The Retirement Portfolio that Generates Cash

Mr. Everyday Dollar is still a few years away from being financially independent, with the choice to retire early (yes, please). According to recent calculations derived from FIRECalc, I shouldn’t have a problem retiring by age 44. I’ve always had my heart set on 42, so that’s what I’m really shooting for.

I know I’ll get there. I’m sure I’m similar to my readers, in that I’m not fiscally perfect. Shocking, I know! Sometimes I go out and spend twice the amount of everyday dollars on one fancy pants meal than I spend in a whole week on eating. Or I take a vacation to South America. Better yet, I own a car too! So yes, there’s still ways I can spend less and save more so I can invest a little more money to further build up my Walk Away Money Pile (WAMP) so I can hit my target.

As I’ve written before, I currently invest in individual stocks in a taxable investment account. This bucket of money will serve as my mid-term money: the money that will get me from about 42 until my 60′s when my 401(k) will kick in.

Let’s step into my time machine and take a little trip to 2021. I’ll be 42, as dapper as ever I hope, and will be ready to leave the workforce. I will have my mid-term money tied up in individual stocks. Some of these are dividend payers and some not. How will I be able to generate everyday dollars to live on from this portfolio?

I see 3 paths:

  1. Liquidate my entire portfolio – making sure I am in the lowest tax bracket to ease the capital gains tax – and put the proceeds into funds that will cut me checks on the regular.
  2. Stay with the portfolio. Generate cash by using stock options, trading positions and collecting dividends.
  3. A blend of 1 and 2. Perhaps keep any dividend payers and sell off the rest, sticking the proceeds into funds. Utilize stock options and trading positions.

You might ask, “Why not just build a dividend producing portfolio from the start?” That’s a great question and certainly a viable option. For instance, Dividend Growth Investor does this. You’d do just fine going this route.

The reason I didn’t strictly build a dividend portfolio was I would be forced to invest only in companies that issue dividends. I wouldn’t have the opportunity to invest in a company like Apple back in 2008, or great growth companies like Amazon, Chipotle and Priceline. In time, as these companies mature, they will probably begin paying dividends. Apple, for instance, finally started paying a dividend out of their $100B coffers earlier this year.

I don’t know which path I’ll take of the aforementioned possibilities. The good news is that I have plenty of time to think about it. If I choose option 1, by far the simplest plus lowest maintenance of the choices, I would be hard pressed to invest outside of Vanguard funds. So let’s explore that. How would we go about building a portfolio with Vanguard funds?

This is so easy! We only need 3 types of investments: broad diversification across the whole stock market for growth (which inherently comes with volatility) plus bonds and REITs to balance that volatility. Bonds and REITS complement each other and here’s why. First, if interest rates rise the value of bonds decrease. And if interest rates are high people are pushed into rentals, thereby increasing demand and rental prices making REITS more profitable. Yin/Yang! Second, inflation eats away at the returns of bonds because the yields are fixed. Not so with REITS, they can charge higher rental prices year-over-year based on current inflation levels. Yin/Yang!

If we already own rental property or a vacation rental that generates income, we want the following allocations, what we’ll call Portfolio 1:

If we do not own rental property or a vacation rental, we have the following allocations in Portfolio 2:

*these funds also have insanely low management fees: VTSAX is 0.06%, VBTLX is 0.10% and VGSLX is 0.10%, thank you John Bogle!

Some astute readers might be screaming and hollering and saying there’s no international exposure! Yes, there is none. Most financial planners would recommend an international fund like the Vanguard Total International Stock Fund Admiral Shares (VTIAX). No worries though, they’re just running down a checklist like they’re taught to do.

James Collins has a good explanation on the reasons why you don’t need international exposure in this post, and I agree with his reasons. My current taxable portfolio is full of international exposure and yet they are all U.S. companies. How? Because companies like Apple, Coach, Google, Netflix, Priceline and Starbucks generate significant sales overseas and will only continue to expand in other countries. So even though I don’t invest in a Chinese or Indian company I still benefit from the fact that consumers in those countries snap up Apple iPads, Coach purses and drink Starbucks Grande Lattes.

Mr. Everyday Dollar doesn’t own any income-producing property. So let’s have some fun and say that on January 3rd 2012 we invested a million dollars in Portfolio 2:

  • $600,000 would go into VTSAX – 18,885 shares @ $31.77
  • $300,000 would go into VBTLX - 27,332 shares @ $10.98
  • $100,000 would go into VGSLX – 1,207 shares @ $82.83

How did our portfolio perform over the course of the year? Let’s take a look:

 

 

The million dollars invested (actually $999,947.82) ended the year up 8.88% to close at $1,088,791.91. In addition to the $88,844.09 increase in portfolio value, we received $27,128.64 in bond interest and REIT distributions to use for our everyday dollars.

But wait! We learned earlier that if we need about $35,000 per year to live on, then our portfolio has to throw off $41,176 pre-tax. So we’re short $14,000! This is where we sell off some of our shares that have appreciated by $88,844.09 to make up the difference.

Every year invested in a portfolio like this will be different because the cash it throws off will vary and the value of the portfolio will vary, sometimes wildly. Some years you might have to sell more shares, other years less. The whole process can be exciting for some and gut-wrenching for others. But most importantly, I think we can reasonably assume our portfolio will be able to generate our everyday dollars over a very long time.