Dividends and True Buy-and-Hold Investing

We are making excellent progress with the True Buy-and-Hold concept. I have just recently investigated dividend-based strategies. Here are some applications of our research.

References

These are applications of Equations for Design and Valuations and Dividend-Based Strategies.
Equations for Design
Valuations and Dividend-Based Strategies

Dividend Yields

I use the S&P500 for these examples. This is not the best choice for a dividend-based strategy. It is the choice for which I have tools and data. It provides a foundation to build upon.

I assume that today’s dividend yield is 2%. I assume that TIPS provide an interest rate of 2%. Neither is exactly true. Both are close enough to be helpful.

All amounts are adjusted for inflation.

Waiting for Better Prices

I will calculate what happens if we wait a decade for stock prices to become more attractive. Today’s P/E10 (i.e., the current price of the S&P500 divided by the average of the previous ten years of earnings) is close to 27. The earnings yield 100E10/P is 3.5% (rounded).

If we wait for 10 years, valuations are likely to fall below 10. They are almost certain to fall below 12. They might fall below 8.

Dividend amounts should remain steady or increase as prices fall. Dividend yields should rise.

Assuming that today’s dividend yield is 2%, P/E10 = 10 (versus today’s value of 27) increases the dividend yield to 5.4%. P/E10 = 12 increases the dividend yield to 4.5%. P/E10 = 8 increases the dividend yield to 6.75%.

If we withdraw 4% of our initial balance for ten years from TIPS at a 2% interest rate, we end up with 78% of our initial balance. If we withdraw 5%, we end up with 67%. If we withdraw 3.7%, we end up with 81%.

[In the formulas in Equations for Design, the 10-year TIPS Equivalent Safe Withdrawal Rate TESWR is 11.13%. The withdrawal rate WR varies, as indicated. The interest rate r is 2%.]

If our balance has fallen to 80% of its initial level at year 10, a dividend yield of 5.4% (corresponding to P/E10 = 10) is 4.3% of the initial balance. If our balance has fallen to 80% of its initial level at year 10, a dividend yield of 4.5% (corresponding to P/E10 = 12) is 3.6% of the initial balance. If our balance has fallen to 80% of its initial level at year 10, a dividend yield of 6.75% (corresponding to P/E10 = 8) is 5.4% of the initial balance.

If our balance has fallen to 67% of its initial level at year 10, a dividend yield of 6.75% (corresponding to P/E10 = 8) is 4.5% of the initial balance.

We can reasonably withdraw 4% of our initial balance (plus inflation) for ten years with 2% TIPS. Dividend yields are likely to fall enough during this interval for us to continue withdrawing 4% of the INITIAL balance (which is 5% of the year 10 current balance) indefinitely.

All of this assumes that our portfolio balance remains steady. We have overstated our financial condition if it loses money. We have understated our financial condition if it gains money.

Portfolio Balances after Removing Dividends

I have applied the equations from Valuations and Dividend-Based Strategies when withdrawing all of the dividends.

P/E10 = 10

When the earnings yield starts at 10% (and P/E10 = 10), the 10-year return y is 5.2% plus and minus 6%. At the lower confidence limit (with a 5% probability), the annualized return is –0.8%. After ten years with a 0.8% per year loss, a balance falls to 92% of its initial level. The odds strongly favor making a gain.

When the earnings yield starts at 10% (and P/E10 = 10), the 20-year return y is 4.5% plus and minus 4%. At the lower confidence limit (with a 5% probability), the annualized return is +0.5%. After twenty years with a 0.5% per year gain, the balance increases to 110% of its initial level.

When the earnings yield starts at 10% (and P/E10 = 10), the 30-year return y is 3.3% plus and minus 2%. At the lower confidence limit (with a 5% probability), the annualized return is +1.3%. After thirty years with a 1.3% per year gain, the balance increases to 147% of its initial level.

P/E10 = 12

When the earnings yield starts at 8.3% (and P/E10 = 12), the 10-year return y is 3.1% plus and minus 6%. At the lower confidence limit (with a 5% probability), the annualized return is –2.9%. After ten years with a 2.9% per year loss, a balance falls to 75% of its initial level. The lower intermediate confidence level is 3% below the 3.1% calculated rate or +0.1%. It has a 20% probability. After ten years with a 0.1% per year gain, the balance increases to 101% of its initial level.

When the earnings yield starts at 8.3% (and P/E10 = 12), the 20-year return y is 2.9% plus and minus 4%. At the lower confidence limit (with a 5% probability), the annualized return is –1.1%. After twenty years with a –1.1% per year loss, the balance falls to 80% of its initial level.

When the earnings yield starts at 8.3% (and P/E10 = 12), the 30-year return y is 3.3% plus and minus 2%. At the lower confidence limit (with a 5% probability), the annualized return is +1.3%. After thirty years with a 1.3% per year gain, the balance increases to 147% of its initial level.

P/E10 = 8

When the earnings yield starts at 12.5% (and P/E10 = 8), the 10-year return y is 14.5% plus and minus 6%. At the lower confidence limit (with a 5% probability), the annualized return is 8.5%. After ten years with an 8.5% per year gain, a balance rises to 226% of its initial level. [Under such circumstances, it is reasonable to increase withdrawals, possibly to 5% of the balance before making withdrawals from the TIPS.]

When the earnings yield starts at 12.5% (and P/E10 = 8), the 20-year return y is 6.9% plus and minus 4%. At the lower confidence limit (with a 5% probability), the annualized return is +2.9%. After twenty years with a +2.9% per year gain, the balance rises to 177% of its initial level.

When the earnings yield starts at 12.5% (and P/E10 = 8), the 30-year return y is 4.0% plus and minus 2%. At the lower confidence limit (with a 5% probability), the annualized return is +2.0%. After thirty years with a 2.0% per year gain, the balance increases to 181% of its initial level.

All Dividends All of the Time

What if you don’t want to buy TIPS? What if you reach 4% simply by withdrawing twice the dividend amount?

We have equations for that. We start with today’s earnings yield 100E10/P of 3.5%.

The return at year 10 when withdrawing twice the dividend amount (which is the same as reinvesting –100% of the dividend amount) is -6.8% per year plus 8% and minus 7%. After ten years of losing money at the Calculated Rate of –6.8% per year, the portfolio balance falls to 49% of its initial level.

If a portfolio balance is 49% of its initial balance and if the initial dividend yield is 2%, prices must fall by a factor of 4.1 to maintain the dividend amount. They must fall by a factor of 8.2 to increase the dividend amount to 4% of the initial balance.

That is, P/E10 must fall from today’s level of 27 to 3.3 for the portfolio dividend amount to equal 4% of the original balance.

Even if we limit our withdrawals to 3% (by reinvesting –50% instead of –100%), we still end up with an annualized loss (Calculated Rate) of 4.9% per year at year 10. The portfolio balance is higher, but not nearly enough. It is 60% of its initial level.

If a portfolio balance is 60% of its initial balance and if the initial dividend yield is 2%, prices must fall by a factor of 3.3 to maintain the dividend amount. They must fall by a factor of 6.7 to increase the dividend amount to 4% of the initial balance.

That is, P/E10 must fall from today’s level of 27 to 4.0 for the portfolio dividend amount to equal 4% of the original balance.

The all time low for P/E10 was 4.8 in December 1920.

Final Remarks

Switching to TIPS is the better choice if the stock holding is the S&P500 index. This is unlikely when using a dividend-based strategy. There are many quality companies with dividend yields of 3%. With care, you can find good companies with dividend yields above 4%.

It is still worthwhile to consider the speculative return. High prices have a disproportionate influence on returns.

This is an area in which a compromise can make sense. Construct a focused dividend-based portfolio with much higher yields than that of the S&P500. It will have uncertainty related to the exact dividend behavior. Invest in 10-year TIPS (and I bonds) as well. That portion will have uncertainty as to exactly when it will be exchanged for stocks and at what valuations. In this case, Benjamin Graham’s allocation advice makes a lot of sense. Restrict both stock and bond allocations to 25% to 75%.

Have fun.

John Walter Russell
September 10, 2005