Dividend Stock Portfolio Provide Higher SWR?

[headingout]

I'm approaching FIRE and pondering the best way to turn my investments into an income stream. Currently I have a well-diversified portfolio of low-cost mutual funds: about 45% stocks, 55% bonds/cash. The current yield across my portfolio is about 3%. I assume I could take a total return approach and cull dividends plus sell/rebalance as needed to draw approximately 4% from this portfolio indefinitely.

However, I also see that it is possible right now to build a somewhat less diversified portfolio (mostly energy, utilities, financials) of several dozen good quality dividend-paying stocks and average a yield of 5-6%. Presumably such an equity-based portfolio would be inflation protected, and could support a withdrawal rate of 5-6% with no threat to principal.

So what's the catch? The lack of sector diversification could be an issue if I had to sell at a bad time, but this is about income. Is it that those dividends aren't guaranteed and could go down substantially? If so, what's the evidence for that? Is it that these kinds of stocks, or their dividends, actually don't keep up with inflation?

Bottom line: why don't quality dividend stocks yielding better than 4% let you increase your SWR?

 

[haha]

Bottom line: why don't quality dividend stocks yielding better than 4% let you increase your SWR?

If you believe in MPT you have to reject any approach such as this as naive.

OTOH, if you reject MPT, you may have a good plan.

Ha

 

[MichaelB]

You are assuming that current high dividend payers are quality and will increase the dividend rate along with inflation. I don't know if that assumption is good or bad, but I have not seen any data or studies anywhere to support it. Companies that do have track records of increasing dividends at or better than inflation have current yields in the 2% to 4% range.

 

[grumpy]

Bank of America used to be considered a solid stock with a nice dividend. Then the financial meltdown hit, they discontinued the dividend and the share price plummeted.

I own shares of 20 high dividend payers with a composite yield of just under 5%. But this just provides me a nice annual increment above my other income sources. I would not sleep well at night if my FIRE lifestyle were totally dependent on that income.

 

[Zathras]

There is always a risk a dividend could go down, and lack of diversification is always a risk.
Some dividends are safer than others. So another 'catch' is that you should do a fair amount of research into the companies you are considering. What is their history of paying and raising their dividends? Do they have the cash flow to maintain their dividend? How much debt do they have? These are just a few of the questions a dividend investor is interested in.
In general, the income stream from dividends is much more stable than the day to day fluctuations in the stock value. During the recent financial crash, a number of financial companies drastically reduced or even eliminated their dividends. However, many othe companies held theirs steady through the recession and some even continued to raise theirs.
MOST companies dividends increases easily surpass the rate of inflation. But again, there is no guarantee.

 

[Onward]

Dividends can be cut or suspended, and it's usually when you need them most. Dividend lovers piled into financials in 2006-07. Ouch.

 

[LOL!]

It's all explained in this: https://institutional.vanguard.com/iip/pdf/WP_TotalRet.pdf
Among other reasons to use a total return approach instead of a dividend approach: LT capital gains are taxed less than dividends.

 

[lowflyer]

That investment approach does have some merit and works well at times. In the past couple years, of course, even a portfolio of "high quality" dividend stocks took a significant hit. For years, the idea of an electric utility company cutting its dividend was unthinkable, but now it's a reality. I opt for a diversified mix, but do lean in the direction you describe.

 

[Zathras]

... In the past couple years, of course, even a portfolio of "high quality" dividend stocks took a significant hit.

While "some" high quality dividend stock portfolios may have taken a hit, not all did. If diversification was lacking, the portfolio definitely took greater risks. However the income stream of some portfolios consisting of high quality dividend payers took no loss, while some continued to grow.

 

[Marc1962]

It's all explained in this: https://institutional.vanguard.com/iip/pdf/WP_TotalRet.pdf
Among other reasons to use a total return approach instead of a dividend approach: LT capital gains are taxed less than dividends.

Fascinating article - thank you!

 

[teejayevans]

Wasn't BP consider one of those "solid" dividend stocks?
TJ

 

[clifp]

It's all explained in this: https://institutional.vanguard.com/iip/pdf/WP_TotalRet.pdf
Among other reasons to use a total return approach instead of a dividend approach: LT capital gains are taxed less than dividends.

Currently dividends are taxed at same rate as LT Capital gains. This expires at the end of the year but there is bipartisan support for maintaining the favorable tax treatment

While "some" high quality dividend stock portfolios may have taken a hit, not all did. If diversification was lacking, the portfolio definitely took greater risks. However the income stream of some portfolios consisting of high quality dividend payers took no loss, while some continued to grow.

Actually, I think it was very difficultto have a well diversified portfolio of 20+ dividend stock and not have some dividend cuts in the last couple of years Q4/2008 and Q1/2009 were the first quarters since S&P has been tracking dividends that number of dividend cuts exceeded the increases. Since increases are typically a 2%-10% range while cuts are 50%+ cuts matter way more than increases. In Q1/2009 alone S&P reported 77 billion worth dividend cuts.

In addition, to all of the banks, several of the REIT I owned slashed dividends, plus GE, Pfizer and oil refining/pipeline company. Among other companies I didn't own Dow Chemical, Fortune brands, (Liquor distributor), Cedar Fair (amusement parks) and hundreds more in wide variety of industries slash dividends. To me the far most important lesson of the crisis is that in bad times dividends definitely get slashed. That being said I haven's seen any evidence that dividend stock prices fell any more (or less) than non dividend stocks over the last couple of years.

 

[Zathras]

Wasn't BP consider one of those "solid" dividend stocks?
TJ

It may have been for some.
I apologize if I was unclear. I did not intend to give the impression that there are no companies that cut or wiped out their dividends. Just that there were more than enough companies that continued to raise their dividends such that many well diversified dividend portfolios kept their income steady or increased it during the recession.

 

[LOL!]

Currently dividends are taxed at same rate as LT Capital gains. This expires at the end of the year but there is bipartisan support for maintaining the favorable tax treatment

I think you meant qualified dividends. Not all dividends are qualified.

 

[CyclingInvestor]

My retirement is financed entirely by a portfolio of (IMO) high-quality, dividend paying stocks, with an average yield of about 3.1%. I follow a universe of about 25-30 stocks with the characteristics I like in terms of financial stability, long term dividend and earnings growth, good management (IMO), etc. The highest yield of any of them at the moment is JNJ at 3.6% and SYY at 3.5%. All with higher yields are (IMO) too risky or are projected to grow too slowly for my needs.

 

[Zathras]

...
Actually, I think it was very difficult to have a well diversified portfolio of 20+ dividend stock and not have some dividend cuts in the last couple of years Q4/2008 and Q1/2009 were the first quarters since S&P has been tracking dividends that number of dividend cuts exceeded the increases. Since increases are typically a 2%-10% range while cuts are 50%+ cuts matter way more than increases. In Q1/2009 alone S&P reported 77 billion worth dividend cuts.
...

I agree it would have been VERY difficult not to have any cuts.
I also agree that the cuts are, the vast majority, of the time, much more than the increases. However, I still hold that many well diversified dividend paying portfolios held their own during the recession (in terms of income stream).
While companies such as GE, FO and USB slashes their dividends, companies such as KO, JNJ, MMM, PG, LLY, SYY, KFT, GGG, MCD and many others continued to raise theirs.

If someone was completely in financials, or even a majority, sure they got slammed. But I wouldn't call that well diversified.

 

[lowflyer]

However the income stream of some portfolios consisting of high quality dividend payers took no loss, while some continued to grow.

I guess I was also thinking about the stock price and overall return, but back to the point of the OP, a key factor, as you suggested, is a good, diversified blend of dividend-paying stocks. That concept seems to be gaining in popularity these days...

 

[photoguy]

Since money is fungible what matters is total return (and taxes).

I've just skimmed the following paper, but my reading of it suggests that dividends (dividends / price) is suboptimal compared to buying stocks according to Book / market, earnings/price, or cash flow / price because you get lower returns (through a lower value premium).

http://www.honorvise.com/web/images/stories/papers/defining value and growth.pdf

 

[Marc1962]

Currently dividends are taxed at same rate as LT Capital gains.

The nominal rates are the same, but this paper explains why dividend yield is much less tax-efficient than capital gains:

https://institutional.vanguard.com/iip/pdf/WP_TotalRet.pdf

 

[traineeinvestor]

My retirement is financed entirely by a portfolio of (IMO) high-quality, dividend paying stocks, with an average yield of about 3.1%. I follow a universe of about 25-30 stocks with the characteristics I like in terms of financial stability, long term dividend and earnings growth, good management (IMO), etc. The highest yield of any of them at the moment is JNJ at 3.6% and SYY at 3.5%. All with higher yields are (IMO) too risky or are projected to grow too slowly for my needs.

This is similar to the approach which I will be taking with around half of my retirement portfolio (the other half will be rental income from properties). I agree that considerable care needs to be taken in reaching for higher yield and that a large portfolio of diversified stocks is needed.

I would also argue that the universe of stocks for inclusion in such a portfolio is not static and needs constant review. Companies that have a track record of being payers of good and rising dividends don't always continue to do so. Every downturn results in several "dividend aristocrats" reducing their dividends or cutting them alltogether. Erich Beinhocker gives a good explanation of the reasons why companies rise and fall in The Origin of Wealth. One of the takeaways I took from that books was that I should not expect to hold many of my stocks for very long periods of time.

As part of the strategy, having a portfolio of cash and short term investments large enough to ride out any down turns to avoid the need for forced sales to fund any shortfall in dividends is IMHO quite important.

As the much maligned Jim Cramer says "buy and hoemwork not buy and hold".

 

[kumquat]

Having read the first several posts and skimmed the rest, is this a case of the tax-tail wagging the investment-dog? If not, please ignore the rest of this.

Disclaimer:
I'm Canadian and there is a very clear tax advantage to get one's income from "dividends from Canadian sources".

I'm trying to build a portfolio of Canadian dividend payers to keep my taxes at a minimum and to smooth out the yield of CG and (near zero) interest on anything.

Bottom line: why don't quality dividend stocks yielding better than 4% let you increase your SWR?

I think I had a answer to that recently. Unfortunately, I forgot what it was.

 

[Ronnieboy]

My goal would be to have about 30 to 40 companies at the most, to be well diversified. With enough $$ holdings to generate about $40k annually to cover fixed expenses. Separate savings to generate some more monies for the extra curricular activities.
I would hope that having some kind of buffer (bucket system) would help in surviving any down trend in dividend cuts. Something like 3 yrs annual expenses in cash holdings and the dividends replenishing the bucket.

 

[jebmke]

It's all explained in this: https://institutional.vanguard.com/iip/pdf/WP_TotalRet.pdf
Among other reasons to use a total return approach instead of a dividend approach: LT capital gains are taxed less than dividends.

And if you were aggressive in doing tax loss harvesting in 2008/9 you might be able to run a long time with no tax on gains taken in the future.

 

[clifp]

While "some" high quality dividend stock portfolios may have taken a hit, not all did. If diversification was lacking, the portfolio definitely took greater risks. However the income stream of some portfolios consisting of high quality dividend payers took no loss, while some continued to grow.

Well lets look at some dividend portfolios.
Vanguard Dividend Appreciation ETF (VIG)
Q1 2009 distribution $.2706
Q2 2010 distribution $.25

Vanguard High Yield Dividend ETF (VYN)
Q1 2009 $.31
Q2 2010 $..273

iShare Dow Jones Dividend Index fund (DVY)
Q2 2008 $.631
Q2 2010 $.425

I am glad I went through this exercise cause now I don't feel so bad about my 10-12% in dividend income.

 

[clifp]

The nominal rates are the same, but this paper explains why dividend yield is much less tax-efficient than capital gains:

https://institutional.vanguard.com/iip/pdf/WP_TotalRet.pdf

This is a good paper and while I had some quibble with methodology. Primarily they are looking a portfolio of dividend focused mutual funds as opposed to a portfolio of dividend stocks it isn't that important.

However the conclusion is also important.

In conclusion, the total-return approach to spending
is identical to the income approach for investors whose portfolios generate enough cash flow to meet their spending needs. For those investors
who need more cash flow than their portfolios yield, the total-return approach is the preferred method.

In my case like possibly yours were are talking about very early retirement. Such that I was felt it was more prudent rather than withdraw X% a year, to restrict spending to the amount of interest and dividends earned in year (with a cushion and some flexibility.) The growing dividends would act as an inflation hedge. This approach was working great up until 2008, when the combination of dividend cuts and dramatic decrease in interest rates, reduced current income to slightly below spending needs.