Wednesday, August 22, 2012
Dividends Are My Fruit
As someone who is trying to become financially independent by 40 years old, it's extremely imperative that I build a passive income stream that will exceed my expenses and also outpace inflation. This requirement is what led me to invest in dividend growth stocks. Dividend growth stocks typically have a long track record of paying increasing dividends. I realized that dividends can be a fantastic passive income source. One thing not mentioned often is how easy they are to receive. 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. And by investing in companies that have long track records of raising dividends, I can be assured that my income will only go up over time.
There are many ways to extract income from a stock portfolio. One of the most common ways is to perform a controlled sell-off of assets in order to meet expenses and maintain a certain lifestyle. 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. Usually this selling would only increase in percentage terms over time as your expenses rise and as the asset base dwindles. So effectively, as you age and your expenses keep increasing, you are slowly running out of assets with which to meet these obligations. This makes no sense to me, and I'll discuss why.
I prefer a different approach.
As a dividend growth investor, I plan not to sell any of my stocks in retirement and instead live solely off dividend income. By living off 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. If they're paying me increasing dividends, these raises usually come from increased earnings and revenue. If the dividends are not supported by such, then I would have to find different companies to invest in as the dividend would become unsustainable over time.
I view my portfolio as one large tree. It's a tree that produces bountiful fruit. Let's imagine it as a cherry tree. Each branch is a stock position. I currently have 28 positions in my Freedom Fund, so I have 28 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. When fruit is produced, I can take that fruit and use it to expand my garden or I can provide subsistence for myself (pay bills). Right now I'm expanding my garden, but one day I'll use those cherries and live off of them.
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 branches 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. But, over time that branch dies. And when it dies and disappears 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 eventually you are left with a barren tree that produces nothing.
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 have to repeat the selling process even more rapidly in the future to get the same results. With a proper dividend growth strategy, your cherry tree will only get bigger and stronger over time. It will eventually produce more cherries than you could ever possibly use! 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!
How about you? Are dividends your fruit?
Thanks for reading.
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