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October 10, 2017

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Replacing Income

May 8, 2017

We hope that share prices increase over time. While, this is a noble investing aim, it ignores most investors’ retirement goals. Rather, we should invest to replace income from working with income from investments. Focusing on returns only muddies the water. In my book, Forget the Noise, I first outlined my approach. This approach is one that I have applied consistently ever since.

 

Every month, quarter or however so often, we should buy shares that generate a regular income. The first goal should be for your portfolio to generate one month's worth of your annual salary. After that, aim for two months, and then three months, and so on. The ultimate goal is to be able to replace your annual salary with the income generated by your investments.

 

I propose forgetting about the price return of your portfolio (I can hear asset managers who focus on selling investment performance protesting). Specifically, focus on the income replacement ratio.

 

Income Replacement Ratio = (Annual Investment Portfolio Income) ÷ (Annual Salary)

 

Your aim is to achieve an income replacement ratio of 100%. Think of your investment portfolio as a tree and the income as the fruit. In retirement, if you have a sustainable income replacement ratio above 100%, then you can live off the tree’s fruit. If, however, your income replacement ratio is below 100%, you need to sell some of your investment capital so that you have money to sustain your lifestyle. This is like chopping branches off the tree. Eventually, if you chop too many branches off the tree, it will die. This is not the position you want your investment portfolio to be in.

 

Building a sustainable income replacement ratio is not something that can be achieved overnight. Firstly, you need to invest in companies that generate real (i.e. inflation-beating) dividend growth. This is necessary as your annual salary will hopefully increase over time, typically in line with inflation.

 

Secondly, you need to make regular investments. You should aim to invest monthly, or at the very least, quarterly.

 

Thirdly, you must start early. Do not leave building your retirement nest egg until you are 10 years from retirement.

 

Fourthly, you need patience and must have the temperament to stay the course. Do not get caught up with the latest investment fads and fashion.

 

Next, you must not stress about short-term macroeconomic factors. Do not worry about what the Bloomberg TV or the financial press are carrying on about. For example, at the end of 2014, who would have thought the oil price would crash as far as it did? Rather, invest “through” cycles.

 

Lastly, follow a theme-based approach. Make sure you have exposure to industries that you think are going to be important. (For example, as populations age, healthcare will become more important.)

 

In summary, your investment plan should be to accumulate a share of great businesses over your working life. The focus is on building an income stream to replace your salary. Do not be concerned on timing your purchases or buying them at the best possible price. Try not to pay excessive prices, but it is more important to accumulate positions in the businesses and spend the longest possible time exposed to the market.

 

Importantly, where can you find these companies? A good starting point is the S&P 500® Dividend Aristocrats® Index. The S&P 500® Dividend Aristocrats® is an index of S&P 500 companies that have increased dividends every year for the last 25 consecutive years. Each company is a distinct investment opportunity without regard to its size by equally weighting each company. Some notable Dividend Aristocrat companies include McDonald’s Corp (MCD), 3M Co (MMM), Johnson & Johnson (JNJ) and Wal-Mart Stores (WMT). Whether you are investing for yourself or on behalf of others, you should focus on acquiring these companies over the next 30-plus years. All these companies have a history of growing annual dividends which fits nicely with the aim of achieving a 100% income replacement ratio.

 

 


 

Disclosure: Geoff Noble owns shares in MCD, JNJ and WMT.

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