stock selection to our income goals. The whole process is explained in one of our most popular Seeking Alpha articles: “How You Can Retire On Dividends Forever And Ever“.
It then becomes evident that investing is just one aspect of personal finance.
Nobody invests to keep busy. You’re doing it to meet your personal finance goals. This means that basic considerations about budget, saving and investing need to be taken. Emergency funds are a must: We both have emergency funds sufficient to cover at least one year of expenses. This should be maintained through retirement, which will give investors time to assess and adjust their portfolios without having to rush to not pay the bills.
There is no one size fits all
Investors might have in common that they need to have savings ready for an unplanned event and that they will stay exposed mainly to dividend stocks, but this doesn’t mean that any stock which is suitable for young folks should be suggested to older folks.
Here is the thing: personal finance is personal. Therefore, it cannot possibly be that dividend investing is one size fits all. Depending on different individuals needs and expectations, the approach must differ.
Age is just one of the variables which impact dividend strategy.
The viability of a dividend investing strategy depends on the following:
- Time to retirement: For how many years will the dividends be reinvested before they are spent to cover expenses?
- Investable assets: How much does one have to invest in dividend stocks, right now?
- Monthly contributions: How much does one plan on contributing each month? (and if applicable at what rate will monthly contributions grow?)
- Retirement goal: How much dividends do the portfolio need to generate in retirement? (Other income sources like rentals, social security, company pensions need to be deducted).
The higher the first three, the better off one is. The lower the last is, the better off one is.
But how do we tie this information into stock selection? From these inputs, we can reverse engineer for any given dividend yield, the average dividend growth needed each year to reach the retirement goal.
For instance, using this prototypical tool, we can figure out that if a 20-year old wants to generate $5,000 in dividends per month (adjusted for 2% inflation), 45 years from now, by investing $500 per month, starting with nothing, he could invest in:
- 2%-yielding stocks which grow the dividend at 10.1% per annum
- 4%-yielding stocks which grow the dividend at 5.8% per annum
- 6%-yielding stocks which grow the dividend at 2.5% per annum
Here are a couple more yield-growth couples for this investor:
- 3% yield: 7.4% required CAGR
- 2.5% yield: 8.5% required CAGR
- 5% yield: 3.8% required CAGR
- 7.4% yield and up: 0% required CAGR
Now let’s look at a 60-year old who has a similar goal.
Let’s say this 60-year old has $1 million in the market, wants to retire in five years, can also save just $500 per month, and also wants $5,000 per month + inflation.
The required CAGR at any given yield would be significantly different:
- 2% yield: 32% dividend CAGR
- 2.5% yield: 18.1% dividend CAGR
- 3% yield: 13.2%
- 4% yield: 9% dividend CAGR
- 5% yield and up: 0 dividend growth required
When you look at these numbers, would you really recommend that a 20-year old invest the same way as the 60-year old?
We argue that you shouldn’t. For the 20-year old, we argue that it would be significantly easier to craft a portfolio which yields 2.5% and has the potential to grow the dividend at 8.2% per annum than it would be to craft a portfolio which yields 5% and grow at 3.8%.
Given a good entry point, he could build a rock-solid portfolio with all-weather stocks like Home Depot (HD), Reliance Steel (RS), Union Pacific (UNP), Comcast (CMCSA), Honeywell (HON), BlackRock (BLK), Lockheed Martin (LMT), Amgen (AMGN), T. Rowe Price (TROW), WEC Energy (WEC), and so on.
Investing in stocks which have strong growth will also enable him to increase income when the price invariably keeps up with the dividend over a number of years.
Inversely, we’d argue that for the 60-year old, it would be a lot easier to craft a portfolio which yields 5% and up, which requires no growth for him to meet his objectives than it would be to craft a portfolio which yields 2.5% and averages 18.1% dividend growth per year over five years.
Why should he prefer this?
Intuitively, you’ll understand that it is because even if he somehow picked stocks which over the long term did yield 2.5% and grow the dividend at 18.1% per annum, they would do so with extreme volatility. You simply wouldn’t expect 18.1% dividend growth year in, year out. There would surely be a standard deviation of at least 5%. That is to say, 67% of the time, you’d expect the dividend growth to be 13.1% and 23.1%.
For somebody with five years to go, this would be too much of a gamble.
Source: author’s simulations
After running 2,000 Monte Carlo simulations, such an investor generates at least enough to cover his expenses 50% of the time. That means half of the time he comes up short. In the core 80% of simulations, he would generate between $57,000 and $72,000. Sure, the potential upside is nice, but why risk missing your goal at this stage of life? Time isn’t an asset at this point.
On the other hand, invest at 5%, and he’d be guaranteed to hit his objectives. Any dividend growth would result in upside.
Let’s repeat this. The point is: personal finance is personal. There is no one size fits all. Change any one of the inputs, add in growth rates to the monthly contributions, one off large contributions (inheritance for example), and all these numbers change.
You can’t leave it up to chance.
Some dividend stocks are inappropriate for most investors
Let’s consider the 20-year old that is starting out with nothing. If he invests in an asset like Coca-Cola, which let’s say yields 3.5%, and can be expected to grow the dividend at 3% with a standard deviation of 1%, he would be hard-pressed to reach his retirement goal of approximately $140,000 per year in 45 years. (Note that with 2% inflation, $5,000 per month becomes $12,000 per month 45 years from now).
Source: author’s simulations
To reach that goal, he would need to invest $18,000 per year, or $1,500 per month, when we saw that it would otherwise be possible with $500 per month. The type of risk aversion required to tell somebody to triple contributions without expecting any extra income is just abnormal.
The only case in which it would be advised would be if:
- You have abnormally high savings (and or assets), and
- you have abnormally low retirement expectations.
This just isn’t the case for most people. If you have $2mn at retirement and only need $65k per annum, then sure, you could invest it all in low-yielding, steady-eddy assets like KO or CL.
For most people, this won’t be the case. On the other hand, high-yielding mature companies like Altria (NYSE:MO) and AT&T (NYSE:T) can make more sense, because the high yield compensates for the lack of growth.
While mature businesses with weak combinations of dividend yield and future dividend growth should be avoided. There are other stocks which won’t serve a dividend first approach. It is the high growth, extra low-yielding stocks. Stocks like Visa (NYSE:V), or Apple (NASDAQ:AAPL).
Let’s take AAPL. The stock yields 0.65%. If we expect Apple to grow its dividend at 10% per annum in perpetuity with a standard deviation of 1%, our example investor would need to increase his monthly contributions to $2,250.
Source: author’s simulations.
Of course, the case for Apple isn’t its dividend. We appreciate that. So should other investors. The case for Apple is and has been for the past years capital appreciation. Down the line, of course, this capital appreciation can be converted into a higher-yielding asset.
This can be a successful approach, but it is important to note that it isn’t a dividend-first approach.
Our approach relies on the companies’ dividend policies to be sufficient by themselves to meet our income goals. We do other tricks to increase our income and compensate our mistakes, like selling overvalued positions, but we don’t rely on it.
If you do rely on capital gains as part of your strategy, that is fine. You just need to be aware of it.
Coming across thought-provoking pieces which force us to look again at our strategy reinforces our understanding of what we are doing, and we hope, gives perspective to fellow dividend investors.
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Disclosure: I am/we are long BLK, CMCSA, MMM, HD, T, TROW, WEC, UNP, O, RS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.