Living off dividends, cap gains and interest

[samclem]

"Income investors" need to be careful, they can be at higher risk than their "safe" approach might indicate. An article in today's WSJ points out some pitfalls:
-- A recent and unusual correlation between stock prices and dividends. The growth in investors hunting for dividends has pumped up the prices for high dividend payers==an likely asset bubble that will cause a significant loss in balances when the values reset. The drop could make up for many years of "safe high dividends" investors were expecting.

The correlation between the S&P 500 and the per-share earnings of its components fell to 0.55 at the end of June from 0.90 a year earlier. That relationship, while still mildly positive, was at its lowest since 2002, according to S&P Global Market Intelligence.
(Embedded graphic)

Over the past decade, the two had been highly correlated based on the traditional premise that the more companies earn, the higher their stocks should rise. But the breakdown is one sign that other factors are driving the market.

Enter dividends, which are finding favor among investors who are starved of yield in the fixed-income markets or who are looking for stocks that they see as less risky.
That’s elevated the link between the S&P 500 and dividend yields of its components, or the annual percentage of the share price paid out in dividend income for the 12 months through each quarter. The correlation was at 0.80 at the end of the second quarter, compared with its average of minus-0.1 since 1941. It had been negative as recently as September 2014, according to S&P.
(Embedded graphic)

-- Many companies paying increased dividends despite lack of earnings growth. To pump up stock prices, a response to the demand for high dividend stocks. Obviously unsustainable, will likely end badly

The link:Dividends Can’t Drive This Market Forever - MoneyBeat - WSJ

Add to this the "normal" issues with dividend-focused investment approach (typically highly focused in certain market sectors= uncompensated risk, etc)

TANSTAAFL

 

[Danmar]

Certainly agree that income oriented investors have to be careful about their div payers. It's one of the reasons I pick my own equities and don't rely on MF's or ETF's. Payout ratios are key and I follow these carefully. Other important metric is div growth. Working out for me.

 

[timemoveson]

Certainly agree that income oriented investors have to be careful about their div payers. It's one of the reasons I pick my own equities and don't rely on MF's or ETF's. Payout ratios are key and I follow these carefully. Other important metric is div growth. Working out for me.

That's me too. I use a high dividend ETF sparingly as an adjunct to the core strategy.

 

[fritz]

Hopefully, this question is enough 'on point' for this thread. (Can't find this specific subject via a thread search.)

When structuring ER income strategies, the question of taking as much income as possible within the 15% tax bracket often arises. Given that most of what I've read about the effectiveness of Roth Conversions hinges on what future tax rates (uncertain) will be, it seems to me that capturing Cap Gains @ 0% tax within the 15% tax bracket (certain) is a better move. Of course this depends on the structure of your investments but, it seems it would work for many.

Thoughts?

I always looked at it from the married couple perspective - taxable window for married couples' 15% tax bracket is much higher than when one of you dies and you're now taxed as a single person. For us - it's enough of a gap to pull larger amounts for Roth conversions safely within that 15% bracket.

 

[fritz]

"Income investors" need to be careful, they can be at higher risk than their "safe" approach might indicate. An article in today's WSJ points out some pitfalls:
-- A recent and unusual correlation between stock prices and dividends. The growth in investors hunting for dividends has pumped up the prices for high dividend payers==an likely asset bubble that will cause a significant loss in balances when the values reset. The drop could make up for many years of "safe high dividends" investors were expecting.

-- Many companies paying increased dividends despite lack of earnings growth. To pump up stock prices, a response to the demand for high dividend stocks. Obviously unsustainable, will likely end badly

The link:Dividends Can’t Drive This Market Forever - MoneyBeat - WSJ

Add to this the "normal" issues with dividend-focused investment approach (typically highly focused in certain market sectors= uncompensated risk, etc)

TANSTAAFL

We're 52% stock and 48% bonds (medium duration corporates yielding +2.25%)

 

[Totoro]

+1 on samclem

I have the impression that the new 'always win' strategy of 'everyone' is buying low beta dividend yielders. I guess due to comparing dividends with savings and bond yields + their success in coming through 2009.

Valuations there, consumer staples and discretionary essentially, are going up much more than the market it seems, creating a mini-bubble of sorts.

P&G, Pepsi, KO, Kraft, Kellogs are all pretty high up there, just like Nike, Starbucks, Yum, Dollar Tree, McD, ..

Yet another safe haven lost?

 

[Danmar]

+1 on samclem

I have the impression that the new 'always win' strategy of 'everyone' is buying low beta dividend yielders. I guess due to comparing dividends with savings and bond yields + their success in coming through 2009.

Valuations there, consumer staples and discretionary essentially, are going up much more than the market it seems, creating a mini-bubble of sorts.

P&G, Pepsi, KO, Kraft, Kellogs are all pretty high up there, just like Nike, Starbucks, Yum, Dollar Tree, McD, ..

Yet another safe haven lost?

Must be different in Canada. Don't own any of these names. I have Cdn names in banking, telco. Pipes. and utilities. My banks in particular have done very well over many years.

 

[kcowan]

I think there is general agreement amongst investment professionals that a total return approach is optimal, although there are many who embrace an income approach in retirement. Usual reasons cited include convenience, consistency, and often a sense that divs are in some way more reliable than earnings. But this is unlikely.

I can't stop myself from looking at total return and percentage payout from earnings once in a while, but that does not generate immediate action, just things to watch for an adjustment to mix.

 

[pb4uski]

Hopefully, this question is enough 'on point' for this thread. (Can't find this specific subject via a thread search.)

When structuring ER income strategies, the question of taking as much income as possible within the 15% tax bracket often arises. Given that most of what I've read about the effectiveness of Roth Conversions hinges on what future tax rates (uncertain) will be, it seems to me that capturing Cap Gains @ 0% tax within the 15% tax bracket (certain) is a better move. Of course this depends on the structure of your investments but, it seems it would work for many.

Thoughts?

For us, this will happen naturally as we are living on taxable accounts from ER at 56 until SS starts at FRA or 70... I liquidate equities in our taxable accounts each year and inevitably realize gains on those liquidations and then top them up to the top of the 15% tax bracket with Roth conversions.

But even if we had much more capital gains than I would realize before 70 I don't think I would focus on that... capital gains will likely continue to be at preferential rates.... I'm paying ~7% federal now on my Roth conversions vs 25% or more later so I'm saving 18%... more than the 15% I'll pay on capital gains later in life.

 

[pb4uski]

What I always have trouble understanding is that people save for retirement but then fear using principal.... that is what you saved the money for... to spend it in your retirement! IMO if you can live on just income then you probably worked too long and will have wealthy heirs.

 

[samclem]

Must be different in Canada. Don't own any of these names. I have Cdn names in banking, telco. Pipes. and utilities.

The two red flags to look for:
-- Are the PE10 ratios for your stocks higher than large market indices? Have they gone up a lot in the last few years?
-- Are companies paying out increasing dividends despite flat/decreasing earnings?

Canada is in the same low interest "punish the savers" environment as the US, it would be somewhat surprising if Canadian investors weren't also seeking higher dividend stocks--and maybe bidding them up considerably.

 

[marko]

What I always have trouble understanding is that people save for retirement but then fear using principal.... that is what you saved the money for... to spend it in your retirement! IMO if you can live on just income then you probably worked too long and will have wealthy heirs.

Speaking as a 'wealthy heir', "never touch the principal" was drummed into me since childhood. As a kid, I'd hear elders tsk-tsk-ing someone who had 'gone to the principal' and hear them wonder aloud 'what are they thinking?!' It was an embarrassment!

 

[Another Reader]

Speaking as a 'wealthy heir', "never touch the principal" was drummed into me since childhood. As a kid, I'd hear elders tsk-tsk-ing someone who had 'gone to the principal' and hear them wonder aloud 'what are they thinking?!' It was an embarrassment!

+1. Instruction from an early age was never to touch the invested principal. To do so was reducing the assets that produced the income and would eventually put you in a financial hole.

Of course, share buybacks weren't done much 60 years ago...

 

[samclem]

Speaking as a 'wealthy heir', "never touch the principal" was drummed into me since childhood.

But, if the companies are effectively cutting into principal (paying a dividend by neglecting R&D, marketing, etc) apparently there's no shame in spending that money.

 

[pb4uski]

+1. Instruction from an early age was never to touch the invested principal. To do so was reducing the assets that produced the income and would eventually put you in a financial hole.

Of course, share buybacks weren't done much 60 years ago...

But there is a huge difference between NEVER touch principal and sometimes touch principal and routinely touch principal. No one seems to be advocating routinely touching principal but if you touch principal in a bad year to me it is not the end of the world.

From 1976 to 2015 a 60/40 blend returned greater than 4% (assumed withdrawal) in 9 out of 39 (and sometimes only by a little bit) so if someone has a 60/40 portfolio, it will be rare that they would dip into principal, even with a 4% WR. An actually it would be rare that you would touch principal... more likely you would tap into prior undistributed income or unrealized gains.

https://www.mfs.com/wps/FileServerS.../data/news/mfse_bal_wp&servletCommand=default

 

[omni550]

Since we are discussing the "never touch the principal" concept, could someone please define what constitutes "the principal"? I've never been clear on this. At what point in time is "the principal" defined?

omni

Save
Save​

 

[hesperus]

'Principal' to me is cashing out one or more of the securities we hold.

We also have been living purely off dividends, haven't ever touched principal in the five years I've been ER'd. Haven't yet taken my pension and SS yet, either. In fact we only use about 30% of the divs/cap gains we generate, the rest goes right back in thru auto re-invest. We have also kept a mid six figure cash balance (@1%) to be available for various things, ie perhaps an additional home purchase, or rental property.

 

[Montecfo]

Since we are discussing the "never touch the principal" concept, could someone please define what constitutes "the principal"? I've never been clear on this. At what point in time is "the principal" defined?

omni

Save
Save​

I suspect folks here would not share a single definition. Classically your principal is the original amount invested. So spending net gains does not invade it.

Objectively, your "return" has both dividends and cap gains as components. I get wanting to "live off the dividends" (and I saw the comments about seeking to as a game ). However, as a total return investor, I would not expect my portfolio to "yield" 3-4%+ overall in dividends and interest. Nor would I seek it to.

To the point about dividend growth investing being in a mini-bubble, there is certainly evidence to that effect. Very crowded strategy.

Good Investing!

 

[pb4uski]

'Principal' to me is cashing out one or more of the securities we hold.

We also have been living purely off dividends, haven't ever touched principal in the five years I've been ER'd. Haven't yet taken my pension and SS yet, either. In fact we only use about 30% of the divs/cap gains we generate, the rest goes right back in thru auto re-invest. We have also kept a mid six figure cash balance (@1%) to be available for various things, ie perhaps an additional home purchase, or rental property.

If you're looking for heirs, I'll volunteer.

 

[mpeirce]

'Principal' to me is cashing out one or more of the securities we hold.

I suspect folks here would not share a single definition.

Classically your principal is the original amount invested. So spending net gains does not invade it.

Investopedia defines it thus:

Original Investment
Principal is also used to refer to the original amount of investment, separate from any earnings accrued. Assume you deposit $5,000 into an interest-bearing savings account, for example. At the end of 10 years, your account balance has grown to $6,500. The $5,000 you initially deposited is your principal, while the remaining $1,500 is attributed to earnings.


Of course their example doesn't help clarify the case of owning stocks or mutual funds.

I've often heard people say something along the lines of "I live of the dividends and never touch the principal" which points toward never selling the underlaying shares of stock.

The real question in my mind is how view the capital gains. Maintaining the number of shares won't necessarily work if there are splits. And yes, buy backs complicate this.

If it's just a dollar amount that seems wrong too. - I've actually paid for my DS's entire college education from $3,000 of AAPL stock I bought in the 90's. BUT SINCE I HAVE MORE THAN $3,000 LEFT IN THAT ACCOUNT, "I NEVER TOUCHED THE PRINCIPAL!" Nope.

So my take is that it's a pretty plastic term that can be used to support a wide variety of behaviors. i.e. not particularly useful.

 

[scrabbler1]

For me, the principal is the big blob of money which bought shares of the various bond and stock funds which generate monthly or quarterly income used to cover my expenses while providing a surplus or cushion to cover me for small, unforeseen expenses. If I sell principal, I am selling shares which are used to generate that income.


That being said, I have a slush fund containing shares of a bond mutual fund whose relatively small monthly dividend income is not used to cover my expenses. That's my "Tier 2" emergency fund I tap into once in a while to cover larger, unforeseen expenses the regular monthly surplus can't cover.

 

[Tadpole]

Although it isn't really principal, I always consider my retirement day savings as the amount I want to preserve.

 

[Another Reader]

Principal is not just an arbitrary dollar amount or number of shares you own at some starting point in time. Capital gains become part of your principal. That's how wealth is built. You own a small piece of a business. You spend some or all the income the business produces. Your capital gains go back into the business (or another business) to produce more income.

Businesses allocate capital. Good businesses allocate capital relatively efficiently. When they have met their capital needs to preserve and grow the business, the remaining cash is either retained for future spending or distributed as income.

As a shareholder, I take on business risk to generate income to eat and have a roof over my head. I can take on a lot of risk in hopes I own the next Google that I can sell parts of at some future date for a big pile of money. Or I can invest and reinvest in a business that's likely to produce the income I need while growing to produce more income in the future.

 

[Another Reader]

"Investopedia defines it thus:

Original Investment
Principal is also used to refer to the original amount of investment, separate from any earnings accrued. Assume you deposit $5,000 into an interest-bearing savings account, for example. At the end of 10 years, your account balance has grown to $6,500. The $5,000 you initially deposited is your principal, while the remaining $1,500 is attributed to earnings."

And if you buy a $6,500 CD at that point, that's your new principal.

 

[samclem]

As a shareholder, I take on business risk to generate income to eat and have a roof over my head. I can take on a lot of risk in hopes I own the next Google that I can sell parts of at some future date for a big pile of money. Or I can invest and reinvest in a business that's likely to produce the income I need while growing to produce more income in the future.

Yes. The market rewards the first business type (growth stock) at some times, and rewards the second type (typically a value stock) at other times. If a total return investor owns a wide variety of both types and sells each year to support income needs while being careful to not deplete the underlying shares, it could be just as responsible, sustainable, and more stable than constructing a narrower portfolio to optimize dividend returns in order to support spending.