The S&P 500 recently dipped (for a few hours) below the -20% threshold (relative to its recent highs of 4,818.62).
Personally, I’d been hoping this would happen. As I said at the start of the year (when the negative volatility began to rear its ugly head) I have a plan for success in a potential bear market scenario, which included slowly, but surely, averaging into a macro sell-off with a bear market cash position that I’d saved up over the years.
In other words, I made hay while the sun was shining (stashing cash away with markets hovering near all-time highs in recent years) and now that a storm is brewing, I’m prepared to take advantage of it.
I’ve done my best over the years to talk about asset allocation, maintaining a bear market fund, and highlighting the importance of figuring out what sort of cash position makes sense for various investors, so that they can sleep well at night during all types of market environments.
As the old saying goes, “An ounce of preparation is worth a pound of cure.”
Yes, the downside with cash is that it doesn’t generate much of a return. That’s especially the case during periods of high inflation like we’re living in now. The value of cash is being eroded away at historically high rates at the moment, meaning that to many, a sizable cash position coming into 2022 didn’t make sense.
I totally understand that (and I considered it strongly over the last year or so; as many long-term followers of my portfolio know, I adjusted my cash position slightly lower in late 2021 because of concerns surrounding rising inflation).
This reluctance to hold cash is especially common amongst the dividend growth investor community because these individuals tend to enjoy maintaining a very overweight exposure to equities because of their reliance on the passive income that their stocks generate and the importance of the compounding process associated with re-investing this passive income over time.
I definitely fall into this category. Historically, my equity exposure has hovered around the 85%-95% range. I’m sure there are financial advisers out there who believe that I’m absolutely crazy for this equity allotment; however, I have little desire to own fixed income (ever) because it doesn’t organically grow over time. But, regardless of how high my equity weighting has been over the years, it’s never been 100%. I always make sure to maintain a cash position to ensure that I have dry powder available for times like the bear market scenario that we’re faced with today.
Yes, it’s scary seeing headlines about the market being down 20%. But, it’s also incredibly exciting for someone like me who absolutely loves to buy blue chip stocks when they’re trading below fair value. Right now, I’m seeing dozens of wonderful companies trading with irrationally low (in my opinion) valuations attached to them and therefore, I’ve been allocating as much capital to the markets as I can (in a responsible manner).
As excited (or even greedy) as I may feel at the moment, I’m also not breaking the rules that I discussed in that Bear Market Success article that I linked above.
As great as the deals that I’m seeing today seem, I know that they could get better moving forward if the negative sentiment that is currently surrounding the market grows even more fearful.
And, many analysts believe that markets are heading lower. For instance, last week I read a report published by Michael Harnett, a strategist at Bank of America Securities, who said that the 3,600 level on the S&P 500 is now the firm’s “bull case” scenario, noting that he has not seen capitulation occur in the markets.
Frankly, I have no idea when or where stocks will bottom. If I had a working crystal ball, I’d be a trillionaire, but alas, I don’t. This is why I’ve decided upon a plan that provides me with the opportunity to take advantage of opportunities in the markets, all the way down to -40% from the highs, which would represent abnormally steep sell-off, by long-term historical standards.
The entire point of preparing and coming up with a plan is to stay disciplined and stick to it. Therefore, at -10%, -15%, and now, -20% (with regard to the S&P 500’s discount from its all-time highs) I’ve allocated previously decided upon piles of cash into the market. And, at -25%, -30%, -35%, and -40%, I’ll do the same (at that point, I’ll be out of dry powder and I’ll be relying on monthly savings and my passive income stream to fund new investments).
With all of that being said, I’ve been truly giddy in recent weeks, due to the very high degree of confidence that I have that the investments that I’m making today, when the market is down double digits from its highs, will pay off in a very significant way for me and my family down the road. But, having spoken with a lot of other investors, I know that there are many people who don’t share my cheerful sentiment.
They’re not excited. They’re not happy. On the contrary, they’re sad, scared, or worse.
It seems as though many of the individuals that I’ve spoken to who fall into this second (gloomy) category are often retired (or close to retirement) and they’re fearful about what a -20% drop in their net worth means for their financial plans.
In short, without an active income to fund dip buying, dips seem meaningless to some.
And, for investors who have subscribed to the 4% rule (a common retirement plan described in greater detail here), being forced to liquidate equities into a -20% decline begins to feel hopeless.
And, fears of selling more assets into a further slump in the markets can be downright terrifying.
So, I get it…during bear markets, retirees, in particular, may experience fear or anxiety.
But, I wanted to write this piece, explaining why that doesn’t have to be the case…highlighting how the dividend growth investing strategy and a reliably increasing passive income stream can protect investors from the common pitfalls associated with the 4% rules (or other retirement plans like it) and allow them to sleep well at night knowing that their nest egg can (and should) last up until their mortal ends (and even long after).
The wonderful thing about the dividend growth strategy is that once someone reaches financial freedom via a reliably increasing passive income stream, it doesn’t really matter if the value of their holdings drops 20%.
A market sell-off doesn’t mean that one’s dividend income will fall.
So long as investors have done a good job of selective high quality companies, a garden variety recession might not negatively impact their passive income stream one bit.
No dividend is ever 100% safe. Dividend cuts happen. Oftentimes, they’re predictable (I’ve had a high degree of success when it comes to predicting dividend income in the past). However, sometimes they’re not (I’ve been surprised a time or two throughout my investing career; past dividend cuts from Boeing and Disney come to mind here). But, in general, monitoring cash flows, margin strength, balance sheet health, and sales growth trajectories should allow investors to gauge company (and dividend) health and largely avoid unexpected and untimely dents to their passive income streams.
The fact that dividends are not 100% safe and secure is why I believe that it’s important for retirees who’ve chosen to rely on dividend income to support their lifestyle’s expenses in retirement to ensure that they have an appropriate margin of safety with regard to the size of their dividend income stream being larger than expected expenses.
But, the fact is, there are many wonderful companies with 20, 30, 40, and 50+ year dividend increase streaks, meaning that they’ve managed to not only maintain their dividends, but also grow them, throughout a slew of economic downturns and moving forward, I expect that there will be many more companies who manage to do this as well.
Personally, my plan is to not retire until my passive income stream is 120% larger or so than my expected lifestyle expenses in retirement.
This means that in retirement, not only will my passive income stream grow annually via regular dividend increases, but also, via continued dividend reinvestment.
In retirement, I won’t be re-investing 100% of my dividend income like I do now in the accumulation phase, but even once I enter into the distribution phase – meaning that I’m withdrawing funds from my portfolio every month to pay the bills – I should have ~20% of my passive income left over to either put away in emergency savings (you never know when a hot water heater will stop working or an emergency medical bill will pop up) or continue to plow into the markets, ensuring that my passive income stream expands and grows.
To me, this plan should ensure that the purchasing power of my passive income stream is not eroded away by inflation. It should also mean that I am not at risk of running out of funds in retirement.
Frankly, the idea of selling assets in retirement to fund living expenses is horrifying to me. I’ve said this before, but I hate the idea of stashing away resources throughout my working life only to see them dwindle away in retirement.
Man oh man, talking about hopelessness…
The dividend growth path that I’m on means that I should never be forced to sell a single share of stock in retirement. Therefore, during macro downdrafts like we see today, the dividend growth investing strategy will protect me from becoming a forced seller into weakness (a cardinal sin in the stock market)…and experience existential dread.
Lastly, knowing that the resources that I’ve stashed away throughout my life will remain intact when I die provides solace to me, because I know that my life’s work (the dividend growth machine that I’m in the process of constructing) will be passed down to my offspring, proving future generations of Wards a reliably growing stream of passive income which should make their lives easier as well.
I imagine that on my deathbed, I’ll feel at ease, knowing that my life is going to have a lasting, positive impact on my children’s and my (hopeful) grandchildren’s lives as well.
With all in this being said…so long as a retiree has planned accordingly, there is no reason to fear recessions; once again, an ounce of preparation…
Obviously, no two financial situations are the same. Not everyone has the capability to save enough money throughout their working lives to be supported by a 2-5% yield in retirement (generally, yields above 5% are relatively unstable and don’t offer the reliable annual growth that I’m looking for as a dividend growth investor). But, I suspect that the majority of individuals can achieve this success, especially if they’re prudent about their spending habits (it’s impossible to save if you’re not living below your means), disciplined with their investing habits throughout their working lives, and realistic their the quality of life that they can reasonably expect to afford in retirement.
I don’t know about you, but I know that I’ll likely never own multiple vacation homes and a yacht in the Caribbean. And I’m okay with that.
I don’t need those things to be happy. So long as I don’t become overzealous with my spending (and expectations) a comfortable (and early) retirement is within reach…all thanks to my savings rate and the compounding of my passive income stream.
In conclusion, I believe that dividend growth investors in retirement who are fearful of prolonged weakness in the market have likely taken on too much risk (with regard to low quality companies, not enough fixed income exposure (if you’re into that sort of thing), and/or an insufficient margin of safety with regard to the size of their passive income relative to their spending needs).
Thankfully, this can likely be resolved by slight changes to asset allocation and/or spending habits.
That’s the good news…and remember, at the end of the day, so long as you’re truly financially free (you trust the strength and reliability of your passive income stream throughout a wide variety of economic environments) then a lower for longer situation in the stock market can be a blessing.
Lower share prices equate to higher yields on cost and therefore, whether you’re re-investing 100% of your passive income or 5%, macro weakness still provides the opportunity to compound your passive income stream at an abnormally high rate and this is something that dividend growth investors should be thankful for, not fearful of.
If you want to learn more about a model dividend growth portfolio that has maintained a perfect dividend growth rate (100% of companies have raised their dividends on schedule since the portfolio was created on 3/1/2020) then check out the Intelligent Dividend Investor…
Nicholas Ward is a research analyst who currently writes for Seeking Alpha, The Dividend Kings, iREIT, and Forbes Real Estate Investor. Before that, he was Founder and Editor-in-Chief of The Dividend Growth Club, as well as the Income Minded Millennial. Nicholas has also contributed to Sure Dividend, Investing Daily, and The Street, where he covered stocks in Jim Cramer's Action Alerts PLUS Portfolio.
Nicholas holds a bachelor of arts from The University of Virginia, where he studied English and studio art. Prior to transitioning into the financial industry, he managed a vineyard in the foothills of the Blue Ridge Mountains.