Here is the simple answer: live off dividends.
Here is the longer answer — when you live off the income that your portfolio produces, the chance that you will ever run out of money is greatly reduced. If you have to sell portions of your portfolio and thus rely on finding someone else to sell at higher prices than you bought, then you increase the risk of outliving your money.
It is very easy to monetize a pile of cash and convert it into a neat dividend machine, which will deposit cold hard cash into your brokerage account regularly. You can then use that cash to either spend or to reinvest into more dividend paying stocks, paying even more cash.
As I discussed earlier, there are largely two types of dividend growth investors. The first group are those who have been putting money mostly in dividend growth stocks regularly, reinvested dividends, and maintained their portfolios. The second group include those who are trying to convert a nest egg accumulated over a lifetime of hard work, or an inheritance or another pile of cash received recently as a lump sum. Those are the ones who want to learn how to pensionize their assets and live off that pile, while also minimizing the risk of loss to the minimum.
If you are building a dividend growth portfolio from scratch, the first step is to start slow. Get a list of dividend growth stocks and identify the leaders in their industries that also have dividend growth streaks. A great place to start is the CCC list from David Fish, who tirelessly updates it every month. A long streak of regular dividend increases shows a company which is prospering, as evidenced by the higher amounts of cash it sends to shareholders. A company cannot fake cash for long, which is why many investors consider the proof of regularly increasing cash dividends as proof that earnings are increasing and business is good. It is also important to understand which stage of dividend growth the company is. You are mostly interested in companies that manage to increase dividends because their earnings improved over time. When earnings and dividend growth go in lockstep, you know you have found a candidate for further research.
If that candidate is available at a good price, then it can find a place in my portfolio. I usually try to avoid paying more than 20 times earnings for a company. I also require adequate dividend growth exceeding 6%/year, rising earnings and dividends, and try to understand if the company can continue its growth. Most often, I have found out that a body in motion keeps its upward trajectory for years to come, until something changes. When something does change, the company cannot fake cash flow anymore, and they either freeze or cut dividends. I am a very patient investor, and will hold even through long periods of time while a company works its issues out, as long as my payout is at least maintained. I won’t add any more funds to this position, and would monitor it more closely, but would not sell it. If however a company does cut or eliminate distributions, I am out one second after the announcement. I can get back in if they start raise dividends again, and I believe earnings can grow and sustain the streak again. Having an exit plan is as important as having an entry plan.
I also try to build my dividend portfolio stock by stock, in an effort to have a diverse stream of cash coming my way. I do not want to be overly dependent on any single company for my dividend income, or a single sector. The nature of dividend growth stocks means that I own too many consumer staples and energy companies unfortunately. It is also important not to diversify just for the sake of diversification, but genuinely look for companies which you believe will be there in 20-30 years, and possibly earn more to pay more in dividend income. If there is a high confidence that a company will be there in 20-30 years, that increases the chances that it will be hopefully earning more over those years and rewarding that shareholder with more cash. Those growing dividend payments will protect the dividend income of the investor from the destructive power of inflation.
It is also important to dollar cost average my way into those quality companies. Remember, Rome was not built in one day. Your portfolio should not be built in one day either. When I dollar cost average every month, I put money to compound for me in some of the best businesses in the world today. I ignore noise such as “the market is overvalued and will crash” or “the market has crashed and will crash further” and keep buying through thick and thin. That way I have a psychological advantage, because I will be putting money regularly, while everyone else will be panicking and selling during the next bear market or piling most of their money right when the current/next bull market is about to end. I don’t have to worry about ups and down, and I ignore market fluctuations, because I am investing in real businesses, not some lottery tickets. I also invest for the next 30 years, plan to live on dividends that are derived from earnings, which is why fluctuations today don’t really impact me. What impacts me is only how the business does over those 30 years.
This is essentially what many trust funds and some major foundations have been doing for decades. If you look at the Hershey Foundation or the Kellogg Foundation, you will notice that a large portion of their income comes in the form of stock dividends. Those dividends are spent for charitable purposes. Of course, this has not stopped either Kellogg (NYSE:K) or Hershey (NYSE:HSY) from prospering as well. You can also look no further than the descendants of Standard Oil, whose trust fund accounts are filled with shares in Exxon Mobil (NYSE:XOM), or Chevron (NYSE:CVX) to name a few, which have been able to raise and pay stable dividends for a century. If those foundations or trust fund babies have been able to live off their portfolios using dividend growth stocks, then why can’t someone ordinary like me live off dividends generated by my portfolio for about 30-40 years?
To summarize, I plan on creating a diversified portfolio of dividend growth stocks, by slowly dollar cost averaging my way into attractively valued quality companies over time. By only spending the dividend income, I believe I am being more conservative than investors who sell off portions of their assets in retirement, which dramatically the lowers chances of me running out of money in retirement. In addition, I would not be at the mercy of stock market prices and risk selling when prices are low, but I will be getting cash no matter what stocks do. I will be essentially sharing in the profits of the enterprise and be essentially paid to hold interest in some of the best businesses in the world.
Source: Dividend Growth Investor