The Ultimate Dividend Playbook

Income, Insight and Independence for Today's Investor

Josh Peters

• Publisher: Wiley
• Year: 2011
• Print ISBN:
  9780470125120
• eBook ISBN:
  9781118045046
• Edition: 1
• Topic: Personal Development
• Subtopic: Personal Finance

Many people believe that the key to success in the stock market is buying low and selling high. But how many investors have the time, talent, and luck to earn consistent returns this way? In The Ultimate Dividend Playbook: Income, Insight, and Independence for Today's Investor, Josh Peters, editor of the monthly Morningstar DividendInvestor newsletter, shows you why you don't have to try to beat the market and how you can use dividends to capture the income and growth you seek.

1

Income? From Stocks?

CONGRATULATIONS ARE IN order! If you’ve picked up this book, you probably have some money to invest. Perhaps you’ve just retired with a couple of hundred thousand dollars, maybe even a million or two. Funny thing about money, though: It doesn’t come with instructions. Television commercials for the Wall Street Journal in the 1980s used this line to suggest that the Journal was the next best thing. I appreciate the Journal’s insightful missives as much as anyone. For the most part, though, you and your money are largely on your own.

Whether your accumulated savings are large or small, we can begin by asking what you want from the money. “To get rich” is a straightforward and honest answer, but it may not quite get to the heart of the matter. Fortunes have been and will be made by investors who can outguess the market, especially with large quantities of other people’s money. It’s also true that very few of us will reach the ranks of the superrich. Even on Wall Street, there’s only so much dough to go around.

Then again, it’s not necessary for one’s investments to generate fantastic fortunes. Buying groceries, paying the gas bill, taking a vacation now and again—these are the bread-and-butter activities of Main Street, both before retirement and after. The goal of saving and investing, then, is to replace the paychecks earned by the sweat of your brow with paychecks from your investment portfolio. Income—steady, reliable, predictable, and rising income—is the objective.

Portfolios: Piles and Flows

There was a time, a generation ago or thereabouts, when the average working stiff didn’t have to think too hard about retirement. We were thriftier back then, with a lot fewer financial choices. Savings went into passbook accounts that paid 5 percent interest. Paying off the mortgage was a well-earned cause for celebration. The boss took care of retirement income, through defined-benefit pension plans. And whatever the pension couldn’t cover, Social Security and a modest accumulation of savings would.

Though held in derision and contempt today, defined-benefit pensions plan were reasonably well suited to the needs of the average worker and retiree of the time. Only a tiny proportion of the American public is trained in investment analysis and portfolio management. We all memorized the state capitals and learned how to dissect frogs, but they didn’t teach much (if anything) about personal finance in school. Having employers and their investment managers take responsibility for investment decisions made a lot of sense. Leaving asset-allocation and security-selection decisions to the professionals allowed ordinary folks to concentrate on their jobs and personal lives.

Of course, defined-benefit pensions had significant drawbacks; this is why they’ve all but disappeared from the private sector. When an employee changed jobs—a phenomenon that became much more frequent in the 1980s and 1990s—accumulated pension benefits would stay with the original employer, usually at a sharply diminished value. The monthly pension benefit in retirement was typically fixed, meaning its purchasing power would shrink over time because of inflation. And if the employer went bankrupt, retirees could find their monthly pension checks slashed.

In the early 1980s, a new vehicle came along to replace defined-benefit pensions: the defined-contribution plan, most frequently in the form of a 401(k) account. Defined contribution describes these plans perfectly: The only known factor is how much money is put in; no one guarantees any particular amount of money the beneficiary will one day take out. Employees, not employers, are responsible for saving. Employees, not employers, determine how these savings are invested. And retirees, not the former employers, have to figure out how to turn accumulated assets into income. In fact, 401(k) plans are often lauded for providing employees with the freedom to choose their own investments. But no freedom exists without responsibility—a responsibility few people are adequately trained to shoulder.

In addition to shifting the responsibility for saving and investing from boss to worker, 401(k) plans changed the focal point of retirement planning. The defined-benefit plan was all about flows of cash—the pensioner’s monthly check. The worker might receive a statement of benefits showing how much he was eligible to collect; translating this into a budget was easy. The value of the assets in the plan that would provide these payments was not terribly relevant and was rarely of interest to the beneficiary. The 401(k) plan, by contrast, shows you every three months how much you’ve accumulated—the emphasis is on the size of the pile. Someone close to retirement might have a statement balance of $500,000, but how much of the pile can be safely extracted each month is a matter of guesswork.

Living Off the Pile

Let’s all say hello to Sally, who has just retired with $500,000 worth of savings in her 401(k) account. Her situation is not too different from millions of newly retired Americans, possibly even you. Sally’s expenses are manageable, especially after taking Social Security income into account, but she still figures to draw $30,000 worth of cash from her portfolio every year.

Sally’s account is invested in a handful of stock mutual funds. Over the past 20 years, these funds have done a wonderful job helping her accumulate this $500,000 balance. Assuming that her mix of funds mirrors the industry average, they provide very little dividend income: a yield of about 1 percent, or $5,000 annually. Not much more than a rounding error in the big scheme of things, these dividends have always been reinvested automatically. To generate income—or at least cash flows that look like income—Sally plans to sell off $30,000 worth of mutual fund shares every year.

This is a strategy we might call living off the pile. Sally is implicitly assuming that her portfolio will grow more valuable over time, enough that drawing $30,000 a year out of the account won’t actually cause its value to fall. If her savings were simply dollar bills stuffed in a mattress (earning an investment return of zero), she’d run out of money in less than 17 years. But Sally knows, or thinks she knows, that the stock market returns 10 percent a year on average. A 10 percent gain for a $500,000 portfolio means an annual dollar increase of $50,000. Even after taking out $30,000, Sally figures she’ll still be $20,000 ahead at year-end.

This rising balance is important to Sally because she’s counting on being able to draw more money out of the account next year and still more the year after that. Like anyone, she’s feeling the effects of inflation—at the grocery store, the gas pump, the car dealership, you name it. As the cost of living rises, her portfolio withdrawals will have to grow. If inflation runs at 3 percent annually, that $30,000 withdrawal in year one will have to rise to $30,900 in year two, $31,827 the year after that, and so on.

Fooling around with a spreadsheet, she makes five-year projections based on 10 percent portfolio returns and a $30,000 withdrawal that grows 3 percent annually, as shown in Figure 1.1.

Figure 1.1 Living Off a $500,000 Pile: Projected Balances and Withdrawals

On the surface, this doesn’t seem like a bad strategy. It does assume a 10 percent return from stocks—a bit higher than I think the market is capable of over the long run, as I show in Chapter 5. But even though Sally’s withdrawals rise with each passing year, her account balance is rising faster. Maybe she can take even more than $30,000 annually out of the account and add exotic travel to her plans. At the very least, it provides a bit of room for the market to fall short of a 10 percent return without blowing up her portfolio.

Hearing of Sally’s strategy, I should introduce her to this fellow I know. His name is Mr. Market.

Meet Mr. Market

Even though the market is made up of millions of individual buyers and sellers, it forms something of a collective consciousness of its own. Ben Graham, the father of value investing, understood this when he suggested the character of the mythical Mr. Market. He’s the guy on the other end of your stock trades. When you buy, it’s his shares you’re buying. When you sell, you’re selling to him. Every moment of every trading day, Mr. Market can be found quoting prices for publicly traded stocks.

To understand Mr. Market, we must begin with the premise that price and value are distinct concepts. On Wall Street—as with any economic transaction—price is simply what you pay, but value is what you get in return. The value of a stock is a function of its capacity and propensity to return cash to its owner. Were Mr. Market a steady, reasonable man, his price offers would reflect these future cash returns perfectly. A $1,000 investment today would provide $1,000 worth of value, no more and no less.

But Mr. Market is not what you’d call a steady business partner. An incurable manic-depressive whose actions define the words fear and greed, Mr. Market will offer ridiculously high prices for a given stock at one point and insanely low prices the next. Mr. Market is the guy who does most of the obsessing about quarterly earnings, economic reports, and so-called technical trends in stock prices. Does anyone really believe that the value of large, well-established, profitable businesses should change 50 percent or more over the course of a year? But Mr. Market’s prices fluctuate that widely all the time.

So who’s in charge of your money, you or Mr. Market? No one wants to admit to being in Mr. Market’s thrall, but the observed collective behavior says otherwise. Rather than buying low and selling high, we see the market’s individual participants doing the opposite: buying high and selling low. These are the ancient and ineradicable emotions of greed and fear in action. And if you’re interested in seeing what this Mr. Market fellow looks like, you might want to check a mirror. There’s at least a bit of him in all of us.

I’m not sure that most of us are prepared to engage Mr. Market, even if the odds can—through great effort—be tipped in the investor’s favor. As with any active strategy, the onus of the buy-high-and-sell-low approach is on the stockholder, not the stock. The investor does the bulk of the work to earn his expected return; whatever the underlying business may be up to is of secondary importance. And at the end of the day, success or failure will be measured when the stock is sold: that is, success or failure depends on Mr. Market’s attitude shifting from gloom to glee.

Sally and Mr. Market

This volatility is not necessarily a problem. This year’s drop leads to next year’s rebound; those who hang on to investments in good companies will be fine. Indeed, the investor who has the ability to add money consistently—whether stock prices are high or low—will wind up with more shares, lower purchase prices, and higher returns than a portfolio without inflows. This is a financial phenomenon known as dollar-cost averaging, and it’s a terrific tool for growing and compounding wealth. (See accompanying box.)

But Sally’s investment strategy is about to change dramatically. Every year, Sally will have to sell shares to generate cash. If prices are high, she’ll have the luxury of selling fewer shares and leaving more money working for her financial future. If prices are low, she’ll have to sell many more shares at lower prices to generate the same amount of cash. As a result, her selling prices will be lower than the average level of the market. She’s still going to be dollar-cost averaging, all right—dollar-cost averaging in reverse.

Dollar-Cost Averaging

Stock prices fluctuate. Even watching a stock for a couple of minutes...

Table of contents

• Title Page
• Copyright Page
• Acknowledgments
• Introduction
• Chapter 1 - Income? From Stocks?
• Chapter 2 - Dividends, Values, and Returns
• Chapter 3 - Corporations: Dividend Machines
• Chapter 4 - Dividend Insight
• Chapter 5 - Dividends Past, Present, and Projected
• Chapter 6 - Is It Safe?
• Chapter 7 - Will It Grow?
• Chapter 8 - What’s the Return?
• Chapter 9 - Independence
• Chapter 10 - Managing a Dividend Portfolio
• Chapter 11 - The Future of Dividends"
• Epilogue
• Appendix 1 - The Nuts and Bolts of Dividend Payments
• Appendix 2 - Dividends and Taxes
• Appendix 3 - Banks
• Appendix 4 - Utilities
• Appendix 5 - Real Estate Investment Trusts
• Appendix 6 - Energy Partnerships
• Appendix 7 - Other Dividend Opportunities
• Index