The 4 Percent Rule vs. Dividend FIREhoses

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In case the title to my blog didn’t give it away, the Dividend FIREman is a devotee of dividend investing and other forms of passive income investing.  My view is that investing in assets that pay dividends, interest, rents, royalties, or other income on a regular basis gives me the opportunity to have my cake and eat it too.  To borrow Tom Wolfe’s Bonfire of the Vanities metaphor, as long as I only eat the crumbs, I will never have to eat the actual cake.

However, many investment advisors recommend against an approach that focuses solely on the revenue thrown off by a particular investment, especially in a “low yield” environment like we are experiencing these days.  Under this theory, a stock that pays dividends is really just giving you back a part of the value of the company.   You can get to the same thing (income from a stock portfolio) simply by reinvesting dividends and then selling shares as you need money.  Presumably you either have more shares (because of the dividend reinvestment), or for stocks that don’t pay dividends, those shares are theoretically worth more money because the company has taken the dividends and plowed them back into the business to increase its value (Warren Buffet’s company Berkshire Hathaway has never paid dividends, for this exact reason).

Advisors that adhere to this philosophy often recommend some version of the “four percent rule,” which (based on several respected studies that are generally accepted as reliable in the finance community) means your portfolio can reasonably be expected to last at least 30 years if you invest in a stock/bond portfolio that has at least 60 percent stocks, and spend no more than four percent of your portfolio’s value every year to fund your living expenses (note that there are other studies suggesting that a safe withdrawal rate for this kind of portfolio is anywhere from 3.0 to 3.5 percent).  Regardless of the exact percentage (called the “safe withdrawal rate” or SWR), folks with this investing philosophy believe (perhaps rightly so), that most people will never pile up enough money to survive on “only” a 2.2 or 2.4 percent dividend or bond yield, and that trying to increase this yield in a passive income portfolio can cause you to unnecessarily increase the risk in your portfolio (by, for example, buying a stock that pays a high dividend but does not have good underlying fundamentals, or by investing in junk bonds to increase the yield).

Another benefit to the “four percent rule” approach is that it lends itself to easy calculations.  Due to the magic of arithmetic, the “four percent rule” will apply if you save up 25 times your annual spending needs.  Using round numbers, if you need $100,000 per year, then you need $2.5 million in total investment assets.  Four percent of $2.5 million is….you guessed it…$100,000 per year!  Isn’t math fun?

I take these kinds of philosophical disagreements with a grain of salt.  At present this is truly an academic question for me, because my “pile” is too small to survive on, even if I were to withdraw 4 percent.  The risk factor that could apply to a “yield only” approach is not really applicable to me personally, because (aside from a small stake of roughly 8 percent of my net worth in hard money real estate loans), I don’t really invest strictly for higher yield.  The bulk of my investments are in “total market” index funds, blue-chip companies, and (more recently) well-located real estate (which should yield over 6 percent over the long term).  Plus I want to leave a legacy for my children, and thus I don’t want to spend down my entire portfolio.  And I am hopeful that as interest rates increase, the return on my bond funds and bank savings will increase.  Finally (at last for me), studies have shown that solid dividend-paying stocks have less risk and higher returns over the long term.

The best answer for you depends somewhat on where you are on the investment timeline.  If you are a younger investor, with more time for compound interest to work its magic, you are in the accumulation phase of your investing career, and you don’t have to choose a distribution approach.  Simply invest consistently and wisely (hint – low cost index funds), reinvest all dividends and interest and other income from the investments, and watch your grubstake grow.  If you are an older feller (or gal), you need to start thinking about which approach will work for you as you approach the distribution phase of your investing career.  And then this decision will turn on some of the factors I mentioned above that are important to me (leaving a legacy, diversifying into real estate, etc.), as well as what is happening with the Schiller PE Ratio, whether bond yields/interest rates are increasing or decreasing, etc.

Ultimately, I don’t think this dispute should matter much to you if you are in the accumulation phase of your investing career.  The more important thing is to spend less than you earn, and invest the difference.  When it is time to decide how much you can safely withdraw, you can always reallocate your holdings into different investments if you choose a dividend/passive income approach.  Hopefully your stash will be big enough that your safe withdrawal rate can be low and still fund a long, happy retirement.

There will be future posts on this topic.  I’m interested in your thoughts on this topic in the comments.  Happy investing!

-Dividend FIREman

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