In my last article we learned that a portfolio of bonds alone will not be enough for most of us to replace our paycheck once we stop working.
But could we use a stock portfolio to get the income we need and have that income increase as the years go by so our spending can keep up with inflation?
To answer this question, let’s start with the basics.
Stocks, In A Nutshell
A stock represents ownership in a company. The company can be private or public, but we will focus our attention on publicly traded companies. These are the companies that trade on the various exchanges such as the NY Stock Exchange and the NASDAQ.
When we invest in publicly traded companies by buying shares of their stock, we participate in the growth of these companies. In other words, if the company is profitable, well run, and grows in value, that increased value will result in rising share prices and greater wealth for us.
Of course, the opposite is true as well. If we buy stocks in companies that are not well run, or run into problems, those companies will lose value, their stocks will go down, and we will lose money.
Can We Replace Our Paycheck By Periodically Selling Shares of Stocks?
I occasionally meet people who believe they can create an income stream in retirement by selling shares of their stocks every so often. They work under the assumption that whenever they need money, they can simply sell a few shares of one of their stocks.
This may seem like a viable strategy when the market is rising but unfortunately, the market doesn’t always go up.
If we try and use this strategy when the market is dropping, you will be forced to sell shares of your stocks when they are down which will undermine your investment portfolio. Following this strategy is likely to erode away your principal and leave you with a smaller retirement nest egg in the future. And a smaller nest egg in the future will make it impossible to increase your income as the years go by so you can keep up with inflation.
Although selling shares of your stock portfolio might seem like a good idea, this alone will not serve as a long-term method to replacing your paycheck.
What About Stock Dividends?
In addition to stock prices rising and falling, some stocks will pay you dividends. However, the dividends from stocks are not the same as the interest you receive from bonds.
One way they are different is that stock dividends are not contractual obligations. A corporation can increase, decrease or completely cancel their dividends any time they choose.
Another reason has to do with the frequency of payments. Bonds pay interest every 6 months, but stocks pay dividends every 3 months, so you would receive income more frequently.
Can We Use Stock Dividends To Replace Our Paycheck?
Since our goal is to create an income stream in retirement that can replace our paycheck and increase over time, let’s consider if dividends from stocks or stock mutual funds might be the solution. Maybe all we need to do to get the income we need is to find the right stocks.
What if we were to invest in stocks with a 2-3 percent dividend yield? There are many to choose from. Intel and Procter and Gamble are good examples.
If we invested one million dollars into a portfolio of stocks that pay a 2-3% dividend, we would generate $20-30,000 a year in income. Unfortunately for most of us, an extra $20-30,000 added to our Social Security check will probably not be enough to retire comfortably.
But some stocks pay higher dividends. Let’s see what happens if we invested our million dollars in a stock portfolio that had an average yield of 5%.
In this case we could get $50,000 per year in extra income. And if we added that to our Social Security, we might now be able to replace our paycheck after we stop working. However, there is more to consider.
High Dividend Yields Vs Growth Potential
Although building a portfolio of higher yielding stocks may seem like a solution at first glance, it will not work over the 20 to 30 years you can expect to be retired.
There are two problems with this approach.
One is that although the dividends may increase over time, it is unlikely those increases will keep up with inflation. So, as the years go by, you will be unable to increase your income enough to keep up with the rising cost of living.
The second problem has to do with the growth rate of higher yielding stocks. Or more accurately, their lack of growth.
There is an inverse relationship between the growth potential of a stock and its dividend yield. The higher the dividend yield, the less that stock is likely to grow as the years pass.
This is because those companies paying higher dividends are choosing to use their excess capital as payments to shareholders rather than investing it back into their business.
Companies that pay no or low dividends on the other hand, are typically investing their excess capital back into their own companies. This creates the potential for these companies’ growth to far outpace inflation. That is why they are often referred to as growth companies.
Thus, if we invest in a higher yielding stock portfolio, we might be able to get the income we need initially. But it’s likely that as the years go by and prices rise due to inflation that we will reach a point where our dividend income won’t keep up with our rising expenses.
Stocks Are Not The Complete Solution But They Are An Important Part Of Your Retirement Income Strategy
While stocks have some attractive qualities such as the ability to provide income every quarter and to grow in value over time, a stock portfolio alone will not be able to provide the income we need to replace our paycheck.
But stay tuned! In my next article I’m going to show you a strategy you can use to replace your paycheck once you stop working. This will be a strategy that is both insulated from stock market volatility ,and has the ability to increase as the years go by so our spending can keep up with inflation.