It is possible to achieve financial freedom by living off dividends forever.
That isn't to say it's easy, but it's possible.
Those starting from nothing admittedly have a hard road to retirement-enabling passive income. Unless one has a preternatural ability to save a huge portion of their income for over a decade without interruption, achieving financial freedom requires at least a moderately high income and/or certain other advantages in life, such as a large inheritance.
But does the difficulty of achieving this goal make it not worth pursuing? No, I definitely think it is worth pursuing. I'm pursuing it myself.
Every summer, I spend as much time as possible hiking in the Rocky Mountains. Generally speaking, the bigger the mountain, the more rewarding it is to climb.
In what follows, we'll first look at some timely data that bolsters my thesis from last week's missive, titled "Recession Is Imminent: Position Your Portfolio For Monster Dividend Growth."
Next, I'll briefly discuss why an investor would choose dividend stocks over other forms of passive income like bonds or rental properties.
Finally, we'll look at three practical elements of achieving financial freedom.
More Signs Of A Coming Recession
Last week, I made the case that there is more weakness among consumers and businesses than many investors recognize. This makes recession closer than many realize.
Recessions, mind you, usually don't start with a bang. Rather, they come about the same way Ernest Hemingway described the process of going bankrupt: "Gradually and then suddenly."
Consider unemployment, which is still quite low all things considered. But the important thing is not the absolute level but the trend. The unemployment rate is no longer falling. It's rising.
A Federal Reserve economist named Claudia Sahm found that every time the unemployment rate rose 50 basis points above the minimum three-month average from the past 12 months, it correlated with the beginning of a recession.
As of October, the US unemployment rate is 33 basis points above the lowest 3-month unemployment rate from the last 12 months.
To be fair, the month that the NBER retrospectively marks as the beginning of recessions tends to have lower than 50-basis point increases in unemployment.
In December 2007, the official start month of the Great Recession, that metric was 40 basis points. It wasn't until April 2008 that 50 basis points was reached.
In March 2001, the official start month of the post-Dot Com bubble recession, that metric was 30 basis points. That recession didn't see a 50 basis point increase until June, about a third of the way through the official recession.
What's more important is the sustained increase in the unemployment rate. So far this year, the unemployment rate has trended higher, albeit in a zigzag pattern.
Tellingly, data shows that the most overrepresented job among recent layoffs is "recruiter."
At the very least, this signifies a slowing of further job growth. But my hunch is that recruiters are merely among the first wave of many layoffs to come.
Last week's article also discussed the weakening consumer. Bolstering this view of a weakening consumer, a collaboration between the National Retail Foundation and CNBC offers a new retail spending measurement that uses real-time transaction data. It shows a steady softening in retail sales over the course of the year.
This aligns with some anecdotal data presented by the management team of Walmart (WMT) in their Q3 2023 conference call, in which they mention that they "think slightly more cautiously about the consumer versus 90 days ago" and call this an "uncertain consumer environment." They mentioned on the call that Walmart's sales particularly weakened in the second half of October.
And Walmart, mind you, sells mostly essential items and consumables. Discretionary retail is typically getting hit even worse.
Worse yet, while retail sales are dipping into the negative month-over-month, bank lending is dipping into the negative year-over-year -- for the first time since the Great Financial Crisis.
Before the GFC, the US economy hadn't seen contraction in bank lending since the late 1940s, which presaged the 1949 recession.
Normally, sharp drops in bank lending come right before or at the beginning of recessions.
Also notable is the fact that analysts are rapidly lowering their earnings estimates for Q4.
Since peak earnings optimism early this summer, the consensus S&P 500 earnings estimate for Q4 2023 has fallen 17%.
Outside of the Magnificent 7 mega-caps, the economy seems to be showing more and more cracks.
That doesn't mean investors should sell all their stocks and go to cash. When most investors think of a recession, they think of the devastating GFC of 2008-2009, often considered the worst economic downturn since the Great Depression.
But recessions are like snowflakes. Every one is unique.
Rather than a devastating, GFC-like recession, I think the potentially ensuing recession will look more like the one from the early 2000s.
During that recession, richly valued tech stocks such as those in the Nasdaq index (QQQ) dropped precipitously, along with interest rates, while rate-sensitive real estate (VGSIX, VNQ) soared.
Likewise, defensive dividend stalwarts like NextEra Energy (NEE) and PepsiCo (PEP) also fared quite well, suffering only a brief correction in 2002 during the final capitulation of tech stocks.
Why Dividends?
During recessions, reliable dividend payers are a godsend, as the regular stream of dividend income into one's account allows for reinvestment at lower stock prices and therefore higher dividend yields. This accelerates the growth of your passive dividend income, as I explained in "Use This Bear Market As A Passive Income Accelerator."
But there are many reasons why dividend stocks make a great form of passive income. Here are eight:
- Dividend-paying companies tend to be larger and more mature with less risky business models.
- They allow access to many of the best and highest quality businesses and (for REITs) real estate properties in the world.
- They provide truly passive income, unlike rental properties that typically require untold hours of personal labor.
- Dividend stocks can use leverage to increase returns on equity without shareholders bearing direct liability for the debt, unlike mortgages on rental properties.
- Dividend stocks offer two sources of regular income growth: dividend increases and the ability to immediately reinvest dividends into ownership of more shares.
- Unlike bonds, dividend stocks offer inflation protection through dividend growth. Historically, during years when inflation was over 5%, dividends produced 54% of the S&P 500's total returns.
- As of 2022, for qualified dividends, single filers can earn up to $41,675 and married-joint filers can earn up to $83,350 in dividends while paying a 0% tax rate. Above that, incremental qualified dividends are taxed at the long-term capital gains rate.
- Non-qualified dividend payers, such as real estate investment trusts ("REITs"), master limited partnerships ("MLPs"), and business development companies ("BDCs") have certain other tax advantages, as we explained recently in this article.
Over the last 50 years, the S&P 500's (SPY) dividend growth has averaged 6.5% per year.
During the last three recessions, the index's dividend growth went negative as more companies cut their dividends than raised their dividends. But in the four recessions prior, the S&P 500's dividend growth did not turn negative.
You might object that the S&P 500's dividend growth is only that high because of its many low dividend yielders with low payout ratios and yields under 2%. Who could ever retire on that?
But it is entirely possible to assemble a portfolio of moderate-yielding dividend stocks with strong dividend growth.
For example, the Schwab US Dividend Equity ETF (SCHD) and iShares Core High Dividend ETF (HDV) yield 3.7% and 4.2%, respectively, but both have put up impressive dividend growth over the last decade.
SCHD's dividend growth has averaged over 12% per year, while HDV has generated roughly 6% average annual dividend growth.
According to the portfolio tracking software I use, my current portfolio-wide dividend yield is 6.1%, and over the past 5 years, my portfolio's dividend growth has averaged 6.7% annually.
In short, then, dividends are a great form of passive income because (among other reasons) they provide inflation protection, unlike bonds, and are truly passive, unlike rental properties.
Three Steps To Financial Freedom
The first rule of compounding: Never interrupt it unnecessarily.
--Charlie Munger
The ability to actually live off dividends indefinitely assumes no interruptions to the compounding that dividends provide. But life happens. Interruptions happen. Whether from divorce, huge medical bills, a kid attending an Ivy League university, setbacks happen.
The following steps are not meant to be an impossible ideal, but rather an identifiable goal to strive for.
These three steps are, in my view, the three basic building blocks of financial freedom.
Step 1: Situationally Appropriate Savings Cushion
This first step is among the most basic and critical rules of personal finance. It is a piece of wisdom my father has long emphatically espoused to his children.
- Build and maintain a situationally appropriate cushion of savings in cash or other liquid, short-term investments equal to 3 months to a year (or more) of living expenses.
Stocks are ownership stakes in real businesses and are inherently long-term investments. There should be no predetermined holding period for long-term investments. Buying and selling shouldn't be forced to fit into some artificial temporal framework but should happen as appropriate. (I.e. "Buy low, sell high.")
An adequately sized savings cushion in a money market, ultra-short term bond fund (VUSB), or bank savings account prevents one from the need to sell stock at inopportune times to pay for some expense that is above and beyond what can be paid for with one's regular monthly income, whether that income is active (from a job) or passive (from one's investments).
An adequate savings cushion also goes a long way in helping retirees feel comfortable about sitting on unrealized losses in their stock positions during bear markets.
If an unexpected expense arises, this cash cushion allows retirees to wait out temporary stock price weakness in otherwise strong companies that are likely to rebound.
The size of this savings cushion should be "situationally appropriate," meaning that it incorporates one's particular risk of needing to tap into it. If one has a health condition that makes one susceptible to more frequent medical bills, for example, it might be situationally appropriate to maintain a larger savings cushion.
Step 2: The 125% Rule
Determine your desired level of living expenses. Be realistic.
One's desired living expenses is also situationally appropriate, because the number will differ wildly between someone living in a downtown San Francisco or Washington DC townhouse and someone living in a rural part of the Midwest.
Also estimate your personal inflation rate. If you own your home with no mortgage, don't have kids in college, and are generally healthy, your personal inflation rate might be quite low. But if you rent, have kids in college, and/or have health conditions, your personal inflation rate might be higher.
For those assuming a lower personal inflation rate, you might target stocks with higher yields while generally growing their dividends at a slower rate.
The ultimate example of this is Realty Income (O), a single-tenant net lease REIT with a massive portfolio of mostly retail and industrial properties. While O's dividend growth rate will likely slow to the low- to mid-single-digits going forward due to its huge existing asset base ($55 billion+), the REIT also sports a yield of about 5.8%.
Instead of O, I prefer its smaller peer Agree Realty (ADC), which only has about $7.65 billion in total assets and exclusively targets the highest quality single-tenant retail properties leased to strong retailers like Walmart (its largest tenant). ADC currently yields 5.1% but boasts a roughly 7% average dividend growth rate over the last five years.
For those assuming a higher personal inflation rate, you might lean more heavily into stocks that you believe will grow their dividends at a faster rate going forward.
Two examples of these types of companies already mentioned in this article are PepsiCo (PEP) and NextEra Energy Inc. (NEE).
Both of these dividend stalwarts boast long dividend growth records (50 years for PEP and 27 years for NEE), both currently yield over 3%, and both have been growing their dividends in recent years at 10% annual rates.
Now, once you've determined your desired level of living expenses and personal inflation rate, the admittedly lofty and ambitious passive income number you should target is described by what I call "the 125% rule."
- The minimum threshold of passive income needed to achieve financial freedom is 125% of your desired living expenses.
This extra 25% of passive income does two things: (1) It allows you to continue reinvesting a portion of your dividends for further income compounding, and (2) it acts as a buffer in case of dividend cuts.
Of course, there's nothing magical about the number 125%. It could be more or less than that, but I like 125% for a few reasons.
First, if you have a broadly diversified portfolio of dividend stocks, your portfolio is highly unlikely to suffer a 25% hit to total dividend income. During the Great Financial Crisis, the S&P 500 only saw its dividend drop by about 20%.
Second, by the time one achieves financial freedom, they have probably been investing in dividend stocks for a long time and have grown to enjoy reinvesting dividends. Having a relatively big buffer of 25% (or somewhere thereabouts) allows one the simple pleasure of continuing to do what they've enjoyed doing for many years.
By the way, financial freedom does not necessarily mean ceasing all paid work forever. I think meaningful work and the sense of purpose it provides is a critical piece in the puzzle of a happy, fulfilling life. Perhaps financial freedom simply affords one the ability to seek out different work, be it a job with fewer hours, starting one's own business, whatever.
Financial freedom is just that: the freedom to decide what to do with your limited time on Earth.
Step 3: Diligent Monitoring
Finally, one cannot overlook the need to diligently monitor the investments that are throwing off all this passive income.
Truthfully, dividend investing in a portfolio of individual stocks isn't totally passive in the sense of requiring zero time from you. These are ownership stakes in real businesses, after all. Even if you seek to own high-quality dividend payers, as I do, you should still stay apprised of their business fundamentals.
Even the best businesses can decline over time.
Of course, one can own a portfolio of only diversified dividend ETFs, which require little to no monitoring. That is an option.
But for many of us dividend investors, achieving financial freedom is faster and more effective through individual stock selection.
Being a stock-picker ain't easy, though, even if your goal is passive income growth.
Fortunately, the Internet is a wide world of data, and information has never been easier to obtain. Plus, there are many investing research services and software programs that make life easier for the dividend stock-picker. It is worth forking over a few hundred bucks a year if it potentially saves you thousands!
Bottom Line
A recession still appears to be inbound. More and more signs of that are popping up.
But for the investor focused on financial freedom, it is best simply to stay the course, no matter what the economy throws your way.
There are many reasons to pursue financial freedom through the passive income generated by dividend stocks. I listed 8 above, but there are others.
And the three basic steps to financial freedom discussed above are my framework for how I aim to achieve this goal, and how I'll know when I get there. Hopefully, they can be a helpful framework for you to use as well.
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