Retirement: The Rule Of 72, And The 'Income Method'

Jan. 26, 2020 9:35 AM ETAMZN, ANGI, ARQL, AVHHL, DDRX, META, GOOG, GOOGL, IMBBF, IMBBY, M, NFLX, PCG, PDI, PTY, RCEL, SPY, TSLA, VET, VET:CA264 Comments87 Likes

Summary

  • The Rule of 72 is a basic mathematical formula to determine the approximate doubling time of various items.
  • We use this tool to find our desired portfolio yield as income investors.
  • Core holdings and opportunistic purchases together can generate your desired income stream.
  • Looking for a portfolio of ideas like this one? Members of High Dividend Opportunities get exclusive access to our model portfolio. Get started today »

Co-produced with Treading Softly

Here at High Dividend Opportunities we love to embrace change. Change often is driven by time, as time seems to necessitate change. For many, the change to retirement, from having worked daily, forces a change in perspective on their investing. When retirees realize that depending on share prices to be high when they need to sell them is akin to gambling, it drives them to a different kind of investing. They become income investors who depend on a steady stream of dividends to fund retirement. We use our unique Income Method to create a steady stream of dividend income to fund our day-to-day lives and reinvest the rest. One rule we use to calculate our expected returns from our cash flow is the Rule of 72. Today we go over this rule and explain how we use it and its limitations.

The Rule of 72

The Rule of 72 is a classic investment and saving rule to easily determine how long it will take something to double in size based on its growth rate. While not limited just to investments (you could apply it to anything, really) we are interested in its application for investments and by extension, for retirement investing. We calculate this by taking 72 and dividing it by the percent of return of your investment or saving account.

https://static.seekingalpha.com/uploads/2019/5/16/48716285-1558023249153278.png

(Source)

This Rule of 72 can help careful investors calculate how long they need to achieve the desired portfolio size or how many years they need to keep investing all of their returns to achieve a set goal. When it comes to income investing - something we focus on here at High Dividend Opportunities - we can use the Rule of 72 to determine how long it will take for our revenue stream to grow to the desired size. For maintaining a portfolio yielding 9%-10% - which is the target yield of our Core Portfolio - you can see it would take 7.2-8 years to double the portfolio and thus double your income stream.

The Rule of 72 Has Some Big Limitations

The problem many savers and investors have with this rule is that they are forced to add in many of their own assumptions to the formula. Some will mix in the expected price appreciation of their shares - essentially using the Rule of 72 attached not to the yield of the portfolio but its total return. This assumes an even or flat return in relation to price appreciation. We are hesitant to advise anyone to do this ever. Why? The market does not grow at a steady rate, but it moves up and down based on numerous factors that you cannot readily project years into the future.

ChartData by YCharts

While the S&P 500 has historically increased in value, there are extended periods of negative returns that can't be accurately predicted in a simple math equation. Furthermore, with stocks that have seen massive price growth like Facebook (FB), Netflix (NFLX), Amazon (AMZN), Tesla (TSLA) and Google (GOOG) (GOOGL), it would be next to impossible to accurately predict portfolio growth using this rule.

If you invested in a few select names (like Arqule (ARQL), Durect Corp (DDRX) or Avita (RCEL)) your portfolio dominated the S&P 500 (SPY).

ChartData by YCharts

Meanwhile, other picks would have your portfolio crashing in 2019, like Macy's (M), PG&E (PCG) or ANGI (ANGI).

ChartData by YCharts

The Rule of 72 is thus limited to a set expected rate of return to properly work. High fliers or bottom crashers cannot be accurately predicted.

Those using this rule for calculating a savings account where there's no pricing exposure will have greater success projecting many years into the future. These savings accounts, however, will have lower yields - needing more time to achieve the results.

How Did We Use The Rule of 72?

Knowing a rule and applying it are different steps altogether. Here at HDO we target a 9%-10% yielding portfolio. Why do we use a portfolio goal vs. an individual security goal? Because many fantastic opportunities exist outside of those boundaries. Plus, it allows us to mix safe, lower-yielding picks with high-yielding securities that boost yields and only require minimal exposure.

We focus on the income stream vs. the price appreciation aspect. This is because we understand that market prices will move up and down. You, however, can control the amount of income your investments produce for you by selecting securities to achieve the desired portfolio yield. As you invest your capital and dividends into new or previous securities, you can maintain the overall portfolio yield and achieve the planned Rule of 72 results - regardless of underlying price action. Retirees or investors building their portfolio for retirement or to produce income to live off should focus more on the cash flow of their portfolio than short-term price movements.

Income Targets

If an investor starts with a portfolio of $100,000 and aims to have $80,000 annually from just his investments alone in retirement, how long does he need to be investing?

Yield of Portfolio

Years to Reach Goal

10%

21.6 years

5%

57.6 years

3%

120 years

The time frame it takes to achieve your goal expands exponentially, the lower your portfolio yield is. This is because your portfolio yields less income and that income compounds at a slower rate.

Building the Base of Your Portfolio

To build your portfolio with a target yield, we suggest having CORE holdings - ones you do not need to closely monitor - as well as opportunistic buys when the market sells off irrationally.

Consider the following, a portfolio invested in two high-quality PIMCO funds PIMCO Corporate & Income Opportunity Fund (PTY) and PIMCO Dynamic Credit Income Fund (PCI), each generating a yield of +8% paid monthly, not including the annual special distributions.

We also made opportunistic purchases of Imperial Brands (OTCQX:IMBBY) at 12% and Vermilion (VET) at 14%.

These two core positions and opportunistic purchases balanced 70-30 (between core and opportunistic) provide a 9.5% yield. We do suggest having more than four positions in your portfolio, but every investor must start somewhere! Using your received dividends to diversify into new positions - along with infusions of new cash - you will be well on your way to a great immediate income portfolio.

Future additions to the portfolio could be tailored to support your desired yield moving forward. By doing so, you are managing your portfolio based on its income stream and not on the gambling hopes of rising share prices. Dividends are stickier than price movements. Any investor who has years under their belt remembers when the market has sharply dropped in value. Those investors know that hoping for selling at a premium to your purchase price brings fear. This managed income stream works hand in hand with the Rule of 72's limitations.

Hedging Against Market Volatility

Keeping a yield target in mind is essential when applying the Rule of 72, and this is how we do it here at High Dividend Opportunities. We've been preparing for a recession that's coming. We don't expect it to come in the next 12-24 months, however, being prepared is extremely important. As such we've adjusted our Core Portfolio to be ready and defensive in the face of it.

To hedge against this, you should adjust your portfolio to contain 40% fixed-income securities - preferred shares, bonds and baby bonds or funds that contain these items. Why? The answer is two fold:

  • The income produced by these items is more secure than the income from common stock dividends, as they must be paid prior to common dividends.
  • As the market forecast darkens, fixed-income securities typically see a rise in value due to investors fleeing common equity in search of safer waters.

By already being invested in these securities, you can expect to see strong income generation and price appreciation during a recession that typically lowers portfolio values overall. During recent spells of market volatility, we already have seen that investors are moving into preferred securities that HDO members have previously invested in - providing us with capital gains on top of our steady income.

The second means of hedging is through diversification. We encourage every investor to be invested in no less than 40 individual securities or funds. This way, no individual fund or security can overwhelmingly harm your portfolio. Typically, we suggest an allocation of no more than 1%-3% for the vast majority of the securities we suggest. These securities should not be invested in a single sector but spread across multiple sectors like REITs, MLPs and utilities. This way, you have protection via a diversity of securities and a diversity of sectors.

Currently, we expect the energy sector and mREIT sector to outperform throughout 2020. Adding additional exposure to these sectors will provide a boost in income but also additional alpha, which can be rotated into other opportunities as they arrive.

The final hedge is something that only High Dividend Opportunities members benefit from - real-time alerts from our six experts. We are constantly monitoring our Core Portfolio and actively engaging our members in chat. This provides an additional means of protection to your portfolio.

The Wrap Up

The Rule of 72 is a time-proven method to predict the time needed for a portfolio or income stream to double. At HDO, we have fixed our portfolio’s goal to produce 9%-10% yield, providing the ability for our members' income streams to double every 7.2 to 8 years. This leaves plenty of time for investors or near-retirees to see their income stream grow and provide additional cushion to their budgets.

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This article was written by

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I am a former Investment and Commercial Banker with over 35 years experience in the field. I have been advising both individuals and institutional clients on high-yield investment strategies since 1991. As author of High Dividend Opportunities, the #1 service on Seeking Alpha for the 6th year in a row.

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In addition to being a former Certified Public Accountant ("CPA") from the State of Arizona (License # 8693-E), I hold a BS Degree from Indiana University, Bloomington, and a Masters degree from Thunderbird School of Global Management (Arizona). I am also a Certified Mortgage Advisor CEMAP, a UK certification. I currently serve as a CEO of Aiko Capital Ltd, an investment research company incorporated in the UK. My Research and Articles have been featured on Forbes, Yahoo Finance, TheStreet, Seeking Alpha, Investing.com, ETFdailynews, and on FXEmpire.

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Disclosure: I am/we are long IMBBY, PCI, PTY, VET. 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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