Dave Van Knapp: Here’s What I’m Doing With My Money Now

Dividend Growth Investing Isn’t Just About Income

About a year ago, I presented my wife’s and my plan for capturing some of the large capital gains that we’d earned in our dividend growth accounts.

Here’s a brief recap.

We had invested in stocks for income – without much regard for capital gains or losses – for about 10 years.

I purchased dividend growth (DG) stocks of strong companies, and I timed the purchases to make them when shares were favorably valued.

My public Dividend Growth Portfolio is part of our investments and an example of how all of our stock investments are managed.

As a byproduct to the DG way of investing, we amassed unexpectedly large capital gains.

Those gains, in turn, led us to partially change our approach to retirement last year.

I will begin my tale at June, 2008, because that coincides with the starting date of my Dividend Growth Portfolio.

Here’s what the market did from June, 2008 until the end of 2017. The first part of the chart shows the last 9 months of the market crash from 2007-09. The last day of that bear market is marked by the red dot on March 9, 2009. The rest of the chart shows the bull market that started the next day.

If we omit the part before the red dot, we can see the bull market in all its glory through the end of 2017.

As you can see, price gains in the S&P 500 were almost 300% once the bull market got started, though the end of 2017.

How Dividend Growth Investing Led to Our Significant Capital Gains

Of course, you had to be in the market to participate in the 300% market gains. Investors who developed a perma-bear mentality from the crash, or stayed largely in cash, or moved their money to bonds, missed out on a once-in-a-generation opportunity to make a lot of money.

That’s where dividend growth investing helped us. While the crash of 2007-2009 chased many investors out of the market, DG investing focuses on income, not prices. As a result, I was willing to wade right into the market, even when it was still crashing in 2008.

In fact, I largely stopped thinking about “the market” as controlling our investment outcomes. Instead I simply saw the stock exchange as a store where I could buy whatever I wanted, whenever I wanted to buy it.

So we were mostly in stocks throughout the entire 2009-17 bull market. The income was fine, so there was no reason to be scared or sell out. The market is not a player in dividends.  (See DGI Lesson 7, Dividends are Independent from the Market.)

The decade-long bull market has often been called “the most hated bull market in history.” That’s because the market crash that preceded it (2007-09, with a 57% loss in the S&P 500) scared the wits out of so many investors. Many sold out and took years to tiptoe back in. Some are still out.

But we didn’t hate the bull market at all. It was helping us build our income stream for retirement.

The rising prices of our stocks also meant that we accumulated some significant (unrealized) capital gains, without having tried to do so. While we didn’t invest with the goal of sizable price gains in mind, we got them anyway.

I’ll be the first to acknowledge that we were lucky. But some of the luck was the residue of design: Investing for dividend income led us to be heavily invested in the stock market at a time when many fled from stocks and stayed out for years.

“Retiring” Some Money

If you recall January, 2018, the market was getting wobbly. The “paper” capital gains in our accounts did not go unnoticed by my wife and myself, and we began to wonder about grabbing some of them.

As described in last year’s article, we decided to use sell-stops to sell some shares if the gains started to disappear in a market correction or crash. And that’s what happened.

Sell-stops kicked in, and by the end of March, we had sold about 16% of the value of the stocks in our portfolios. (I did not sell anything from the public Dividend Growth Portfolio. I kept that intact as a “pure” DG demonstration.)

The way we looked at it was that we were retiring some of our money. We moved it into completely risk-free cash and Certificates of Deposit. We now view that money as coasting along. It’s out of the race; its work is done.

If you put our portfolios together into one combined picture, this is what our asset allocation looked like at the beginning of 2018, before we embarked on the money-retirement program.

After the program, our asset allocation looked like this.

As you can see, some of what had been stocks became cash.

After March, we shut down the selling program. The result of our program was to move some money from the stock market to risk-free cash and CDs.

While our purpose was not to de-risk our investments in the traditional sense, that is what happened. Every dollar moved from stocks into cash proportionately reduced our overall price volatility, because cash and CDs have no volatility.

Don’t Ignore Social Security and Pensions

At this point, I want to interrupt my story to tell you about my view of Social Security and pensions. I count them as if they were my own money invested.

The late John Bogle (founder of Vanguard and the inventor of index funds) recommended doing this. Here’s how USA Today described Bogle’s view:

In particular, Vanguard Group founder Jack Bogle has argued in favor of treating Social Security like a bond investment for purposes of allocating the rest of your portfolio, arguing that you can take more risk in buying stocks with the remainder of your savings if you know that Social Security will offer you the monthly income you’d otherwise need to get from bonds.[Source]

The idea is to not get too afraid of stock market volatility – and thus invest too conservatively – by forgetting that a great deal of your retirement income is essentially guaranteed.

As you can see from the charts above, we have (and still have) a much higher allocation to stocks than is generally considered prudent for people our age (I am 72). One of the reasons that I am comfortable with such a high percentage in stocks is that I consider SS and pension benefits to be the functional equivalent of fixed income (bonds).

I call them “vested interests,” and I assign an equivalent capital value to them, as if they were money invested in our portfolios. My reasoning is that the vested interests provide reliable monthly income, just as bonds do.

Obviously, I can’t sell my pension or SS rights as I could sell bonds, but from an income point of view, our vested interests work as if we owned bonds throwing off the same amount of income. (SS is indexed to inflation, so its income actually rises, but I ignore that as icing on the cake.)

After figuring out the equivalent capital value of our vested interests, our asset allocation looks like this.

Viewed that way, our allocation to “risky” stocks doesn’t look so aggressive; it looks pretty mainstream.

I would be remiss if I didn’t point out that not everyone agrees with Bogle. For a discussion about the pros and cons of viewing vested interests as if you owned an asset, see this article from MarketWatch.

Our Bucket System

Bucketing is a widely-used tool to help investors understand their portfolios in a straightforward way. Often the buckets are presented as portions of the portfolios that will be used at different times in retirement. These two depictions are from Morningstar and AAII (American Association of Individual Investors).

[Image sources: Left, right]

Note the similarities:

  • Three buckets defined according to time periods (1-3, 3-10, and 10+ years)
  • Cash in Bucket 1
  • Bonds and balanced funds in Bucket 2
  • Stocks and risky (high-yield) bonds in Bucket 3

How much is in each bucket should be a function of age, according to conventional advice. It is universally declared that risk tolerance declines with age. Here’s the way AARP puts it:

In the second bucket, you own short- and intermediate-term bond mutual funds, with dividends reinvested. You gradually add to your bonds during your preretirement and immediate postretirement years. By age 60 or 65, these first two buckets might hold 70 percent of your retirement investments. … The remaining 30 percent of your money goes into the third bucket, invested in mutual funds that own U.S. and international stocks. You don’t expect to touch these stock funds for 10 to 15 years. [Emphasis added.][Source]

The idea of having 70% of your money in cash and bonds by age 65 is widely espoused. The famous “age in bonds” rule is that your allocation to bonds should match your age. At age 72, I should have 70% of my money in bonds.

But we own essentially no bonds. Dividend growth investing, and viewing vested interests as cash-cow assets, work together to stand conventional wisdom on its head. The reasons are twofold:

  • Bonds are for income, but we own vested interests to a lot of income without any bonds. We don’t need more fixed income.
  • Bonds are also for smoothing out total returns (protecting them from market volatility), but our income is already smoothed out. Most of its volatility is “good” volatility, meaning that our income usually goes up, rather than up and down.

So my approach to retirement buckets is different. Whereas the traditional approach has stocks in the long-term bucket for use 10 years out – meaning that you’ll sell them to generate retirement “income” – I own stocks that produce real income naturally. Not only that, the income can be used immediately (if we like) for any purpose: to spend, save, or reinvest.

So my buckets aren’t denominated by when they’ll be used. Rather, they are simply another way of looking at asset allocation. They depict what kinds of assets they hold. For us, almost 100% of our investments are:

  • Cash and cash equivalents
  • DG stocks and ETFs
  • Vested interests

Compared to the Morningstar and AAII buckets, we do not own bonds, balanced funds, high-risk bonds, or “other” investment products. With just a few remaining exceptions, we’ve sold those off over the past 10 years as we moved to a nearly complete DG philosophy.

So our bucket approach is relatively simple and straightforward. Once again, the emphasis on income leads us to disregard the more complex investment products that the financial services industry constantly invents and offers.

Most advisers would say that our approach is too risky, meaning there is way too much money in stocks.

My response would be that our stocks are not there primarily to be sold off, but rather for the income they provide. Therefore, the conventional industry definition of risk – price volatility – doesn’t apply so much to us, because with the cash cushion and focus on income, we have greatly reduced the odds of ever being “forced sellers” at the worst time – when prices crater.

There is rarely any downward volatility in the income that our DG investments deliver.

Cash Management

Until 2017, we were reinvesting all dividends. We didn’t use them for spending money. We used pension and Social Security income, plus we were selling off non-DG assets (like I-bonds and index funds) that we had accumulated in the old days.

Since RMDs started for me, and now that almost all of our non-DG assets have been sold off, we’re no longer reinvesting all dividends. Instead, some of the dividends now flow out of our brokerage accounts rather than being reinvested.

The following diagram shows how our cash flows work. The accounts and vested interests are color-keyed to the bucket colors seen earlier.

In practice, it’s less complicated than it looks. Most cash transfers are automated, including most of our bills that are paid out of the checking account. We charge practically everything we buy to credit cards (to get free miles), and those are paid off monthly automatically out of the checking account too. We never pay interest or late fees.

The black arrow labeled “4x/year” represents my quarterly big-picture reviews and the manual movement of cash into our checking account, where it supplements cash from our vested interests.

Here’s a summary of how our cash management works. Automated payments are highlighted in yellow.

I divide our cash (Bucket 1) into literal cash (checking) and “money coasting.” The latter is retired, but it picks up a little in returns from:

  • Ally savings account interest
  • Ally CD interest
  • CDs in brokerage accounts (where stocks were sold as part of the money-retirement program)

The reason for the Ally savings account and the CDs is that we don’t want our cash to earn zero. It’s not under the mattress or buried in a bucket in the backyard. Rising interest rates actually help us here.

Closing Thoughts

By selling some stocks in early 2018, we did not abandon dividend growth investing. When we stopped selling, we still had a sizable chunk – one that most advisers would call too risky – in stocks.

Rather, what we did was layer another strategy on top of DG investing that is almost all based on psychological contentment: Having generated hundreds of thousands of dollars in market gains during the long bull market, we decided to cash in some of those gains and protect them from any possibility of market damage.

I often say that financial decisions are a combination of math plus psychology. In my house, the psychology is a combination of my wife’s and my desires.

Our decision to realize some profits felt right to both of us a year ago, and it still feels right. We’re both comfortable with giving up a portion of future income growth in exchange for removing some of our money entirely from the risks of the market.

We experienced good fortune for 9 years on the price side as a result of the DG investing that we did. Our lack of fear of the market allowed us to reap the benefits of stock investing and staying in the market no matter what it was doing.

At the end of 2017, we had an opportunity to capture many years’ of expected future dividends in the form of price increases that had already occurred. So that’s what we did.

So now our plan for funding retirement is a hybrid that involves not only DG investments and vested interests, but also money coasting along in savings and CD accounts. It feels very comfortable.

Of course, none of this is a recommendation to anyone to look at things the way we did or to copy us. As always, I write about what I do and why I do it, in the hope that a broad range of investors will find something of value in seeing how someone else does it.

— Dave Van Knapp