Everyone knows that in order to make money in the stock market, you need to buy low and sell high. But, during a downturn, you will be making withdrawals (selling) when the market is at a relative low. The greatest risk to financial independence is a market downturn early on in your non-salaried life. If the market downturn happens further in the future, you will have had all that time to build up a surplus. A FIRE investor holding an S&P 500 index and following the 4% withdrawal rate would have seen their money grow by about 0.5% a year, even after subtracting taxes and inflation. But, those gains would not have been steady. There would have been a random number of good years followed by a bad year (or 2 at most). Saving the extra money during the good years would have provided the cushion needed to come out of the bad years in good shape. But, if the market went down 20% in the first year, you would have had to start with 20% more money than you needed in order to have come out OK.
So far, we have seen that the surest way to be financially independent while reducing risk is to save more money. But the thought that instead of saving $1,250,000, you would need to save $2,500,000 can be fairly depressing. Is there a way to make withdrawals that do not fluctuate so much with market downturns? Is there a way to make withdrawals during a downturn that does not result in buying high and selling low? Is there a way to make those withdrawals increase with inflation? It turns out there is, but the cost is the higher risk of owning individual stocks or mutual funds.
Most stocks pay out a dividend of some sort. These dividends are paid out to shareholders on a per share basis. The dividend amount is usually tied to the company’s profits and is not tied to the share price. In addition, dividend payouts do not result in the sale of any shares. Lastly, if the company does well and grows, they usually increase their dividend payout to match.
Some dividends are taxed at the regular rate, and some are taxed at the long-term capital gains rate. Since our previous example involved an income less than $165,000 per year, we would ideally find a stock that paid dividends taxed at the regular rate. So, our single person living in California who had a non-salary income of $59,000 would have an effective tax rate of about 15%. A dividend payout of 4.7% would result in an after tax payout of 4%. Most dividend mutual funds pay less than 4.7%, but a few pay more. For instance PXFX pays out 6.15% (as of 1/28/2019). In addition, a stock screener can find many stocks with a yield greater than 4.7%. If you had $1,200,000 million invested in stocks that paid a 5% yield, you would be paid $60,000 per year in dividends without having to sell any shares. After taxes, this would leave you with $51,000 per year. If the market were to drop 20%, this payout would remain the same as long as the dividend payment remained the same. If the market were to then recover, you would regain all your stock value since you did not need to sell any shares while the market was down. Lastly, if the company’s profits grew at the rate of inflation, it would be reasonable to expect that the dividend payouts would increase to match inflation.
The big problem with this approach is the high risk of owning individual stocks or mutual funds. During market downturns it is common for companies to run into trouble and reduce their dividends. Companies can and do go bankrupt. So, you have to find companies that can sustain their income during a recession. In addition, you have to pay constant attention to the financial reports of the company so you can sell if the company runs into trouble. A common belief is that fast food restaurant chains are recession proof. However, the biggest companies typically pay less than 4% in dividends: McDonalds (stock symbol MCD) only pays 2.53% (as of 1/29/2019), Taco Bell - KFC - etc. (stock symbol YUM) only pays 1.55% (as of 1/29/2019), and Starbucks (stock symbol SBUX) only pays 2.15% (as of 1/29/2019). In order to get a high yield, you have to be willing to buy a much smaller and less well known restaurant company like Ark Restaurants (ARKR) which pays out 5.41% (as of 1/29/2019).