As someone who is trying to become financially independent by 40 years old, it’s imperative that I build a passive income stream that will exceed my expenses and outpace inflation.
Exceeding expenses is obvious.
Outpacing inflation is less so, but still important. After all, inflation is like an invisible tax. Consider that $1 in 1982 (the year I was born) would have the same purchasing power as $2.45 in 2014. As such, $1 today will very likely be worth much less in the future.
So I need to find a source of income that isn’t just passive (so that I can enjoy life), but one that’s growing so that my purchasing power is increasing at least in line with inflation, but preferably in excess of.This is what led me to invest in dividend growth stocks.
Dividend growth stocks typically have long track records of paying increasing dividends.
How long? What kind of track records?
Check it out for yourself.
A gentleman by the name of David Fish has compiled every single US-listed stock that has increased its respective dividend for at least the last five consecutive years. The finished product is an invaluable resource called the Dividend Champions, Contenders, and Challengers list.
What you’ll find on the CCC list is hundreds of stocks, with a substantial portion of them having increased their respective dividends for over 25 consecutive years.
Not only do dividend growth stocks increase their dividends, but they increase them at an attractive rate, typically well over and above the rate of inflation.
So there are definitely some attractive aspects of dividend growth investing as it relates to achieving financial independence and maintaining/increasing your purchasing power.
However, one aspect that’s less often discussed is how easy they are to receive.
Receiving dividends from a dividend growth stock requires no work on my part. They’re deposited automatically in my brokerage account. I don’t have to go to some office and turn in a voucher or call up some 1-800 number. It just doesn’t get much easier than that.
Now, dividends aren’t the only way to extract income from a stock portfolio.
One can certainly invest in index funds or stocks that don’t pay dividends and then perform a controlled sell-off of assets in order to meet expenses and maintain a certain lifestyle once income is necessary.
This would usually involve building up a large portfolio over your working years and then drawing down income from the portfolio by selling off stock once you’re retired.
You would determine a safe withdrawal rate, based on your expenses and asset base, and then start to slowly bleed your portfolio dry.
Generally speaking, it’s very possible this selling would only increase in percentage terms relative to the portfolio value over time as your expenses rise and as the asset base dwindles. Plus, you have to factor in that pesky aforementioned inflation. Thus, starting out with selling off 4% of your portfolio will need to be adjusted upward over time to maintain or increase purchasing power.
So as you age and your expenses likely increase, you’ll quite possibly be slowly running out of assets with which to meet these rising obligations.
This makes no sense to me, and I’ll discuss why.
I prefer a different approach.
As a dividend growth investor, I don’t plan to sell any of my stocks in retirement. Instead, I plan to live solely off of the dividend income my portfolio generates.
By living off of only dividend income, my asset base will stay in place and (hopefully) increase in value over time as the underlying companies paying me dividends become more and more valuable.
See, a company is only able to increase its dividend for decades on end if the underlying profits are rising in kind. A dividend is paid in cash from cash. It can’t be faked – a dividend is basically the “proof in the pudding”. Don’t tell me how profitable you are; show me.
And a company that is making far more profit today than it was a year or five or ten years ago is also very likely worth more money, thus increasing the asset base along with the income.
I view my portfolio as one large tree. And it’s a tree that produces bountiful fruit.
Let’s imagine it as a cherry tree. And let’s also imagine each branch is a stock position. I currently have more than 60 positions in my Freedom Fund – that’s what I call my portfolio – so I have over 60 branches on my cherry tree.
Each branch produces cherries – dividends – at varying frequencies. Most branches produce fruit every quarter, while some give fruit semi-annually or, rarely, annually.
When fruit is produced, I can either take that fruit and use it to expand my garden – reinvest dividends – or I can provide sustenance for myself – pay for rent, food, etc. Right now I’m expanding my garden, but one day I’ll use those cherries to live off of.
Now, let’s compare this to the earlier example of using a safe withdrawal rate and selling off the portfolio slowly. Effectively, what you would be doing by selling off your stocks is you would be chopping off little bits of each branch whenever you need cherries.
Instead of simply plucking the cherries from the branch and waiting until another cherry appears, you’d be chopping off a section of the branch and taking the cherry and branch with you.
However, branches slowly die over time when they’re being cut off. And when they die and disappear you will no longer produce cherries from that section of the tree any more.
So what do you do?
You move on to another branch and repeat the process all over again. The problem is that the tree only has so many branches and you’ll quite possibly, in the end, be left with a barren tree that produces nothing.
Now, someone who follows this strategy is hoping that the tree – and its branches – grows faster than they cut it down.
But which strategy seems preferable to you?
I have always looked at my portfolio in such a way. Each position produces bountiful dividends for me. I would never want to reduce or sell off these positions for income, because once they’re gone, the dividends no longer show up in my brokerage account and I’d have to repeat the selling process over and over again in the future just to get the same results. Even worse, it’s likely I’d have to actually accelerate the selling over time just to keep up with inflation. All while the asset base is possibly shrinking from all that selling.
Bottom line: With a proper dividend growth strategy, your portfolio will very likely get bigger and stronger over time. Think of your portfolio like a cherry tree, where you live only off of the fruit. It will likely eventually produce more cherries than you could ever possibly use. And that’s the position I want to eventually find myself in. I’m no gardener, but I think I’d be perfectly happy with such overgrowth!
– Jason Fieber, Dividend Mantra