A little bit of yield goes a long way, folks.
While it’s important to never chase yield for the sake of it, which could lead to taking on excess risk by investing in lower-quality companies and experiencing dividend cuts, I think it’s just as important to always be cognizant of your portfolio’s overall yield and how that impacts your long-term financial plans.
My goal all along was to live off of growing dividend income.
I never wanted to sell stocks to produce income. To me, that’s akin to slaying the golden geese that lay the golden eggs. I’d rather keep those geese fat and happy, which allows them to lay an ever-growing amount of eggs for me.
But balancing that desire to never touch principle with the need to generate enough income to live off of is a delicate act that has to be carefully approached and managed.
Now, I don’t invest much capital any longer. My FIRE Fund is now in “maintenance mode” after achieving my primary financial goal of financial independence and early retirement.
However, I spent six years constructing the Fund in such a way that it would generate enough passive growing dividend income for me to live off of at a young age. And I wanted to make sure I didn’t sacrifice overall portfolio quality or growth prospects in the process.
Yield and growth are generally inversely correlated. Higher-yielding stocks often feature lower growth properties, while lower-yielding stocks often feature higher growth properties. High perceived growth and quality lend themselves to a high valuation, pushing down yield (because price and yield are also inversely correlated, all else equal).
It’s not an exact science, and sometimes an incredible opportunity will buck this trend, but this is the gist of it for most of the time.
In addition, yield and risk tend to correlate pretty closely. Stocks that present extremely high yields (say, 3x+ market) tend to present significant yield because of significant perceived risk. The perceived risk pushes down valuation, thus causing yield to rise. Conversely, high-quality companies tend to be less risky investments that often offer lower yields.
Keeping all of this in mind, I did my best to diversify the Fund across this matrix. I picked up equity in many different businesses that each offered me something a bit different in terms of yield, growth, quality, and risk.
This is how I achieved the balance I sought.
I would invest in a company like Visa Inc. (V) because I saw both the quality and growth prospects as outstanding. In my view, it was a low-risk investment. But it also offered a low yield as a counterweight against the high-growth properties because the stock was in demand and commanded a premium valuation. In addition, Visa has historically paid out a small portion of its earnings in the form of a dividend, further reducing the potential yield.
On the other end of the spectrum, I own equity in Main Street Capital Corporation (MAIN) because I love the huge yield and monthly dividends it offers, all while still maintaining a certain amount of quality as a business. However, because of the nature of the business model (a BDC), it’s a riskier investment for me (relative to a blue-chip dividend growth stock). And the growth will probably not come anywhere close to a Visa. But the nature of that business model almost ensures a big dividend.
These are stocks that feature very different dynamics. But I don’t see one set of dynamics as necessarily superior to the other. They’re just different. Different business models, different dynamics, different objectives across the board.
Of course, the bulk of the portfolio is invested in what I’ve always felt is the “sweet spot” of dividend growth investing – stocks that offer a 3-4% starting yield, 6-7% growth, high quality, and fairly low risk.
Think blue-chip stocks like McDonald’s Corp. (MCD) and Johnson & Johnson (JNJ).
I’ve loaded up on these stocks, particularly when their valuations seemed appealing.
But even a lot of these “sweet spot” stocks have seen their yields fall due to higher valuations across the board (relative to where things were at, say, 5-6 years ago).
If I were only buying these stocks along the way, my portfolio’s yield would be lower than it is today.
And I’d also be far less diversified because that “sweet spot” doesn’t offer a terribly large variety of stocks. It’s akin to a bullseye on a dart board.
I set up a plan when I first started marching toward FIRE that I thought would get me there ASAP. That plan included a thoughtfulness around yield. This is something I discuss in my latest best-selling book, 5 Steps To Retire In 5 Years.
I wanted a portfolio yield that was significantly higher than the market, which could produce enough dividend income for me to live off of without requiring an unrealistic portfolio size.
But I didn’t want to sacrifice too much growth or take on too much risk, for I had to think about both the Jason of 2020 and the Jason of 2050 (the latter of which will be paying higher prices for everything due to inflation).
When I initially did my back-of-the-envelope math, I figured a yield of somewhere around 3.5% on the portfolio would work best. Back then, that’s where many stocks that made the most sense to me as a new investor were at – the “sweet spot” – which was perfect. So I loaded up.
All the same, though, I have a number of small and large holdings that offer me a higher yield along with, in my view, an acceptable range of other aspects across the aforementioned matrix. And this methodology has had the effect of buoying my overall yield. If I wouldn’t have done this, I wouldn’t have been able to start living my dream life as soon as I did.
Because a little bit of yield goes a long way, I’ve been able to keep the bulk of the Fund in blue-chip stocks while still maintaining an overall portfolio yield that fulfills my lifestyle and income objectives. This yield, by the way, is almost twice what the broader market offers, which is a substantial difference.
A Little Bit Of Yield Goes A Long Way
I’m very happy with the Fund. It’s a fine collection of businesses, and I’m very proud of what I’ve been able to build on modest means. I honestly wouldn’t have done things any differently.
That said, I think it’s important to recognize how your overall portfolio’s yield can and will impact your long-term financial plans.
A little bit of yield goes a long way.
To illustrate this, I’ll show you what my own FIRE Fund would look like with a yield that’s 100 basis points lower than where it’s currently at.
Then I’ll compare that to what the Fund would look like if the yield across the portfolio were 100 basis points higher than where it’s currently at.
This is, of course, purely hypothetical. Changing the yield dynamics would change the other aforementioned aspects, too. Yield doesn’t exist in a vacuum. But I do think this exercise is useful for illustrative purposes as it relates to how you go about investing on your way to FIRE.
The FIRE Fund, as of the last monthly update, is worth $398,730.25. It’s expected to produce $13,753.25 in dividends over the next 12 months. That implies a yield of 3.45%. Right in line with the goal I noted earlier.
Including other passive income like royalties from my best-selling books, my total passive income is coming in at over $1,400 per month.
Let’s now assume that yield drops to 2.45% across the portfolio.
The Fund would then generate $9,768.89 in dividend income over the next 12 months. That’s only $814.07 per month.
That’s simply not enough for me, even after factoring in royalties. Not based on my current lifestyle.
I spend between $1,200 on $1,300 per month here in Chiang Mai, Thailand. To be fair, that includes certain luxuries and covering my significant other whenever we’re together. I’m spending something closer to $1,000/month on just my essential expenses, so my dividend income alone does cover me.
However, ~$815/month doesn’t cut it. And I’m not even including visa expenses in this, which are a necessary component to living here. Add another $100/month for that and you can quickly see how the delta is too wide.
Now, I could alter my lifestyle somewhat substantially and get by on that. It’s entirely possible to retire here in Thailand on this kind of income.
I could be single or tell Oh that she has to start covering her own way. I could move into a more basic apartment that has a less central location. Eating at Thai markets for dinner far more often would be a must.
It’d be a situation where I’d be going back to the days when I used to watch every penny.
But I wouldn’t want to do any of that. Not if I don’t have to.
I worked hard to achieve FIRE in order to increase my quality of life and happiness. This isn’t about being miserly. Not for me, at least. I want to live my dream life. It just so happens that my dream doesn’t cost much in Thailand due to person I am, the lifestyle I desire, and the cost structure in place over here.
More Than Enough
Let’s now compare this example to a hypothetical Fund that offers a much higher yield.
I’ll assume the yield rises to 4.45% across the portfolio.
The Fund would then generate $17,743.50 in dividend income over the next 12 months. That’s an impressive $1,478.62 per month.
Almost $1,500 per month would be more than enough passive income for me, especially after factoring in royalties. It would actually be superfluous based on my needs and lifestyle.
However, I’ve never heard anyone complain about having too much money. You won’t hear me complaining, either. I would just see it as additional cash flow for areas that fall outside the normal scope of my daily lifestyle: investing, philanthropy, travel, etc.
But – and this is a big but – that excess current income would come with the disadvantages I laid out earlier.
Namely, I’d most likely be taking on extra risk. And I’d probably be sacrificing some growth in the dividend income, which might limit the opportunities for the Jason of 2040 or 2050. I do try to be just as mindful of that guy as the guy that walks around today. After all, they’re both me.
I would strongly recommend you be mindful of this, too.
Not just thinking of the you of this year or next year as an investor is just as important as not falling into the instant gratification trap as a consumer. Tomorrow will come. And you’ll likely be here to see it. Be careful. Don’t sell that future version of yourself short in pursuit of something unnecessary today.
The “Right” Yield
Is there a “right” yield for a portfolio?
Of course not.
It’s ultimately up to you to construct your early retirement dividend growth stock portfolio in a way that makes the most sense for you.
You have to consider your objectives, risk tolerance, circle of competence, needs, age, time horizon, lifestyle preference, etc.
I will say this: the older one is when starting, the higher the yield they’ll probably need in order to make the numbers work under a reasonable time frame.
The difference between 2.5% and 3.5% on a single stock might not seem like a big difference. Likewise, 4.5% might not seem like a world away from 3.5%.
But it can add up. Quickly.
As you’re buying stocks and constructing your portfolio, be cognizant of how each new stock impacts your overall portfolio yield and your long-term income objectives. The occasional 5% or 6% yielder, assuming the right amount of growth, risk, and quality, can totally change your FIRE trajectory.
Using my own FIRE Fund as a real-life example, we can see how the income swings from ~$815/month to almost $1,500/month when altering the portfolio-wide yield by just 100 basis points up and down. That’s a material change in monthly income (almost doubling from low to high) that has a massive difference in day-to-day lifestyle, opportunities, flexibility, freedom, and attitude.
This scales up, of course, which is something you’d experience as time marches on and your own portfolio grows.
A $1 million portfolio generates $45,000 in annual dividend income at a 4.5% yield, but that annual dividend income drops to $25,000 at a 2.5% yield on the same $1 million portfolio. This could be the difference between being financially independent and not being financially independent.
So make sure you’re aware of the interplay between yield, growth, quality, and risk as you build out your own portfolio. And make sure you’re aware that a little bit of yield goes a long way.
Full disclosure: I’m long all aforementioned stocks.
What do you think? Did these numbers surprise you? How have you constructed your own portfolio? What is your portfolio’s overall yield?
Thanks for reading.
Image courtesy of: Sira Anamwong at FreeDigitalPhotos.net
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