Being financially independent is a must for retirees, but it could be a desirable way of life even for folks who are much younger and are several years away from retirement. Being financially independent does not mean that you necessarily want to retire early or quit working altogether, it just means that it affords you the choice of living life on your terms. In simple terms, being financially independent means that your passive investments generate (or can generate) enough income on a regular basis so as to meet your basic living expenses. Obviously, the surest way to achieve financial freedom is by saving more and investing wisely for the long term. It is also important to be able to distinguish between the ‘needs’ and ‘wants’ in your life and reduce unnecessary spending, thus reducing your basic living expenses. However, this is something that is very personal and can vary greatly from one person to another.
Whether you are a retiree or you just want to be financially independent, you need a strategy that should meet the following goals:
- Produce sufficiently high income to meet basic needs.
- Preserve capital in bad times.
- Provide reasonable growth for long-term wealth preservation.
Income:
When we say “sufficiently high income,” this is more of a subjective term, and it depends upon the size of your assets, your lifestyle, and basic living expenses. Obviously, different people have different needs. If you could reduce your expenses, then your need for income also gets lower accordingly.
Percentage Yield required = 100 * ( Yearly Expenses / Size of Assets)
In the above formula, retirees getting social security or any other fixed income should reduce the yearly expense by the amount of fixed income.
It’s a widely accepted notion that any portfolio that claims to produce more than 8% income would run the risk of depleting the capital. In fact, we would rather put the red line at 6%. Your portfolio could be generating more than 8%, but any excess income over 6% should be reinvested back into the portfolio for it to prosper in the long term. Withdrawing more than 6% of income from any portfolio would put the original capital at a higher risk of depletion. Sure, if your asset size is large enough and income needs are smaller than 6%, you should reinvest the balance back into the portfolio.
Capital Preservation:
There’s almost no financial investment that can preserve the capital 100% in all kinds of situations. Even the value of cash is subject to inflation and currency fluctuations over time, especially now when the inflation is running at 40-year high. It’s a given fact that your investments (other than cash) will have some level of volatility – obviously, the lower, the better. So, one has to know one’s tolerance for volatility. We can have all the talk about capital preservation, but the real test comes when the market takes a huge dive in real-time, something akin to what we saw in 2020 due to the coronavirus pandemic or during the financial crisis of 2008. An event or correction like this can act as a real eye-opener to review and judge if your portfolio is meeting its defined goals, especially risk tolerance. If not, you should modify your strategy.
Preservation of capital is probably one of the most important factors for retirees and conservative investors. In order to preserve capital, it’s important that our overall portfolio is able to achieve low volatility and smaller drawdowns while not compromising on growth during good times.
Reasonable Growth:
It’s debatable as to how much growth is reasonable. It can vary based on your personal expectations and factors like the rate of inflation and interest rates. But assuming an average of 3% rate of long-term inflation, in our view, a 9%-10% overall annual growth of the capital (including the income withdrawals) would be very reasonable. However, more recently, inflation has been running at a much higher clip, which makes things a bit more complicated for savers.
Financial Independence:
We have already talked about it in the introductory section. Just like many other things in life, the meaning of this term would vary from person to person. There’s no universal definition of financial independence. One size does not fit all. However, the way we see it is that if your investment portfolio can safely generate enough income to sustain your basic needs (not including luxuries or vacations, etc.), you should consider yourself financially independent.
For example, your annual earnings are $100K, but if your basic needs are only $50K, then your investment portfolio should generate at least $50,000 annually, minus any other fixed income like Social Security, pension, or rental income. You could be financially independent in your 30s or 40s and still be pursuing a great career, whatever that may be. However, what financial freedom does is that it accords you the freedom to choose to do what interests you rather than doing something that you hate to do. In essence, it’s a great stress reducer that you are not fearful of losing your job on an everyday basis.
Investment Strategy:
In this article, we present a multi-basket strategy that attempts to meet most of the above goals. As such, besides growth, we focus on income-producing strategies that also preserve capital during times of crisis.
We will review our multi-basket strategy that’s not overly complicated and easy to get started. We will provide as many as five sub-strategies (or buckets), but as an individual, you could just do fine by picking and mixing up to three sub-strategies. We also will provide some backtesting examples for each sub-strategy and how they would have behaved during the 2020 crisis or during the 2008-09 financial crisis.
Please note that we manage most of these strategies/portfolios in our Marketplace service that has live performance records at least since 2018 and for some limited portfolios since 2014.
Brief Description Of Multi-Basket Strategy
Here we will discuss a multi-basket strategy, with each sub-strategy being unique in terms of income, growth goals, and risk levels. One of the buckets is specifically designed to provide the hedging mechanism to bring lower volatility and lower drawdowns to the overall portfolio. An individual investor will be well served to pick up at least three buckets and preferably include the hedging bucket.
Below we will provide several investment buckets for consideration, along with their performance overviews. Depending upon your personal situation, you can pick and choose various baskets and assign them the allocation percentages.
DGI Basket 1: (With Individual Stocks):
Allocation: 35-50%
We believe that a diversified DGI (Dividend Growth Investing) portfolio should hold roughly 15-25 stocks. We like to invest in individual stocks, and that’s what we are going to focus on in this bucket. The best part of owning individual stocks is that once you have acquired the position, there are no ongoing fees or expenses.
For our sample portfolio presented below, we will look for companies that are large-cap, blue-chip, relatively safe, and have solid dividend records. For our list below, we will try to select stocks that are likely to provide a high level of resistance to downward pressure in an outright panic situation.
We must put emphasis on diversifying among various sectors and industry segments of the economy. A selection of roughly 15-25 stocks could provide more than enough diversification. We will present 15 such stocks based on our past research, current dividend payouts, and a high level of dividend safety.
For this part of the portfolio, our focus is to select stocks that tend to do well in both good times and during recessions/corrections. This is especially important if you are a retiree. Please note that this is just a list for demonstration purposes, and there can be many other stocks that could be equally qualified.
Stocks selected:
AbbVie Inc. (ABBV), Amgen (AMGN), Clorox (CLX), Digital Realty (DLR), Enbridge (ENB), Fastenal (FAST), Home Depot (HD), Johnson & Johnson (JNJ), Kimberly-Clark (KMB), Lockheed Martin (LMT), McDonald’s (MCD), Altria (MO), NextEra Energy (NEE), Texas Instruments (TXN), and Verizon (VZ).
Table-1:
The average yield from this group of 15 stocks is reasonable at 3.32% compared to 1.3% from S&P 500. If you still have some years before retirement, reinvesting the dividends for a few years would take the yield on cost up to 4% easily.
Chart 1:
The below chart provides a backtested performance comparison with the S&P 500.
Note: For performance analysis, ABBV was replaced with its parent co. ABT, prior to the year 2013 (prior to spinoff).
DGI Basket 2: (With ETFs and Funds)
(Allocation: 35-45%)
This bucket is an alternative to DGI-bucket with individual stocks.
Many folks do not like to own individual stocks. Some do not have time or interest to research individual stocks, while others just want to have a more simplified way of investing. So, keeping in mind the interests of such investors, we will provide two options for the DGI portfolio based solely on funds or ETFs. Even though constructing a DGI portfolio of individual stocks is not a complicated process, in this bucket, we will make it even simpler.
In this option, we will not pick individual stocks. We will select a few low-cost ETFs and mix them with a few high-yield closed-end funds. We provide two options, a conservative one and another one that is a bit aggressive. Please note that option-1 may underperform the market (during bull runs), whereas option-2 should match the market performance. But in both options, the distribution yield is very respectable and more than double of S&P 500.
Please note that in option-1, we allocate up to a total of 21% to high yield securities that include two CEFs and one energy partnership. In option-2, we allocate up to 40% to high-yield funds, including four CEFs and an energy…
Read More: How This Income Method Could Make You Financially Independent