Financial Independence through Dividends: Income Volatility

Kyith from Investment Moats has put out a blogpost titled:

9 Strong Points to Why I Say, the Dividend Income Retirement Mindset is Not a Good Retirement Risk Management Model.

The post is well-written and well-organised so it is worth a read. I feel that his points are all valid.

Not being as organised or committed to writing a lengthy response to all 9 points, I will take a approach of occasionally posting my views on each point.


TL:DR? While the points are valid, I feel that the "reality" of Dividends is not as terrible/risky/scary as the post might suggest. In addition, some of the concerns raised apply equally to other investing strategies so I'm not sure why "dividends" are singled out for special attention.

Income Volatility?

One "problem" with dividend investing is that there is no guarantee regarding the amount of dividends received. Kyith makes specific reference to COVID:

Covid has probably given us a glimpse that your income can be very volatile.

I have no argument about this and it squares with my experience as well as the experience of other dividend investors that the amount of dividends you get each year can change.



Kyith says:

Keeping the income stable requires more thinking instead of just spending the dividends.

I fully agree that dividend investing is more than thinking about how to spend your money. That applies to any type of investing. Fortunately, dividend investors can call upon the power of diversification.


Three points to consider are:

• Point 1: Dividend income may be volatile, but not that volatile.
• Point 2: Any retirement strategy has to manage volatility, and its easy to manage
• Point 3: Long-term experience of dividend investors

Point 1: Income is volatile, but not that volatile

In 2020, COVID-19 happened, and there were 2 things that were of special significance to dividend investors:

• Earnings per share of certain sectors collapsed as economic activity in those areas ground to a halt. I can point to Comfort Delgro, a dividend investing favourite as one such victim
• Regulators told banks to stop paying dividends. As a big fan of Euro and SG banks, this was pretty significant to me.

Nevertheless, as I had a diversified portfolio comprising mainly counters that pay a dividend, my passive income fell by 'only' 20%. Other bloggers who are not as bank heavy as I am, like Dividend Warrior and GlobalPassiveIncome only suffered income falls of about 3% and 13% respectively. (2nd figure is my estimate from his blog, he didn't specifically state his income fall). Furthermore, the fall in dividend income was only temporary and everyone's dividend income recovered by the following year.


As long as you remember that diversification doesn't mean having only DBS, UOB, and OCBC in your portfolio, that's a good start.


Of course, some might say that COVID-19 was only a minor blip compared to the Great Financial Crisis. Wouldn't your dividend income have collapsed during the GFC?


I had a brief look at the data and there is some cleaning up to do (eg: STI ETF had a stock split and adjustment during the GFC so one needs to normalise the dividend - similarly for stocks that did dilutive rights issues). However my recollection of the GFC is that stock prices fell more than dividends (at least for stocks I owned), so those who have to sell stocks to fund their retirement would be in at least as much trouble than those that fund it via dividends. Also, GFC was unusual as there was deflation in asset prices so the cost of living was not as high - you could buy a new Mercedes C180 for as low as $135,000 from a parallel importer during the GFC.

Point 2: Any retirement strategy has to manage volatility

If you are planning to FIRE and live off your investments, then as a matter of common sense you will need to have a plan how to manage volatility. Before you FIRE, you would have gone through a few bear markets like COVID19 which would provide an opportunity to 'stress test' and plan your volatility management strategy.


The nice thing about collecting dividends during a bear market is that you don't have to sell your stocks when they are super cheap in order to fund your expense.


Strategy 1: Decide what discretionary items you can cut
Returning to income volatility, those on regular or "FAT" FIRE will have built into their planning some discretionary items that they are willing to forgo temporarily when times are bad. In 2020, my travel expenses were ZERO because I did not travel overseas. However, you may have other discretionary items that you can forgo such as restaurant meals.


Strategy 2: Build a buffer - and retire later
Assuming that you don't hate your job, you can always build in a margin of safety by working one more year so that you can increase your dividend income a little more. For example, since my dividend fell by 20% in 2020, I might want to build in a 20% buffer to my dividend income if I absolutely do not want to cut overseas travel during 'bad years'.


Actually if you do the maths, you might only need to build in a 5% buffer which means that every year your dividend income exceeds your annual spending by 5%. Assuming that a major year-long bear market only comes every 5 years, in the 4 normal years, you will end up getting 5+5+5+5% extra dividend income which you do not spend. In year 5, when there is a major bear market and your dividend income drops by 20%, you have the extra savings from the 4 previous years.

Point 3: Long Term experience of dividend investors

The final point is a practical point. If the dividend retirement mindset is so bad, why haven't more local dividend bloggers 'failed' or 'blown up'? Instead, what we see are their dividends slowly increasing, for those who are still working towards retirement, or dividends that are stable after FIRE (ASSI).


I suspect that the simplicity of the dividend retirement concept has a part to play. Anyone can understand it and with greater understanding comes greater commitment to staying the course.


On the other hand, after the Crypto Crash, we have a pair of local bloggers who lost $2m and stopped blogging (but kept their blog up so that others can learn), another local youtuber who was really pushing Crypto, also had paper losses of a similar amount, posted 1 apology video and shut his channel (classic example of survivorship bias).


One might say that past performance is not indicative of future performance, but that applies to every investing strategy.

Conclusion

Investors must accept that income flows from dividends will be volatile. When preparing to FIRE, they should:

• Stress test the portfolio by going through bear markets and crashes and monitoring the effect on income.
• Understanding the role of diversification in stabilising dividend income.
• Have a plan to cut discretionary income in bad years; OR
• Build a 'buffer' of having dividend income above your needs, which you will save every year to prepare for the next (temporary) crash.