OVERVIEW
This is a long post on an overlooked aspect of HYP investing that has been troubling me for a while. In essence it describes a problem at the heart of the HYP approach that we rarely address, namely, how much money should we invest in our HYPs to ensure that we have enough income when we need it? Some with large pots (e.g. Doris) may not need to reinvest. Others reinvest dividends topped up with a fixed amount each month. Some invest surplus cash when or if it becomes available. Some only reinvest dividends. While the time to invest may be now, how much do we actually need to invest now? The rest of this post will suggest a method of planning an HYP so this question can be answered. I’m going to call this method Dividend Averaging for reasons which will become clear later. I offer it tentatively to the board for discussion and further development. I very much welcome any feedback, especially those comments as to why it might not work or why my figures are wrong!

THE PROBLEM WITH HYPs
The stated aim of the HYP approach is to produce an income that beats inflation, and I believe that this outcome is likely over the long term. However, while this aim is useful as a way of benchmarking the performance of HYPs against other approaches, it doesn’t help us deal with some of the real life issues we face from time to time. I’ve been investing in my HYP for a number of years now, but is only recently that I have begun to wonder why I reinvest dividends rather than spend them. Yes, the trite answer is to make more money. But do I want to die at 90 living in a hovel with hundreds of thousands(!) of pounds in share certificates in my bottom drawer? Should I still be throwing all my spare cash at my HYP instead of enjoying the cash and dividends here and now? When will my HYP be self-sustaining (in other words, at what point will reinvesting dividends be enough)? At what point can I spend all of my dividends without undermining my financial security? These are big questions, but ones that are rarely addressed on this board. Instead we tend to obsess about the performance of HY shares as though there is no real world where we have to make these kind of decisions. We are addicted to HYPNOGs – High Yield Portfolios with No Obvious Goals.

Typical examples from the real world:

1. I need to replace my car. How much can I afford? Can I put some dividend income towards the cost, or should I choose a cheaper model so I can continue to reinvest the dividends and any surplus cash?
2. I receive an unexpected lump sum. Should I invest it all in my HYP or can I afford to spend some of it on a once-in-a-lifetime holiday?
3. I’m buying a house. Should I cash in some of my HYP, or should I leave well alone?
4. Can I stop investing new cash and just reinvest dividends?

Crucially, these questions can’t be answered until I know how well my HYP is doing, not in relation to inflation or the FTSE 100, but in relation to my personal financial goals. This requires a fundamental shift in thinking and the creation of a financial plan for the future which progress can be measured against.

SHIFTING FINANCIAL GOALS
HYPs are often thought of as a way of providing retirement income. But how much income can we expect? To take the pension analogy further, we tend to view HYPs as defined contribution schemes. In other words, we know how much money we put in, but can't be sure of how much money we will get out in 20, 30 or 40 years down the line when we retire. The alternative to this kind of scheme is a defined benefits scheme offered by (fewer and fewer) companies, where the income we get when we retire is defined in advance, for example a pension plan may offer to pay 70% of the final salary starting at age 65. If we could view our HYP income as a defined benefit scheme rather than a defined contribution scheme then we could create useful goals which we can measure our performance against. If we are underperforming our target, we need to add more cash. If we are ahead of our targets, we can reduce the amount of money we invest in our HYP. This shift in perspective would have a number of important implications and help give a rational basis for making decisions about whether to tinker, how much to invest etc.

WORKED EXAMPLE
Let’s take the case of a 40-year-old man called Bob Ortu who expects to retire at 65. He has a small company pension which he wants to supplement with the dividends from his HYP. He currently has an annual income of £3,000 from his HYP and believes that when he retires in 25 years’ time, he will need an annual income of £14,000 from his HYP at today’s cost of living. Fortunately, he has been reading these boards and understands that he needs a safety margin. He remembers the sage advice from Gengulphus that a 25% safety margin in income would be prudent. Bob thus plans for a retirement dividend income of £17,500 (£14,000+25%) of which he will spend £14,000 and reinvest the remaining £3,500 which should help him cope with market turmoil of the kind we have seen recently. How much does Bob have to invest over the coming 25 years to achieve this goal? If he invests too much, he will deny himself money to enjoy while he is still young and healthy enough to enjoy it. If he invests too little, he may not have enough to live on when he does retire.

How can we resolve this? Well, with a bit of maths we can work out that Bob needs to grow his income at approximately 7.31% a year to reach his goal of £17,500. This can be calculated using the following formula [IMPORTANT - THIS IS ONLY ONE WAY TO CALCULATE THE GROWTH IN INCOME NEEDED AND IS MOST APPROPRIATE FOR FAIRLY MATURE HYPS - PLEASE SEE DISCUSSION BELOW UNDER "OBSERVATIONS]:

growth rate needed = (target_income/current_income)^(1/years)-1
= (17,500/3,000)^(1/25)-1

Annual income targets from the figures above can easily be plugged into a spreadsheet to produce the following table where each subsequent target has 7.31% added to it:

              Target Income
year 0        £3,000
year 1        £3,219
year 2        £3,455
year 3        £3,707
year 4        £3,978
year 5        £4,269
year 6        £4,581
year 7        £4,916
year 8        £5,275
year 9        £5,660
year 10       £6,074
year 11       £6,518
year 12       £6,995
year 13       £7,506
year 14       £8,054
year 15       £8,643
year 16       £9,275
year 17       £9,953
year 18       £10,680
year 19       £11,461
year 20       £12,299
year 21       £13,197
year 22       £14,162
year 23       £15,197
year 24       £16,308
year 25       £17,500

So if Bob follows this plan, at the end of Year 25, he will have achieved his goal of £17,500 in income from his HYP. Of course, these figures don’t take account of inflation. We can’t know what inflation will be over the 25 year period, but we do know what the inflation rate is at the moment, and THIS IS ALL WE NEED TO KNOW WHETHER WE ARE ON TARGET OR NOT. Let’s say inflation is currently running at 2% per year. Bob needs to grow his current income at 9.31% or £279 over the next year [7.31% growth + 2% inflation] if he is to stay on target. This is clearly possible given that many dividends paid should increase, dividends received are to be reinvested and new money will be added to the portfolio. If this inflation figure and guesses about future inflation are added to the spreadsheet, we get the following:

               Target Income    Inflation
Year 0         £3,000
year 1         £3,279           2.0%
year 2         £3,585           2.0% ?
year 3         £3,918           2.0% ?
year 4         £4,283           2.0% ?
year 5         £4,682           2.0% ?
year 6         £5,118           2.0% ?
year 7         £5,594           2.0% ?
year 8         £6,115           2.0% ?
year 9         £6,684           2.0% ?
year 10        £7,306           2.0% ?
year 11        £7,986           2.0% ?
year 12        £8,730           2.0% ?
year 13        £9,542           2.0% ?
year 14        £10,431          2.0% ?
year 15        £11,402          2.0% ?
year 16        £12,463          2.0% ?
year 17        £13,623          2.0% ?
year 18        £14,891          2.0% ?
year 19        £16,278          2.0% ?
year 20        £17,793          2.0% ?
year 21        £19,449          2.0% ?
year 22        £21,260          2.0% ?
year 23        £23,239          2.0% ?
year 24        £25,402          2.0% ?
year 25        £27,767          2.0% ?

From this table we can see that if inflation stays at 2% (which it won’t!), in 25 years Bob will need an annual income of £27,767 to have the same purchasing power of £17,500 in today’s money. Clearly inflation will change from year to year, but crucially for our purposes, IT DOESN’T MATTER as when the inflation figures are available, we plug them into the spreadsheet and it will automatically adjust all the target incomes for the remainder of the table, and most importantly, for the subsequent year.

What happens then at the end of the first year? Here are three possible scenarios:

Scenario 1: Over the year, Bob has received less dividend income than his target figure. Let’s say there were some dividend cutters and static dividends and he has only received £2,750, a deficit of £529 on the target of £3,279. (Sound familiar?) Bob is thankful that he listened to Gengulphus and incorporated a safety margin into his calculations. However, this money has to be recouped somehow. It is relatively easy to calculate how much Bob has to invest to recover this ‘lost’ income and get back to his target. For shares yielding 6% on average, he needs to invest £8,821. [This figure can be calculated by dividing the deficit by the percentage as a decimal, e.g. £529/0.06 = £8,821.] Bob has received £2,750 in dividend income, so he needs to add £6,071 to this in new funds to be invested over the year. If Bob has more spare cash, he could decide to invest more but go the safety first route as suggested by Luniversal. For shares yielding 5%, the total amount to be invested would be £10,585. For shares yielding 4%, £13,225 would be required. Bob can choose the level of risk he takes. Crucially however, he knows his HYP is underfunded and he should invest as much spare cash as possible in Year 2 to try and bring his dividend income back in line with his target. Another option open to Bob (if he were in a tinkering mood) would be to sell some of his lower yielding shares or shares that have scrapped the dividend and invest the proceeds in higher yielding shares to generate additional income, though he knows this carries risks of its own. He even considers selling some of his racy non-HYP blue-sky stocks that don’t offer dividends and using the money to bolster his HYP. Expensive holidays and new cars are out for the time being, though as an experienced investor, he knows there could be bumper years ahead for his dividend stream (for example when dividend skippers start repaying) which will help – he doesn’t necessarily have to catch up with his target over a single year.

Scenario 2: Over the year, Bob has received more income than expected. In total, his dividends are £3,500, giving a surplus income of £221 over the end of Year 1 target. Bob’s HYP is slightly overfunded. He doesn’t need to tinker. Yippee! Let’s say that inflation has stayed at 2% in Year 2 (to keep the table above valid), so he knows only has to generate an income of £3,585 in Year 2 or £85 more than he currently receives. He spots a good HYP share yielding 5% and so invests £1,700 (excluding charges) in it to generate this £85 over the coming year [£85/0.05 = £1,700]. As an experienced investor, he knows that his other shares should also raise their dividends at an inflation-beating rate to give another surplus in Year 3, but that nothing in life is certain, so he will ignore this for the time being. He knows he also has a 25% safety margin built into his calculations. As nothing in life is certain, including life itself, Bob takes great delight in spending £1,800 [£3,500-£1,700] of his dividend income on a trip to Disneyland for his kids.

Scenario 3: It has been a bumper year for dividends with companies raising their payouts across the board. Bob now has a dividend income of £3,700, a surplus of £321 over his Year 1 target of £3,279. He notices that he even has a surplus of £115 over the following Year 2’s target of £3,585 - Bob’s HYP is overfunded! So, Bob doesn’t need to reinvest any dividends this year or add any new cash – he can spend the lot! In fact, is wife, Penny Ortu wants a new kitchen. So Bob looks at his portfolio and notices a share that has done very well and which now only yields 2%. He could afford to sell £5,750 of this share [£115/0.02 = £5,750] and still be on track in terms of his long term dividend goal. However, being a prudent sort and not being particularly interested in kitchens, he only sells half this amount to put towards his beloved’s new kitchen and keeps the remainder invested. Bob looks forward expectantly for another surplus in Year 2, though he knows that anything can happen and he may need to invest more funds at a later date.

At the end of Year 2, Bob once more gets out his spreadsheet and repeats the above process. He finds out the latest inflation figures and enters them into the spreadsheet. He then adjusts how much he needs to invest in his HYP based on the new targets and the yields available in the market. He also reviews his long term goal. Perhaps Bob gets a major promotion at work so Bob feels he can also strive for early retirement by reducing the number of years in the spreadsheet and trying to match the new higher targets. He may decide that he wants a more comfortable retirement and now feels that £14,000 in today’s money is not going to be enough so he increases his long term dividend target to £15,500 (plus 25% safety margin). He then puts the spreadsheet away for another year.

OBSERVATIONS

MATHS AND TARGETS
1. The maths described above for calculating the growth needed is most appropriate for fairly mature portfolios. In cases where the starting income is low, and/or the number of years left is too high, the growth in income in the final years will be impossibly high. In these cases it would make more sense to take a simpler route and use the formula:

extra income needed each year = (final income - starting income)/years

2. Life is not a formula. Finacial situations change dramatically from one year to another. However, some of these can be predicted with reasonable accuracy. For example, if you have children, considerations such as school fees, helping out when they go to university etc can be built into the spreadsheet so that dividends can be directed towards these expenses rather than reinvested. In many cases, loss of job or illness might make it impossible to meet the targets over the short term, but at least there may be a better chance to make up the lost ground at a later stage if there are targets in place.

DIVIDEND AVERAGING vs VALUE AVERAGING
The idea of having long term income goals (Dividend Averaging) came to me after reading the recent Fool article on Value Averaging which can be found here: http://www.fool.co.uk/news/investing/investing-strategy/2009... I have no idea if anyone has previously adapted it to work exclusively with dividends.

The main aim of Value Averaging is to increase long term performance. In a sense it is Pound Cost Averaging on steroids. When a portfolio underperforms long-term averages, an investor has to invest more to try to bring it up to the average. If the portfolio outperforms the long-term averages, less money is invested, or in extreme cases, some of the portfolio is liquidated. This approach encourages investors to take a contrarian position. When the markets are down (as they are now) investors are required to invest more. When markets are doing well, investors are required to invest less.

The approach described here (Dividend Averaging) is different from true Value Averaging because it deals with dividend income rather than capital value of a portfolio. Also, the annual growth required is not determined by long-term market averages, but by practical financial goals. Although I have no evidence (and would welcome any!), I suspect it may offer similar outperformance.

FINANCIAL GOALS
Financial goals are something that seem to be missing from the HYP approach to investing. Very often, HYP goals are thought of as sector diversification, inflation-beating dividends or as an aside, increasing capital values. These are the stated goals of HYP1. But these don’t help a real HYPer know what to do with the dividend income or how much to invest. To deal with a real HYP we need to have an idea of what we want the HYP to achieve. I believe this approach can guide us in this respect. Since coming up with this approach, I certainly feel a lot more comfortable with my own HYP because I have a specific target to aim for, and because I know I will be able to pinpoint times when I can put surplus money to other uses. This beats hands down my previous method of scrimping and investing all my surplus cash into my HYP (or rather my HYPWNOG). Not surprisingly, this year will be one of sacrifice because I am underperforming my self-imposed target, but I am hopeful that relatively quickly, I’ll be outperforming. I’m expecting a small lump sum later this year, and I have already earmarked it for investment in my HYP rather than indulgences. Having a concrete target has made this decision easy.

DIVIDENDS, DIVIDENDS, DIVIDENDS
What I find most interesting about this approach is that in true HYP style, capital values are almost an irrelevance. The only time they play a role is in determining how much we have to spend to gain an income stream. When yields are low, we have to pay more. When yields are high we don’t have to invest as much. The other interesting thought is that dividends (in normal markets!) tend to fluctuate far less than capital values. Basing targets on dividend income rather than capital values would seem to a much more practical and manageable approach while still allowing for a high degree of flexibility.

EFFORT NEEDED
Despite the length of this post, Dividend Cost Averaging really doesn’t require much work to follow (though it may be too much for Doris!) A review of a spreadsheet once a year would be enough. In my own case, I tend to invest once a quarter when I have accumulated enough to invest. It would make sense for me to keep a rolling yearly total of dividends received so that investments can be made accordingly. I’m no spreadsheet expert, but I have constructed a simple spreadsheet that can do the basic calculations. However, if anyone would like to take on the task of developing a more flexible spreadsheet that could account for the different goals that HYPers might have, I think it would be very useful for HYPers who would like to play around with figures. Volunteers?

FINALLY
Don’t forget, feedback very welcome, especially the kind that makes me question if I should adopt this method or not!

Kind regards,

Cludgie