Dividend Growth Investing: Creating Your Own Dividend By Selling Shares (Part 1)

by: David Crosetti

Summary

Many investors use the stock market to create wealth and allow them to eventually fund their retirement years.

Traditional retirement advice suggests that an investor can fund his retirement by selling stock in his portfolio to create income.

But what happens when the markets correct? Can selling shares be different from "getting a dividend?"

Introduction:

David Van Knapp recently wrote an article, "Why Selling A Few Shares Is Not The Same As Getting A Dividend." The article generated a lot of discussion and some of it was pretty heated. I don't think that anyone will find the comment stream less than interesting, though.

I have to admit that the comment stream got a little offtrack, relative to the points being made in the article. But that often happens when a comment stream grows as quickly and as large as this one did.

Having a few days away from the article, I began to think about what David was suggesting and after looking at my own retirement portfolio, I began to appreciate his article so much more than I did during my initial read.

Van Knapp takes the position:

  • It is commonly stated that one can create his own dividend by selling a few shares.
  • Likewise, it is said that receiving a dividend is the same as lowering your investment in the company that sent it.
  • Both notions are false.

What I Know:

A Dividend Growth Investor would be an individual who purchases stock in companies that pay and increase their dividends annually. It is an investment strategy that seems to generate a lot of excitement for people, in that there are many proponents and many opponents of the strategy. And both sides are rather passionate about their own particular beliefs pertaining to the value of DGI.

One criticism of DGI is that seems to come up often is that many DGI don't use a "benchmark" to judge their portfolio performance. This bothers a lot of folks, but in reality, a DGI portfolio is not about beating a benchmark. It's about creating an income stream.

From my own perspective, it's also about eliminating the element of concern over portfolio value. As a DGI, I don't worry about the value of my portfolio as I am more concerned about the growth of my income from the portfolio. This is seemingly contrary to "common sense" for many investors, but I want to take some time here to illustrate exactly what I'm talking about.

So, I spent a little time looking at a DGI approach to funding retirement and a non-DGI approach. Traditionally, the financial advisors have come up with what is known as the 4% Rule. This is a retirement plan that suggests an investor sell 4% of his portfolio to fund retirement as long as the portfolio grows at a rate that is larger than the 4% draw down, the investor should see his money outlive him. Seems like a good idea.

So let's say that an investor has been diligently saving money; investing in his company 401k plan; and funding his own Roth or IRA plan on top of all that. This investor has amassed a portfolio worth 1 million dollars and he is getting ready to retire. His plan is simple. He is going to sell a portion of his portfolio every year to fund his retirement needs.

What You Should Know:

None of us have a working crystal ball. We might have a crystal ball someplace in the house, but it does not predict the future very well. But, what we do have is the internet. So we can construct a snapshot of time, from which we can look at a scenario or two that would represent a historical occurrence.

What's I've done is to take a hypothetical investor, with a 1-million dollar portfolio and created a table that does the following:

  1. We establish a starting point.
  2. We have established an annual financial expectation
  3. We have established a benchmark as our scorekeeper.

So, What Does Our Retirement Look Like?

Well, let's see. Our investor has a million-dollar portfolio. He has been planning to retire for some time now, and that moment is upon him. Markets have been doing well and his portfolio has grown nicely. Our investor needs $40k a year to fund his retirement. His plan is to sell enough stock in his portfolio every year to capture that $40k, then allow the growth that he expects from the stock market (for the remaining stocks in his portfolio) to restore the money that he pulled out of his portfolio in the first place.

Since our investor has a concern about inflation, he has decided to increase his annual withdrawal from his portfolio by 4% a year. So, for example, in year one, he will withdraw $40k. In year two, he will withdraw $41.6k and so on, each year.

So, let's take a look at our results. The investor takes his first "withdrawal" in January of 2000. He begins the year with a million dollars, takes 4% (which is $40k), and has a remaining balance of $960k, which he is going to leave invested in the market and allow that money to grow and replace the $40k that he took out of his portfolio. How did that work out for our investor?

Well, the SP500 has three years, 2000-2002 that were an absolute disaster. But, we all know that "things happen" and that there is no guarantee in the market that things will always go up. I guess what we have here is a "timing issue" and unfortunately, our timing was not very good.

We probably should have waited an additional three years before retiring and then, even with 2008 and 2011, out plan would have worked out much better than this one did. I mean, we could have waited an additional three years to retire, right? I mean, something should have warned us about a market correction that was coming, right? But we just didn't know.

Now, it's 2014 and we have a problem. We have only $65,851 left to use to live on in 2015. Out problem is that our needs are $69,267 and we are short. While we do not know where the benchmark is going to take us this year, we do know that year-to-date, the SP500 is up 1.6%. What are we going to do to make up the shortfall? We can't go back and change our withdrawal rate. We can't change what happened in the market.

What You Should Know:

Let's go back to that "crystal ball" again, shall we? Had our investor known that there would be a market melt-down (use your own terminology) in the 2000-2011 calendar years, perhaps he would have not retired at the end of 1999.

If our investor was able to use a "crystal ball" to see that 1998 would have been a better time for him to retire and even with the 2000-2011 market results, his position would have been much better today, I venture to say, had he the good fortune to have "retired early." Looking at that choice, here's where he would have been today.

Well, in this scenario, our investor retires in 1998 (December 31st). In January he withdraws $40k and in 1999, the benchmark (thank goodness) grows 19.53% and his 1-million dollar portfolio has grown to $1.147.5 million. Ok, that's better. Now we're working, here.

But, the 2000-2002 market correction is still going to happen. Just because we changed the chart by giving our investor a "head-start" with a 19.5% jump, doesn't make the picture all that much more comforting moving forward from 2014.

Our investor at the end of 2014, with the market matching current y-t-d performance is going to leave him with $263k in December of 2014 and his need for income in 2015 is going to be $74,919.

After he takes that income, he is only going to have $189k left over and he is going to be leaving that money to the whims of the market. None of us know if the market is going to be up or if the market is going to be down as we move forward. None of us know when the "best time" to retire with this strategy might occur. Is it this year? Next year? Is it the year after that?

Maybe We Should Have Postponed Retirement?

The market correction of 2000-2002 was "seen" by out intrepid investor. He had a clairvoyant moment where he just knew that retiring in 2000 was just not a "good idea." So he stuck it out at a job he hated, with a culture of rewarding younger workers and making life as miserable as possible for older workers and in the end, with his new results, he is the one laughing all the way to the bank. Good for our intrepid investor!

How has he faired?

Well, thank goodness his first 5 years of retirement were good ones as far as his benchmark went. Even with withdrawing money annually, his 1-million dollar portfolio grew to $1.4 million by the end of 2007.

But then 2008 rolled around and that had to be a real bummer. The portfolio "dropped like a rock," but hopefully our investor has a strong stomach and did not sell out his portfolio at the bottom of the market.

If he held on, he was rewarded with great results in 2012 and 2013. His portfolio prospered and for now, at least, everything looks peachy-keen for our investor. But does he or any of us really know what the future is going to bring?

We gave this investor 3 kicks of the can in order to achieve a result that was more in keeping with what he might hope for as results. But we all know that life does not always give us 3 kicks at the can and that things don't always work out the way that we had hoped for.

Conclusion and Summary:

No one can predict the future. If they could, think of all the psychics that would be in Las Vegas and playing Roulette all day. There are many articles out, today that suggest the market is ready for a correction. There are just as many articles that suggest that the market is doing just fine and dandy. In the end, we have little or no idea where it's headed.

The notion of creating your own dividends with the sale of portions of your portfolio is an attractive idea, looking at it from a distance. It's once you get up close and personal that you begin to see some flaws in the idea.

I am not suggesting that it "can't be done," but it would seem to me that there is a better way to accomplish the goal, besides selling your portfolio off a piece at a time.

The concern that many investors share is the concern about portfolio value. A market correction that runs three years can significantly reduce the value of your holdings and at the same time, shake your confidence to continue investing in the stock market.

When you rely on your portfolio value to increase year-over-year and then the market turns on you, it can be devastating. I know a lot of investors who have had to postpone their retirements because of the "bath" they took 2000-2002 and again in 2007-2008.

There might be a better way. In our next article, we'll examine the situation for Investor B. See you then, I hope.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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