Category: Withdrawal Strategy

Posted by BM on January 14, 2022

In November last year we wrote a post about Peter Lynch’s Stay-in-Stocks Strategy that he first introduced in 1995. The withdrawal strategy assumes 8% growth in share prices and dividends with a starting dividend yield of 3%. The strategy will generate $50,000 of income each year from a $500,000 portfolio of dividend growth stocks. The average withdrawal rate in this strategy works out to about 8% over the 20 year period.

As a follow up to that article we came across a study titled ‘Income Withdrawal Sustainability using Large Cap Value Portfolio Historical Period 1932 – 2019. An Alternative Strategy for Income Harvesting’.

In the study the author assumes a 7% withdrawal rate using only large cap stocks as part of his portfolio. Some pay dividends and some do not. The concerns voiced in the study are the same as all investors…will we outlive our investments or “spend down” our principal to zero?

Over the period from 1932 – 2019, seventy-one “rolling” twenty-year periods were tested starting at the beginning of the calendar year. Eleven periods, or 15% of total, ended with the portfolio balance falling to zero (failure) at some point along the period.

Lynch’s returns and strategy were based on averages and as we all know, that sometimes can come back and hurt you as it did in this study, 15% of the time.

The most interesting part of the study was the adjustment the author made to improve on the 15% failure rate. The one change is called the ‘90% Balance Rule’.

“If, after the income withdrawal is taken (at the end of each year), the portfolio balance has fallen below “90%” of the original starting amount, then the annual withdrawal taken is reduced by 50%. In subsequent years, the portfolio balance is then monitored for a rise back above the 90% of the original starting amount, at which point a “7%” income withdrawal can be reinstated.

For example, the investor starts with an initial amount of $100K invested in Large Cap value portfolio. At the end of the first year, the portfolio value rises to $110K, so the investor takes a $7K withdrawal. At the end of the second year, with a portfolio loss and $7k income withdrawal the balance falls to $94K, yet still above $90K ( the “90%” of initial starting amount at the beginning of year one ). However, at the end of year three, the portfolio return and income withdrawal reduce the balance to $87K, and therefore, the income withdrawal is reduced to $3500. When the portfolio “gains” and income withdrawal equate to the portfolio values rising back above $90K, then the year’s income withdrawal can be increased “back to” $7K ( 7%).

A compelling feature of this method is that at the end of the year, taking into consideration the portfolio’s “balance level” and year’s return, an investor has a solid grasp as to what dollar amount that their income withdrawal is, and can plan their forward year’s expense budgeting accordingly. They can spread their withdrawal out over the course of the year in equal parts (quarterly for example) or take a larger portion of the withdrawal earlier or later, if emergency needs arise.”

By incorporating the 90% Balance Rule over all 20-year periods of the test sample, 96% of finishing portfolio balances ended above initial starting level with no portfolio “failures”. The other interesting observation was that in a high majority (82%) of the twenty-year periods required none or only one reduction in the withdrawal rate.

The author goes on to recommend that investors may want to take additional steps to compensate for a period of lower income, derived from reduced withdrawal rates, by building a ‘safe money’ bucket or having access to other sources of ‘backup’ income.

With so many investors on the sidelines over the last few years, incorporating Lynch’s ‘Stay-in-Stocks DGI Strategy’ with a 90% Balance Rule adjustment may be just what conservative investors are looking for if they fear a market correction or crash is just around the corner.

Posted by BM on November 3, 2021 

“The dividend is such an important factor in the success of many stocks, that you could hardly go wrong by making an entire portfolio of companies that have raised their dividends for 10 to 20 years in a row.” Peter Lynch, Beating the Street p. 49

“The best way to handle a situation in which you love a company but not the current price is to make a small commitment and then increase it in the next sell-off.” Peter Lynch, Beating the Street p. 158

Some good advice from Peter Lynch in his book Beating the Street.

Speaking of Peter Lynch, we were recently made aware of an article (Fear of Crashing) in Worth Magazine written by Mr. Lynch and financial writer John Rothchild in 1995 where Lynch advises how to prepare for, react to and recover from a market correction. We found it relevant not only because it is timely with the stock markets at an all-time high but because many of our subscribers are looking for a different withdrawal strategy other than the ‘4% Rule’.

“The strategy I’m proposing can offer the best of both worlds: money to live on that normally comes from bonds and growth that comes from stocks. Here’s how it works. You sink 100 percent of your investment capital into a portfolio of companies that pay regular dividends. You could do this the easy way and invest in an S&P 500 index fund, currently yielding about 3 percent. Or you could select a few “dividend achievers,” as identified by Moody’s. These are the companies that have a habit of raising their dividends year after year no matter what.

Since dividends are paid out of earnings, these dividend achievers couldn’t have compiled such a record without having enjoyed consistent success in their core business, whatever it is. So you’re looking at a group of profitable enterprises with staying power.”

-Peter Lynch

Interesting to note that even in 1995, one of the greatest growth investors of all-time is recommending dividend growth stocks as the core of his ‘Stay-in-Stocks Strategy’.

In a nutshell here is Lynch’s strategy:

Let’s assume you have $500,000 to invest and you need a minimum of $50,000 each year to meet your spending obligations. First start by building a portfolio of quality dividend growth stocks from ‘The List’ with a starting dividend yield of 3%. Year one you will receive $15,000 in dividends ($500,000 x .03). You are still shy of your spending amount. You sell $35,000 in stock to make up the difference.

To some, selling stock that you have recently bought may sound a little scary but once you assume that the portfolio has risen by 8% (historical norm for stocks) during the year, the strategy begins to make a little more sense. Combine the dividends (3%) and capital growth (8%) of the DGI portfolio and you have an average total return of 11% for the year. This return back tests favorably with the stocks on ‘The List’ who achieved a higher total return CAGR of 13.3% for the last decade.

Here are the 10YR Compound Annual Returns of ‘The List’. 10YR_CAGR-The List-01-01-2021

Your portfolio would now be worth $555,000 had you left it alone ($500,000 x 1.11). The fact that you withdrew funds, $15,000 in dividends and sold $35,000 in stock means you begin the second year with a portfolio worth $505,000.

The good dividend growers raise their dividends again in year two and your portfolio value increases at the same rate (8%). At the end of year two, you sell a little bit less stock to reach your spending goal. Every year thereafter, as dividends are raised and stock prices go up, you’re selling less and less stock to cover your expenses. Selling less stock allows your portfolio to grow beyond its original value.

We have included a table below to show you what happens next as companies in your portfolio continue to raise their dividends and stock prices continue to go up at their historical rates.