← Ready For Retirement
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The biggest myth in retirement investing is that you should only live off your dividends and never actually touch your principal. It sounds safe, it sounds intuitive, it even sounds responsible. But it's one of the riskiest things you can do when designing your retirement strategy. Today, I'm breaking down the math to show you why this approach can jeopardize your entire retirement and show you what you should do instead. To start though, we have to understand, what does this look like? You know, if you want to create a certain amount of income in retirement, how much capital do you need to do so? If you. And if you're going to apply the dividend yield framework or the live off dividends framework, you need to understand what size of portfolio would you need to meet a given level of income. So let's assume that you want to retire, you want to spend $6,000 per month in retirement, $72,000 per year. If you want to live just on your dividends, how much money do you need to have in your portfolio to make that happen? Well, this of course is where it depends on what stocks, what funds, what investments are you owning? Let's take a high dividend paying stock to use as an example. Let's use Ares Capital. Now, this is not an endorsement. This is not a recommendation. None of this video should be advice. This is just to use as an illustration. Aries Capital, as of this recording is paying a dividend yield of about 9.5%. You own $100 worth of Aries stock, you get a dividend of $9.50 per year from those holdings. So let's use that math. Let's work backwards into saying, okay, I want to spend $72,000 per year, so 6,000 per month. How much do I need to have in, in that stock? Well, in this case, I would need about $758,000 in that stock so that on an annual basis I could receive $72,000 per year, which averages out to $6,000 per month. Now set aside taxes for a second. This is not the most tax efficient way to invest because part of that income is going to be taxed at higher ordinary income rates than qualified dividend rates. But set that aside for a second. You can see it doesn't take all that much money to generate $72,000 per year. If you could guarantee that was going to last forever. Now let's compare that to a more diversified portfolio. Let's use the S&P 500 as a simple example. Instead of putting all of your money into areas capital and saying you're going to have that be your retirement portfolio. You're going to put all of your money into the S&P 500 or an S&P 500 fund. The question is, how much do you need to put in there to generate the same level of dividend yield to support that $72,000 per year? Well, as of this recording, the dividend yield on The S&P 500 is pretty small. It's 1.13%. Meaning if you want 6,000 per month or 72,000 per year of dividends just from your investment in the S&P 500, you would need to have about $6,370,000 in your portfolio. So what gives there same exact dividend yield? Yet one of these strategies requires me to fund it with almost $6.4 million, while the other is just north of $750,000. There's a $5.6 million gap there to generate the same level of income. Well, this is the temptation that dividend investors face. No, they're not putting all their money in areas capital I think all of us could probably understand. You can see how putting all of your retirement money in one single stock, bad idea. Too much risk there. There's too much at stake. You would never do that. But what people do is they say, well, this S&P 500, by the way, I'm just using this for illustration purposes. That is not the ideal retirement portfolio. But I could put my money there and get a little bit of a dividend yield, 1.1%, 1.2%. Or I could start chasing higher dividend paying stocks and I could get a higher yield. Well, this is where things start to get dicey. Because keep this in mind. If on the one hand with Ares Capital or any individual stock, high high risk, and on the other side, diversified portfolio, where yes, there's going to be volatility there, but the safety of that is going to be much greater over time. As you start to shift to a higher dividend yield portfolio, you are subtly starting to shift the risk of your portfolio. Here's what I mean. I don't care how many stocks you have. You're probably saying, James, you don't need just one stock. Of course, who would do that? But I have 10 stocks, I have 20 stocks, I have 50 stocks that all pay a high dividend yield. Therefore I'm in a much safer position. Well, sure, you're safer than just owning one stock. But here's the risk you're probably not thinking about when you solve for yield you stop thinking about diversification. Sure, you have 20 names, 30 names, 50 names, you think you're spreading your money out. But these types of companies, high dividend paying stocks tend to be in similar sectors. It's utilities, it's REITs, it's business development companies. These are the types of companies that pay higher yields. And if you were to actually look at your portfolio at a high level, what you start to realize is that an S&P 500 fund or a global stock fund that's covering many different asset classes, that's covering many different sectors, you have zero exposure to to many of those sectors, and very concentrated exposure to other sectors or other asset classes. What does this mean? Well, it means you're much more subject to price volatility. Yes, those dividends may remain, but because you're owning all of the same thing, or many of the same things in just a couple or a few concentrated asset classes or sectors, you're going to be more exposed to sequence of return risk. You're going to be more exposed to that downturn that inevitably happens. And if you don't have your portfolio properly diversified in your sector or your asset class gets hit hardest, I don't care what the dividend yield is, you might not recover from that in a way that allows you to continue living the same retirement lifestyle. Let's look at 10 actual stocks. Again, not recommendations. This is neither an endorsement for nor an endorsement against these specific stocks, but these stocks right here, 10 of the highest dividend yielding stocks in the S&P 500 as of today. Now if you look at these stocks, Pfizer, Verizon, hp, all big established companies, all with pretty high yields today. When you look at the dividend yield of those stocks, all of them underperform the S&P 500 over the last 15 years. So you might own all these names and look at these yields and say, okay, the average dividend yield is, let's say six, six and a half percent. I'm just going to live on that. I have $1 million. I'm going to get 60,000, $65,000 per year. You're going to live on that. But keep this in mind, you significantly underperformed a group of securities that provided way less risk due to not being as concentrated as you were facing yourself. So sure, good today, it feels good today to have that level of income. But what about 5 years from now and 10 years from now and 20 years from now? What if the health of the underlying company itself is not keeping up and therefore the price of the underlying company is not keeping up, or the dividend yield is no longer growing like it needs to, you might not be in a position to continue maintaining that income years into the future if you're missing out on the growth all around you. So before we go to the next step, which is to understand why does this exist? Why is this like this and what should you do instead? Make sure that you subscribe every single week, putting out videos, videos just like this to help you live a more secure retirement. Subscribe below so you don't miss a video. So why does this happen? Is there a single rule of law, law of physics, that says it has a high dividend yield, is going to underperform the market? No, but you have to keep this in mind. When a company earns cash flow, the company, its boards, its executive team has to determine what are we going to do with this cash flow? Are we going to take these profits and pay them out to investors, or are we going to take these profits and reinvest them because we have some very attractive growth opportunities in front of us. If you look at the highest growth companies, the Amazons, the Nvidias, the Metas, they're not paying high dividends. They're not paying any dividends in many cases. Why? It's not because they're not profitable, they're insanely profitable. But every bit of profit they have, if they're saying we could pay this out to shareholders, or we have amazing opportunities internally that we can reinvest in and grow our share price, that's going to be more beneficial to our shareholders than simply paying them cash. So when many of These companies are paying 6, 7, 8, 9, 10% dividend yields, sure they have the cash flow today to do that. That also might be a sign they don't have very good forward looking growth prospects. That's not to say that's always the case because we don't always know what's going to happen. But if all of your money is invested there, what you're really saying is you might not be owning the companies that have the best long term growth path. Keep in mind that as an investor, yield is absolutely one part of the return that you're going to receive, but so too is the increase in the price of that stock. And you need to be concerned about the combination of those two, the total return that you' to get. I don't care if your dividend yield is 10% per year. If on average the price of those shares is dropping by 5,6% per year on the flip side, I don't care if something's paying you 0% dividend yield if on average its return is 10 plus percent in terms of the price of it. So yes, you need both. You need your dividend payers, you need your growth portfolio. But it's the combination of dividend yield plus price appreciation that you should really care about. Now, a couple more things before we wrap up. Why do we like dividend paying stocks more? Well, we like them because of mental accounting. I own this share and this share pays me money. But here's the thing. If you own $100 of ABC Corp. And ABC Corp. Is about to pay you a $3 dividend, you don't have $100 per share and receive $3 of cash. And nothing changes. As soon as that dividend of $3 is paid to you, the share price drops to $97. Think about it. The $100 per share represents the total value of that company. Some of that value is the cash that that company has. When that company pays that cash out to its shareholders as a dividend, the price of that company, the value of that company shrinks. Now, it might just be temporary because cash starts to build up again. But it's not as if you can manufacture money out of thin air. That $3 in this example is coming directly out of the share price. Why does that matter? Well, let's assume you had another $100 investment that paid nothing in dividends. With that, you could simply sell $3 of shares and have the same exact output. $100 of stock goes to $97 plus you have $3 of cash. The difference. In this example, you fully control the timing. You might need that $3 to support your income, or you might not need that today. Or maybe you need one of those dollars, but not the full three. Now, I know I'm using a very small example, but now magnify this. It's not $100, but it's a million dollars. Well, you might not need the full 30,000 right now, but you want 10,000 to go take a trip or you want 15,000 to help a child pay for tuition. Whatever the case is with dividends, you don't really have control over the timing of when you receive those. The company pays that out quarterly or annually or whatever the frequency is. With a total return approach, you still have dividend stocks. Dividend paying stocks absolutely need to be part of your overall strategy, but you also own other investments. You control the timing of when you're buying and selling and realizing taxable Events of which receiving a dividend is one. So what's the better approach? What's the approach that we recommend here at Root Financial? We've helped hundreds of people go through this exact framework so they can live more secure retirements and ultimately get the most out of life with their money. Well, step number one, identify the need you have from your portfolio. This isn't your total retirement spend. It's the portion of that spend that needs to come from your portfolio. Practically speaking, this means after Social Security, after pension, after other income sources like that, how much do you still need to come from your portfolio? Define that. Let's say it's $40,000 per year and you have a million dollars in your portfolio. Step number two, set enough aside in a root reserves portfolio that will give you a buffer to protect against sequence of return risk. We call this root reserves. It is short term, high quality fixed income that's not going to grow a whole heck of a lot for you over time, but it's going to give you the stability. It's going to give you far more certainty so that not if, but when the market is down and is down for two, three, four, five years in a row, you're not forced to liquidate your great stock investments. When that happens, you have this reserve of conservative stable funds that you can use to live on, giving time for your stocks to recover. So I typically recommend five years there. Going back to having a million dollar portfolio needing 40,000 per year. I might start by having $200,000 in root reserves in laddered bond funds, laddered fixed income funds. That will give you more security, but also a little bit of yield. The further out you go in that reserves framework, then the remaining portion of your portfolio, invest in a total return framework. You're not dependent upon that for the dividend yield to be the max. It possibly can be to support your lifestyle and you've already accounted for that. You need to invest in a way that's going to maximize sustainable growth potential over time. So between your growth bucket and between your root reserves, you've got a total framework that can deliver the income you need from your portfolio to be combined with your Social Security or pension or other income sources so you can go live your retirement and do what you want to do. Not have to be too overly concerned about market movements and have a strategy that's going to carry you through your retirement. But remember this, your portfolio is a tool to support the life you want, not a museum piece that you can't touch unless it happens to be a dividend. Make sure you're using your portfolio the right way. If we can help. This is exactly what our advisors do at Root Financial. All day, every day. We help people just like you understand? What do you want retirement to look like? Then how do you design a retirement plan? A cash flow plan, an investment strategy, a tax strategy, an overall protection strategy. And to ensure you can get the most out of life, using your money as a tool to do so.