Early Retirement: How to Live Off Dividends

Dividends & Retirement

Can You Live Off Dividends?

Recently, I came across a book about living off of dividends.

It’s called Stop Working, Here’s How You Can by Derek Foster, and it delivers exactly what it promises. Foster, Canada’s self-proclaimed youngest retiree, outlines exactly how he retired at age 34 without ever holding a high-paying job.

How did he pull it off? Early on, Foster committed to saving $200.00 every month. Over the years, he developed his own investment philosophy, a kind of hybrid of the teachings of Peter Lynch and Warren Buffett. The crux of his approach comes down to identifying strong dividend stocks with great brand recognition and recession-resistant profits.

Today, Foster pulls in around $40,000 to $45,000 per year in dividend income (equivalent to a salary of around $80,000 to $90,000 per year). He earns some additional money from book sales and rental income generated by a single investment property. He has paid off his house, drives a new car, and goes on vacation each year. All this and he still has enough cash flow to raise three children.

Some of the lessons in this book only apply to Canadians. That said, Foster still offers a lot of great insights for U.S. readers. Here are some of the main takeaways from the book:

You Need Less Income Than You Think: The government takes nearly half of your paycheck before you see one red cent. For this reason, your salary represents the highest-taxed form of income possible. Dividends, by comparison, get taxed at a much more modest rate. This means that on an after-tax basis, you don’t need to replace nearly as much of your salary in retirement through investment income as you’d think.

Compounding Kicks in Quick: When you start saving for retirement, the end goal can seem so far off. That discourages many people from sticking to it. But it doesn’t take long for the power of compounding to work its magic. After a few years of saving, you’ve accumulated a sizable nest egg. That portfolio will start to throw off some decent dividend income, which in turn allows you to buy even more shares. Before you know it, your portfolio has generated considerable momentum.

Diversification: Don’t put all of your eggs in one basket. The mantra has become a cliche over the years, but it truly is possible to have too much of a good thing. When you own too many stocks, you start to water down your best investment ideas. What’s more, it gets difficult to keep up on the latest developments at each company. For instance, Foster keeps his portfolio up to no more than 25 individual holdings.

Early Retirement Costs Less Than You’d Imagine: Think about all the expenses you pay just to show up to work: car payments, gasoline, insurance, professional dues, work clothes, parking, daycare, lunches out, etc. The average American worker spends $3,000 per year getting to their job(s), according to a survey by CareerBuilder. Never mind the fact that many people pay a premium for housing just to live closer to work. When you retire, many of those expenses disappear. Sure, you may spend more on entertainment (not the worst thing in the world), but by and large, your outgoing expenses drop considerably in early retirement. (Source: “New CareerBuilder Survey Reveals Workers Spend More Than $3,000 Annually Just To Go To Work,” CareerBuilder, January 8, 2019.)

Invest in What You Understand: For the most part, you won’t find any exotic stocks in Foster’s portfolio. His holdings consist of simple, easy-to-understand companies you probably do business with every day: the likes of banks, consumer staples, healthcare, oil and gas. Foster admits upfront that he doesn’t have the biggest brain in the world, but that doesn’t present a problem as long as he clearly defines his circle of competence and stays inside those boundaries. For this reason, he avoids emerging tech companies where he doesn’t have an edge. But by sticking to the firms and industries he knows best, Foster has avoided wealth destroying losses.

Focus on Dividend Growth: Dividend growth plays two important roles in income investing. First, unless you’re exceptionally wealthy, you probably won’t be able to invest enough money up front to generate a sufficient income. You need to own stocks that can grow your income stream over time. With the right dividend stock, even a dividend trickle and become a raging river of cash flow. Second, after retirement, dividend growth tackles your greatest enemy: inflation. Over time, the rising cost of living will slowly bite into your income. Dividend growth allows you to maintain (or even improve) your standard of living.

Look for a Wide Competitive Moat: When you count on dividends to pay the bills, you need to be confident in the underlying company. Any firm can earn outsized profits once in a while, but over time, competition will muscle into any firm and grind down those margins (and those dividends). For this reason, Foster looks for wonderful businesses with wide competitive moats: strong brands, high switching costs, irreplaceable assets, or a low-cost advantage. He wants to see some kind of edge in the marketplace that will allow the company to earn outsized profits decade after decade. That way, you can be confident your income stream won’t dry up.

Exploit Options for Income: Options intimidate many investors. But if you know what you’re doing, they present a great way to squeeze a little extra income from your portfolio. Foster suggests selling put options on stocks you’re looking to buy. He also sells call options on underperforming businesses he wants to sell, otherwise known as “covered calls.” Through this technique, investors can add four or five percent in yield to their annual investment income.

My biggest takeaway from the book: you can live off of dividends. Foster harps on many of the same themes we highlight here on Income Investors. It’s proof that if you put this theory into practice, it can really pay off.

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