Published on January 19th, 2015
- See the effects of volatility on retirement savings
- How dividends offset the negative effects of volatility
- Discover the Top 10 lowest volatility Dividend Aristocrats
Are you planning on withdrawing money from your investment accounts in retirement? The majority of retirees withdraw money from their investment accounts on a systematic basis. Taking monthly withdrawals is an easy way to generate consistent and stable cash flows to support yourself in retirement. The roll that dividends and volatility play on retirement is not well understood. This article examines the link between volatility, dividends, and retirement.
Volatility & Retirement
Everyone who has ever invested in the stock market knows that stock prices fluctuate. Volatility (and standard deviation) measure how much stock prices move around. The more they fluctuate, the higher the volatility.
Stocks with stable operations that are not at much perceived risk of business collapse tend to have low stock price volatilities. Businesses like Johnson & Johnson (JNJ) and Consolidated Edison (ED) have very low stock price volatilities.
Interestingly, low volatility stocks have outperformed the S&P 500, with less risk. The S&P 500 Low Volatility Index contains the 100 stocks in the S&P 500 with the lowest stock price volatilities. From the 20 year period ending in September of 2011, the S&P 500 Low Volatility Dividend Index outperformed the S&P 500 by 2 percentage points per year and just 76% of the stock price volatility. Low volatility is one of the ranking rules in The 8 Rules of Dividend Investing.
Low volatility is especially important when investors are withdrawing money from their investment accounts. The higher the volatility, the quicker you will run out of money, even if total return is the same. This is because you are forced to withdraw money when your investment portfolio is it lower lows with higher volatility.
To drive home this point, consider the following extreme example. One investor puts their money in the S&P 500 from the period from 2005 to 2015. Total compound annual return is 7.85% per year and the annualized standard deviation is 20.3%. The other investor finds a magical investment that returns 0.63% a month for a compound annual return of 7.85% a year. Both investments have the exact same compound annual growth rate, while one has a standard deviation of 20.3% and the other has a standard deviation of 0%. Now, assume both investors start with $1,000,000 and withdraw $6,000 a month. The image below shows the value of their investment accounts over time.
As the image above shows, the account value of the investor who has the 0% volatility portfolio has a higher net worth at the end of the 10 year period. This is because they do not have to withdraw money at ‘lower lows’.
Dividends & Retirement
Dividends reduce the amount of a portfolio retirees need to liquidate to generate monthly cash flows. This minimizes the impact of volatility on retiree portfolio performance. If you never had to liquidate your stocks, volatility would not matter. Warren Buffett has this to say about volatility:
“It’s nice, it’s mathematical, and wrong. Volatility (i.e. standard deviation) is not risk. Those who have written about risk don’t know how to measure risk. Past volatility does not measure risk. When farm prices crashed, [farm price] volatility went up, but a farm priced at $600 per acre that was formerly $2,000 per acre isn’t riskier because it’s more volatile.”
As usual, he is right, but only in the case that you do not have to liquidate your holdings for any reason. If you plan to sell your holdings at regular intervals (like many retirees do), volatility does matter.
The goal for investors should be to build a large enough dividend growth portfolio that they can live off their dividends in retirement. In this way, you would never have to sell your holdings to generate monthly income, as dividend payments would cover this.
Even if you cannot cover all your expenses with your dividend portfolio in retirement, covering some expenses helps greatly. If you have 70% of your monthly living expenses covered by dividends in retirement for example, you have insulated yourself from 70% of the negative effects of volatility.
It is important to note that investors should not reach for yield. Don’t invest in risky businesses that have uncertain dividend futures just because they have a high dividend yield. What matters is that the dividend continues to be paid, and continues to grow year after year. If dividends are cut, then the percentage of your living expenses you have covered by dividend payments goes down.
10 Lowest Volatility Dividend Aristocrats
Long-time readers of Sure Dividend know I have done a great deal of research on the Dividend Aristocrats Index. The Dividend Aristocrats Index has outperformed the S&P 500 by 2.88 percentage points a year over the last decade. It is made up exclusively of 53 stocks with 25 or more years of dividend payments without a reduction. You can see a full list of the Dividend Aristocrats along with detailed analysis with the Dividend Aristocrats In Focus series. The list below shows the 10 lowest volatility Dividend Aristocrats:
- Johnson & Johnson (JNJ)
- Consolidated Edison (ED)
- Kimberly-Clark (KMB)
- PepsiCo (PEP)
- Procter & Gamble (PG)
- Clorox (CLX)
- Coca-Cola (KO)
- Colgate-Palmolive (CL)
- Wal-Mart (WMT)
- McCormick & Company (MKC)
Volatility matters for investors who are withdrawing money from their portfolio on a regular basis. Dividend payments offset the negative effects of volatility by providing cash flows that are not tied to market price fluctuations.
Ideally, retired investors will be able to cover all of their living expenses with dividends, social security, pensions, and other income streams without having to sell off portions of their stock portfolios. If this is not the case, covering a percentage of your expenses with dividend payments provides partial coverage against the negative effects of volatility.
A portfolio of high quality dividend stocks will have lower volatility than the overall market, as high quality dividend stocks tend to have low volatility. I believe that the low-volatility phenomenon and the Dividend Aristocrat outperformance phenomenon are linked. In my analysis, both low-volatility stocks and long dividend histories show evidence of sustainable competitive advantages, strong cash flows, and a stable business model.