From Cash to Dividend Stocks: Building a Retirement Portfolio Step by Step

Warning; this article is massive and contains lots of great info 😉

A couple of weeks ago, I received an email from one of my readers. He was in a delicate situation: he was 100% cash and wondered where to start in order to build his retirement portfolio. We exchanged a few emails and I agreed with him that many investors are in the same boat: they got out of the market at one point and are now sitting on the sidelines wondering how they can re-enter without making big mistakes. When you see a few hundred thousand in your retirement account, the last thing you want is to see it disappear because you entered the market right before the next crash. In order to give you the full picture, I asked the reader if I could share his email. He agreed and I decided to call him Caleb, my third child’s name for privacy purposes. Here’s the email from Caleb:

Thanks for the articles, very informative!  I wanted to reply to you to let you know how my investing is going…it’s not to tell you the truth.

Not that I don’t want to…I need to.  But I’m stuck.  I have 600K+ in investment cash (self directed IRA), sitting in money market.  I’m just too spooked with the market, economy, gov’t shutdowns, budget deals, geo-political BS, interest rates, the Fed, all the uncertainty!  And I know its not good to be sitting on the sidelines, I have to get my money working.

So here’s the dilemma, how to I get back in?  What would you do in my situation.  And I can guarantee you, there are many other investors out there like me in the same boat.

My wife and I are in our mid 50’s, we have great jobs, 401K’s, so forth.  I know what to do in the 401’s, I’m just stuck on what to do to get re-engaged with my IRA.

I am interested in managing my own portfolio, a percentage (say 20%) with Covered Calls. And I think it would be prudent to include dividend investing as well.

So I’ll stop there and get your thoughts…how would you approach my situation.

Thanks!

Caleb

First Question: When Do I Get Back In?

Whenever you take the decision to sell your stocks to avoid a market crash or further losses, you also enter very dangerous territory. You enter in an environment of doubt where you will never be certain when is the best time to invest again. If you  exited the market back in 2008, you are probably in a situation where you wonder when it’s time to get back in. While we went through one of the best bull markets ever on the stock market over the past 5 years, there were many occasions with drops to make you wonder even more about the “perfect entry point”:

As you can see, there were 10 spots where the market dropped enough to make you double guess your decision to enter or leave the market. But what is the most important point? The S&P 500 was at 1,200 five years ago and it is at 2,090 today. In other words; someone who hesitated due to short term events, left lots of money on the table. As Caleb mentioned in his email; there is always a good reason to not invest. Since 2008, we had:

• The US Government printing money like there is no tomorrow (QE1, QE2 and QE3)
• US Government budget saga
• Greece default saga
• Germany going through recession
• Oil price falling and forcing Canada to drop interest rates again
• China building ghost cities and showing mid-single digit growth rates
• China (again!) stock market collapse of 43% during summer of 2015
• China (still!!!) with their heavy leverage strategies and shadow banking
• France terrorist assaults

And I’m pretty sure I forgot half a dozen others reasons not to invest over the past 7 years. On the other hand, the past 7 seven years have been some of the most prolific years on the stock market. The thing is that there will always be a “good” outside reason to not invest. But the reason why we all invest is not because we think Governments will do a good job with our economy or because war will end and we will live peacefully. The reason why we invest is because companies make money. And they do it regardless of what is happening in the media. Therefore, the real question is not when do I back in, but rather how do I get back in?

How do I get Back In?

The short answer would be “as soon as possible”, but it doesn’t make sense to invest $500,000 in the stock market over the span of a month. Therefore, you need a reinvesting plan. Mathematically, you would be better off investing as soon as you can in order to build a strong portfolio and benefit from the power of dividend growth. But if you have gotten out of the stock market in the first place, it is because your fear of being burnt by the stock market is greater than missing a dividend payment. Therefore, I would suggest you invest 1/6 of your cash each month over a period of six month. Investing over a longer period of time will make you second guess each of your moves and you will be striken with paralysis by analysis.

By investing a sixth of your money each month, it gives you enough time to build a strong portfolio and not buy everything you see as you were in the middle of Black Friday. If you are unlucky and hit a bear market, you will not lose everything in the first month!

Now that we know how much we will invest, we need to know in which stocks we will invest right?

Which Stocks do I Buy?

Before you make your first purchase, you need to know where you are going. The first step is to build a list of interesting stocks, a list of companies that you want to be included in your portfolio, a list of companies that fit your investing criteria. Such a list can be built from scratch if you like spending lots of time playing with stock screeners and reading financial statements.

The bottom line is to make a list of enough companies that should be part of your portfolio and not from the same sector as well as you want to build a portfolio out of your list. In an ideal world, you would need stocks in the following sectors:

 

 

Consumer defensive – usually part of any core dividend growth portfolio

Consumer cyclical – gives an additional push when the economy is doing well

Industrials – there are some very good and stable companies in the industrial sector

Technology – you might be surprised, but there are some hidden gems in the techno industry paying dividends.

Healthcare – here again, there are a few big pharma that will boost your returns

Communication Services – telecoms are often the most cited as dividend growth stocks

Financial Services – they have experienced bad press since 2008, but they have starting to pay good dividends since then

Utilities – not the best place to find growth, but definitely a good place for steady dividend payments

Real Estate – there isn’t much growth perspective with REITs, but still, you can get high dividend yields here

Basic Materials – more volatile and risky

Energy – same here

MLP’s – Master Limited Partnerships could be an interesting beast to add to your portfolio, I suggest you read Dividend Monk’s Guide to MLPs to fully understand how they work.

There isn’t a perfect asset allocation and the one shown in the graph above is just to provide an image of sector allocation and it’s not close to what I’m using in my own model. The main idea is not to have more than 20% of a specific sector in your portfolio in order to avoid high volatility.

When Should You Buy The Stocks on Your Watch List?

If you are like Caleb, chances are you are not convinced as to when to invest in the stock market… period. Having a watch list is the first active step to building your retirement portfolio. However, a list of stocks won’t do much if you don’t start investing at one point.

To be honest, I would probably buy any company on my watch list at any moment if I had more money to invest. The rationale behind this though is quite simple; a good company remains a good company, even when it is overpriced. Sure, in an ideal world, we would always buy companies at their lowest point ever and see them climbing sky high right after we made the purchase. However, we know it doesn’t work this way.

A few years ago, I bought both Lockheed Martin (LMT) and Disney (DIS) at their 52 week high points. Both show incredible returns so far. Therefore, they were trading high, but they simply continued to go higher. Waiting for these stocks to drop would have had me lose lots of money and I would have probably never bought them. This is the risk with waiting; never buying the stock you should have bought in the first place.

This is why I also use stock valuation methods to determine if a company is trading at a discount or not according to my calculation. I won’t lie to you; stock valuation is halfway between science and magic. The numbers you put in is based on your assumptions for the future. Therefore, your calculations are only as good as your assumptions.

I personally use two methods to determine a stock value. The first one is quite simple; I look at the stock PE ratio over the past 10 years to see how the market values the company on average. This gives me a rough idea if the company is overvalued or not.

Then, I use a double stage dividend growth model (called DDM) to value the stock as a dividend paying machine. I like the Dividend Monk’s calculation spreadsheet as it gives 15 variations of results depending on a margin of safety (or premium) of 10 and 20% along with 3 different discount rates. Here’s an example:

When the value is good, I pull the trigger and buy the stock. In an ideal world, I like to have positions not exceeding 5% of my total portfolio. Depending on the amount invested, the maximum stocks I would hold would be around 30 for a 500K+ portfolio. Most professional managers don’t go over 50-60 and several of them keep to 30-40 holdings. This makes it easy to follow each company with the attention it deserves.

Why I Talk Solely about Dividend Growth Stocks?

The short answer would be: “because I’m The Dividend Guy, DUH!” But there is a smarter answer. Because a dividend growth stock is the perfect tool to design a retirement portfolio. Dividend growth stocks will provide both security and steady payments at the same time. A strong portfolio with sound companies will also grow throughout time and if you build your dividend portfolio today in your 50s as Caleb and his wife are, you will benefit from the power of compounding dividend growth for a good 30-35 years (life expectancy is getting close to 85 in North America).

A company can be called a dividend growth stock when it is obvious that management has been and will continue to increase its dividend payouts for several years. These companies are usually able to generate continuous revenue, earnings and cash flow increases. Do you think such companies lose a lot of value on the stock market over time? Nope, they gain value at the same time they grow their dividend. During a bear market, all you have to do is to ignore the noise and focus on your dividend payment. If you have made the right picks, your payments will increase… even during tough times.

What about Covered Call ETFs?

Caleb also mentioned the thought of using 20% of his portfolio to invest in covered calls. If you have been a long time reader of this blog, you know I’m not a big fan of covered call ETFs and I would not put a penny in such investment vehicle anymore. They sure pay a juicy dividend yield at first and the theory seems to make sense. But in the end, you are not buying anything that will make you rich. You can read about my own adventure in covered calls here:

The Pros and Cons of Selling Covered Calls on Dividend Paying Stocks

Covered Call ETF High Income, Low Risk?

Covered Call ETF Vs Pure Dividend Stocks

Enough said about Covered Call ETFs, they are just a good idea on paper. They are nowhere close to be comparable to dividend growth stocks.

Final Thoughts – Want to Go Further?

All right… I think I’ve exceeded your patience by now with such a long article. However, I really wanted to give you a complete picture of what I would do if I was in Caleb’s shoes. I’m wondering what would you do?

Since Caleb was nice enough to write me an email with a detailed question, I gave him a free access to Dividend Stocks Rock for 6 weeks. I think this site with the real life portfolio models with active trading along with the newsletter (including a monthly buy list) will help him build and manage his portfolio.

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