I came a long way from having $72.00 in the bank (paycheck prisoner) to having a freedom fund that is worth 14 months of freedom (not a lot I know, but I'm getting there).
As this freedom fund grows, I'll have to decide on a strategy for my compounding mechanism.
I'm a firm believer in the fact that the stock market is purely a compounding machine which requires an input of resources. To me, it is not the place to make money, but simply a place to grow & magnify whatever you throw into it.
At the end of the day, you'll still need an active income source for a stock market strategy to work.
Therefore, I'm not counting on stocks alone to path my route to freedom. My focus therefore, is skewed towards the active income side for these formative years. Some may argue that this is a "chicken and egg" problem.
What matters is having a strategy and sticking to it.
So, back to the main point of this post, I have narrowed down my compounding mechanism to 2 choices: Dividend Growth Investing & Index Investing.
I'm no financial expert and this is an over-simplistic view on the topic. Use your bullshit filter to assess whatever is written here.
Dividend Growth Investing
Keyword = Growth.
It's not about generating dividends from this niche class of stocks, but generating growing dividends year after year. This increase in dividends (growth) alone is a good hedge against inflation.
To put it simply, we're not looking for just any stock that pays a fixed sum of dividends every year. What we're looking for is a stock that increases its dividends on a consistent basis. This way, whenever these stocks appreciate in price, the management will also increase dividends to maintain the same (or higher) yield.
In bad times, when the stock market plunges, dividend 'aristocrats' (yes, such stocks exist) still maintain the same dividend payout.
Jason from DividendMantra is a good case study for this strategy.
Criteria for Dividend-Growth Stocks:
1) Dividends must increase every year, or demonstrate an upward trend
2) Dividends must be consistent (monthly, quarterly, bi-annually or annually)
3) Low to mid beta + sound fundamentals
4) Keep costs low
5) Don't focus on market timing. Buy on fundamentals (fair price) and hold for the long run.
1) Dividend 'aristocrats' pay consistent dividends even during major financial crashes. This prevents you from selling in bad times if you happen to need the cash flow.
2) Constant stream of income
3) Growth in dividends is a good hedge against inflation
4) There is a definitive point signifying financial independence when monthly dividends = monthly expenses
1) Requires an active approach
What it really means:
During a market crash like the one we observed in 2008, you'll still get paid your dividends. If you lose your job during this same period, you'll still get paid your dividends. As statistics prove that the market will always rebound (if not soar) after a crash, a dividend growth strategy prevents you from having to sell your assets during a crash if you need the cash flow.
Financial independence is achieved when your monthly dividends cover your expenses, which makes it a popular strategy for those who are seeking early retirement.
I'm still in the midst of reading John Bogle's "The Little Book of Common Sense Investing" which lays out a very strong case for investing in a broad based index fund.
The past is certainly not an indicator of the future. But Bogle (creator of Vanguard funds) argues that if you know why the past happened the way it did, then it is the best indicator of future performance.
The case for index investing is based on a few tenets.
- The first being our inability to time the market. While active stock picking may generate great returns in certain years, it is sporadic. In the long run, a low cost index fund beats 70-80% of actively managed funds.
- The stock market is a zero sum game. Because someone has to sell before another can buy, when a person makes money in the market, someone loses money. So, why bother when you can buy the whole damn market? Instead of playing a game of roulettes, buy the whole damn casino.
- While actively managed funds may be equal/outperform the market in certain years by a few percentage points, costs have proven to negate the returns earned by actively managed funds.
- An index automatically rebalances your portfolio (again reducing the costs associated with manual rebalancing in the case of active stock management)
- US Index Funds will always increase in the long run due to market efficiency & increased productivity, technological innovations which essentially translates to higher earnings by companies in the long run. You're buying all of that.
- Indexing is just common sense.
Criteria for Index Investing:
1) Broad-based (e.g. S&P 500, other Vanguard alternatives, etc.)
2) Low cost
3) Reinvest the dividends earned
1) Investing on autopilot. Almost a no-brainer.
2) Relatively passive approach
3) The S&P 500 index average 10% gains per year since 1871. 10% average every year is certainly not a bad strategy for such a passive approach.
1) When the market tanks by 30-40% like what we saw in 2008, it can be hard to keep calm and not sell
2) Discipline is required. Invest consistently, in good times and in bad times.
3) Benefits of index funds are always skewed towards US Indices. Certain foreign index funds do not rebound like US index funds. Furthermore, as a foreign investor, we are taxed 30% on dividends. Therefore, this strategy is not entirely universal.
What it really means:
All you have to do is to contribute systematically (every month/quarter) to a broad based index fund like Vanguard, sit back, relax and enjoy the ride.
So, dividend growth or index investing for me?
As a foreign, non-US investor, a dividend growth strategy makes more sense as the principles are still applicable if I replicate the strategy in my local stock market. This way, I am also able to circumvent the 30% foreign withholding tax imposed on dividends if I were to buy into a US index like an S&P 500 tracker.
I've started with the dividend growth model and managed to lock in total earnings (capital gains + dividends) of 10.43% last year.
The issue here is I'm not sure if I can maintain that same 10% this year.
"Two lumberjacks arguing about the best way to chop down a tree. "A sharp axe is the way to go." Says the first. The other disagrees, "You can't go wrong with a good saw."
The axe club ridicules the saw group; whereas the saw crowd thinks the axe guys are backwards. At the end of the day, it doesn't matter.
The tree is done for..." - anonymous