Investing for Future Income: Start Early, Save Often

Investing for Future Income

It’s been said that every dollar that you save (and invest) during your twenties will provide one dollar of investment income during your sixties. But is this really true? I recently ran across an interesting test of this idea, and the results were enlightening.

Using the historical S&P 500 total return data compiled by Prof. Robert Shiller (Yale, Economics), the guy who runs backtested this idea to see if it really holds water.

Assuming that an individual invested $1000 once in a single year and did not contribute anything further, he used Shiller’s data to calculate the total return of this investment (including dividends) over the years. He then looked to see how long it would take for the dividend income to exceed $1000 in a single year.

On average, he founds that it took 35 years for a $1000 investment in the S&P 500 to produce $1000 in dividend income in a single year. In other words, you might reasonably expect money that you invest at age 25 to produce an equal amount of income when you turn 60.

The shortest time required to get to the magical $1000 dividend mark was 27 years, for those who started investing in 1941. The longest it took was 45 years, for those who started investing in 1928.

Interestingly, the time required to reach the $1000 mark has been steadily increasing since it bottomed out in 1941, so it’s important not to read too much into a single data point like the average time required.

It’s also important to note that he ignored transaction costs, taxes, and inflation. While transaction costs are quite low nowadays (on the order of 0.2% annually), these costs would still slow down the approach to $1000 in dividend income.

As for taxes, these can be reasonably ignored if you’re investing in a tax-advantaged account, but they would otherwise create significant drag on your investment performance due to the dividends being generated (and reinvested) each year.

Finally, since he ignored the effects of inflation, we’re talking about nominal (not real) dollars in this case. Thus, that $1000 in income won’t be worth nearly as much 35 years from now. Then again, as you approach retirement age, you’ll probably shift into more income-oriented asset classes.

Regardless, this is an interesting test of a handy rule of thumb, and it really underscores the value of starting young. If you’re no longer in your twenties, you can still use it to generate rough prediction of how things might look in the future.

Source: Dividend Growth Investor

5 Responses to “Investing for Future Income: Start Early, Save Often”

  1. Evan: He didn’t address that, but…

    Assuming equal overall growth rates, you’d get there faster with a portfolio with a higher dividend yield – right? Think of it this way:

    Your investment returns are made up of capital gains (price appreciation) and dividends. Let’s imagine that you get 8% overall growth in two portfolios like those described above ($1k one-time investment). Let’s call them Portfolio A & Portfolio B.

    Let’s further assumed that, in Portfolio A, 8.5% of that growth is provided by price appreciation, with 1.5% coming from dividends. In contrast, in Portfolio B 6% comes from price appreciation, and 4% from dividends.

    As long as you are reinvesting dividends (and ignoring taxes) these two portfolios will grow at the same rate (averaging 8% per year). However, Portfolio B will be producing more in the way of dividends each year (offset by less price appreciation), so it should get to that $1000 dividend payout mark much more quickly.

    Of course, once you start retaining (instead of reinvesting) the dividends, the overall size of Portfolio B will start to fall behind that of Portfolio A because you’re essentially spending a portion of the returns.

    Note that I’m not saying that a dividend heavy portfolio would necessarily match the S&P 500 in overall returns – I just through that out there for the sake of argument.

    The problem is that there aren’t a lot of ready-made data sets like the one for the S&P 500 that could be used for backtesting one-off scenarios like this.

  2. Anonymous

    I didn’t head over to DGI’s post yet, but what if you are in a dividend focused portfolio? Many of the members of the S&P don’t provide a dividend.

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