How This Income Method Makes You Financially Independent (2024)

Whether you are a retiree or you just want to be financially independent, you need a strategy that should meet the following goals:

1. Produce sufficiently high income to meet basic needs.
2. Preserve capital in bad times.
3. Provide reasonable growth for long-term wealth preservation.

Income: When we say "sufficiently high income," this is more of a subjective term, and it also depends upon the size of your assets. More important, different people have different needs. So, it also depends on your basic living expenses. If you could reduce your expenses, then your need for income also gets lower accordingly. At the same time, it's a widely accepted notion that any portfolio that claims to produce more than 8% income would run the risk of depleting the capital. In fact, we would rather put the red line at 6%. Your portfolio could be generating more than 8%, but any excess income over 6% should be re-invested back into the portfolio for it to prosper for the long term. Withdrawing more than 6% of income from any portfolio would put the original capital at the risk of depletion. Sure, if your asset-size is large enough and income needs are smaller than 6%, you should re-invest the balance back to the portfolio.

Capital Preservation: There's almost no financial investment that can preserve the capital 100% in all kinds of situations. Even the value of cash is subject to inflation and currency fluctuations over time. It's a given fact that your investments will have some volatility - the lower, the better. So, one has to know one's tolerance for volatility. We can have all the talk about capital preservation, but the real test comes when the market takes a huge dive in real time, something akin to what we saw last year due to the coronavirus pandemic or during the financial crisis of 2008. An event or correction like these can act as a real eye opener to review and judge if your portfolio is meeting its defined goals, especially risk tolerance. If not, you should modify your strategy.

Preservation of capital is probably one of the most important factors for retirees and conservative investors or anyone who wants to be or stay financially independent. In order to preserve capital, it's important that our overall portfolio is able to achieve low volatility and smaller drawdowns while not compromising on growth during good times. We also will provide a real-life view of our three-basket strategy and give readers a view of how they would have fared if they were invested in one such broad-based strategy.

Reasonable Growth: It's debatable as to how much growth is reasonable. It can vary based on your personal expectations and factors like the rate of inflation and interest rates. But assuming an average of 2.5% rate of inflation, in our view, a 9%-10% overall annual growth of the capital (including the income withdrawals) would be reasonable. Sure, we could expect and wish for a higher rate of growth, but this is practical and reasonable if you do not want to take very high risks.

Financial Independence: Just like many other things in life, the meaning of this term would vary from person to person. There's no universal definition of financial independence. One size does not fit all. However, the way we see it is that if your investment portfolio can safely generate enough income to sustain your basic needs (not including luxuries or vacations, etc.), you should consider yourself financially independent. For example, your annual earnings are $100K, but if your basic needs are only $40K, then your investment portfolio should generate at least 40,000 annually, minus any other fixed income like Social Security, pension, or rental income. Also, being financially independent does not necessarily mean early retirement. You could be financially independent in your 30s or 40s and still be pursuing a great career, whatever that may be. However, what financial freedom does is that it accords you the freedom to choose to do what interests you rather than doing something that you hate to do. In essence, it's a great stress reducer that you are not fearful of losing your job on an everyday basis. It provides you the freedom to choose to do what interests you rather than doing something that you hate to do.

In this article, we present one such strategy that attempts to meet all of the above three goals. As such, besides growth, we focus on income-producing strategies that also preserve capital during times of crisis.

We will review our three-basket strategy that's not overly complicated and easy to get started. We also will provide a real-life view of this strategy and how this would have behaved during last year's pandemic-induced crisis or during the 2008-09 financial crisis. First, we will pick the backtesting period starting from Jan. 1, 2018, to Jan 31, 2021. These past 37 months, even though not a very long time, do include two sharp corrections. The first one happened in the fourth quarter of 2018 but was followed by a quick recovery. The second correction, of course, is the recent one, caused by the pandemic. We will use the S&P 500 as our performance benchmark. Later, in the last section, we also will run the comparisons for the last about 13 years, starting from the beginning of the year 2008.

Brief Description Of Three-Basket Strategy

Here we will discuss a three-basket strategy with each sub-strategy being unique in terms of income, growth goals, and risk levels. We also will provide examples using short-term and long-term backtesting.

For the sake of backtesting, we will assume that we invested $1 million of assets into this strategy, but the amount is not of much significance as it would work the same, whether it was $100,000 or $3 million. If you are just starting out, naturally, you may not have $1 million to start with, but more than likely, your retirement is many years away. You could use this time to gradually build a strategy and compound the income over the years. The three-basket strategy that we are going to discuss below can comfortably support 6% income withdrawals. So, if your needs are $40,000 a year, by reverse calculation, you will need to grow your investment portfolio to roughly $670,000. Sure, 40,000 may not be enough for a comfortable retirement, but hopefully, you would have other sources of income like Social Security and/or pension.

Generally, we advocate investing in any new strategy in small lots over a period of time (at least a year). But to keep the calculations from becoming overly complex, we will assume that we invested the entire amount in one lump sum on Jan. 2, 2018. For the sake of illustration, we will assume our hypothetical investor invests $1 million in our strategy, while another investor invested $1 million in the S&P 500 at the same time.

Note: Most retirees and conservative investors should also keep a cash-like bucket; however, the allocation could differ based on the individual situation.

Basket 1: (DGI portfolio 40%)

There are many ways to construct a DGI portfolio, and this is the easiest part of the overall strategy. We will make it even simpler.

In this analysis, we will not pick individual stocks. We will select a few low-cost ETFs, namely the Vanguard Dividend Appreciation ETF (VIG), Vanguard High Dividend Yield ETF (VYM), and Invesco QQQ Trust (QQQ). We also will add small percentages of other assets like Municipals, Utilities, and Preferreds – Nuveen Muni Inc (NMZ), Reaves Utility (UTG), and iShares Preferred securities (PFF). The resulting portfolio of six funds will provide high growth, a reasonable yield of 2.65%, and provide more than enough diversification. Please note that QQQ is not a dividend ETF and does not provide much in terms of dividends. The reason we include it here to boost the growth of this portfolio, while the rest of the funds will provide income.

Note: If this portfolio is within an IRA, instead of NMZ, one could choose a taxable Muni fund like Nuveen Taxable Municipal Inc Fund (NBB), BlackRock Taxable Municipal Bond (BBN).

As you could see from the chart below, the overall total returns of this DGI portfolio almost mirrored the returns of the S&P 500 during the last three years.

However, if you were to run this test with starting date of the year 2008, the DGI portfolio would perform better than the S&P 500, with smaller drawdowns. Also, more recently, the S&P 500 has become heavily concentrated in some of the largest growth names. This is causing it to outperform most DGI portfolios for the time being, but that trend is not going to last forever. Nonetheless, the main difference is about the yield. This portfolio provides a respectable 2.65% yield compared to a paltry 1.54% of the S&P 500, without compromising on growth at all. As the investor progresses in age, he/she can adjust the ratios of the funds and invest more in VYM and less in QQQ to generate higher levels of income.

For investors, who like to invest in individual stocks, one could just start with the top 10 holdings of VIG and VYM. Younger investors and even most retirees should hold some of the growth names as well. For this, they can look at the top holdings of QQQ. There are a few duplicates, though. We like and own many of these names. However, unlike the indexes like S&P500, investors should hold these names in equal proportions.

Top 10 holdings of VIG:

Microsoft (MSFT), Walmart (WMT), Johnson & Johnson (JNJ), Procter & Gamble (PG), UnitedHealth (UNH), Disney (DIS), Home Depot (HD), Visa (V), Comcast (CMCSA), Abbot (ABT).

Top 10 holdings of VYM:

Johnson & Johnson (JNJ), JPMorgan Chase (JPM), Procter & Gamble (PG), Bank Of America (BAC), Intel (INTC), Verizon (VZ), Comcast (CMCSA), AT&T (T), Pfizer (PFE), Walmart (WMT).

Top 10 holdings of QQQ:

Apple (NASDAQ:AAPL), Microsoft (MSFT), Amazon (AMZN), Tesla (TSLA), Facebook (FB), Alphabet (GOOGL), Nvidia (NVDA), Paypal (PYPL), Netflix (NFLX).

After removing duplicates, we will be left with 24 names.

Basket 2: (Rotational RA Portfolios 45%)

This is our hedging or insurance bucket, but by no means it's short on growth. We normally recommend adopting at least two rotational strategies to diversify the risks. Here, in the article, we are providing one such strategy. We believe these strategies invariably work in the long term. Also, even though these strategies do not generate income specifically, but one can safely withdraw 6% income. Since these strategies have very limited drawdowns and low volatility, withdrawing income does not risk depleting the portfolio at the wrong time.

Please note that we do not recommend moving a very large chunk of money in one lump sum to these strategies. What we recommend is that if you are a beginner, start with a small amount and test the waters for a few months. Thereafter, one should increase the allocation gradually over a long period of time.

Bull-N-Bear Risk-Adjusted Rotation Model

This portfolio is designed in such a way that it will preserve capital with minimal drawdowns during corrections and panic situations while providing excellent returns during the bull periods. Due to much lower volatility, this portfolio is likely to outperform the S&P 500 over long periods of time. However, it may underperform to some extent during the bull-runs.

The strategy is based on six diverse securities but will hold any two of them at any given time, based on relative positive momentum over the previous three months. Basically, we will select the two top-performing funds. The rotation will be on a monthly basis. The six securities are:

• Vanguard High Dividend Yield ETF (VYM)
• Vanguard Dividend Appreciation ETF (VIG)
• iShares MSCI EAFE Value ETF (EFV)
• Cohen & Steers Quality Income Realty Fund (RQI)
• iShares 20+ Year Treasury Bond ETF (TLT)
• iShares 1-3 Year Treasury Bond ETF (SHY)

Please note that the last two are long-term and short-term Treasury funds, which are used as hedging securities.

The backtesting results going back to the year 2008 are presented below:

Growth Chart with No Income Withdrawals:

Growth Chart with 6% Income Withdrawals:

The below chart demonstrates the dangers of sequential risk and how devastating a deep correction can be at the onset of retirement (if you are to draw income). So, yes, drawdowns matter a lot, especially if you are a retiree who needs to withdraw income and a correction happens early in your retirement years. Due to a deep drawdown and 6% income withdrawal, the S&P 500 never got a chance to make a comeback in spite of the extraordinary growth of the S&P 500 in recent years.

Basket 3: (8% High-Income Model 15%)

In this basket, we usually recommend selecting one closed-end fund from each of the 10-12 asset classes that are available. In our articles on CEF funds and also based on our "8%-CEF-Income" portfolio, these are the 10 funds that we would have selected. All of these funds are excellent choices per their past history. KYN (Oil & Gas MLP fund) is an exception here, which has obviously suffered this past year greatly due to the double whammy of the crash in oil prices and demand destruction. We have included it in the mix to have exposure to this asset class. However, in hindsight, some individual partnership names like Enterprise Products Partners (EPD) and Magellan Midstream Partners (MMP) would have been much better choices. Here are 10 CEFs:

TABLE of 10 CEFs:

For the purpose of comparing the performance of this basket vis-à-vis the S&P 500, we will assume that we invested equally in these ten funds as of 1^st of January 2018. Now we will compare the performance of this portfolio with the S&P 500 from Jan. 1, 2018, until Jan. 31, 2021). Please keep in mind that many of these funds use leverage and this portfolio does not provide any downside protection. That's why we recommend an allocation of no more than 25% but preferably less. The only purpose is to boost the overall income of the portfolio.

The Combined Portfolio (all three baskets)

Backtesting from January 2008 until now:

We would assume that we started this three-basket portfolio as of 1^st January 2008 so as to include the 2008-2009 recession.

We will provide the backtesting results starting from Jan. 1, 2008, until Jan. 31, 2021. Though we can test the bucket 1 and 3 (DGI and Rotational) without any issues, we will run into issues with the High-Income CEF portfolio due to a couple of securities, namely PCI and PDI. These two PIMCO funds did not start until 2013. If we assume that we invested a total of $100,000 in the three-basket portfolio, we would have invested only about $15,000 in the CEF-portfolio and only $3,000 in PCI and PDI. For the purpose of backtesting, we would assume that we invested $3,000 in another PIMCO fund, PIMCO Corporate & Income Fund (PTY), from Jan. 1, 2008, until Dec. 31, 2013 after which this amount was moved to PCI and PDI. PTY is a different kind of fund than PCI/PDI, but that would not have changed the outcome much.

Please note that how the green line and orange bars are diverging over time, indicating that over a long period of time, the three-basket portfolio outperforms the S&P 500 while avoiding a roller-coaster ride at the same time. Over a 13-year period, the three-basket portfolio achieved a 50% outperformance compared to the S&P 500 with 30% less volatility.

Performance comparison when 6% income is withdrawn:

Now let's see how our combined three-basket portfolio would have fared since 2008 in comparison to the S&P 500 if we were to withdraw 6% inflation-adjusted income each year. As you can see from the below chart, the S&P 500 did not fare very well when the income was withdrawn. However, the combined three-basket portfolio continued to perform very well. One of the main reasons for the S&P 500's underwhelming performance is high volatility and big drawdowns. In fact, the drawdowns for nearly 60% of the three-basket portfolio (DGI and CEF) are similar to S&P500, but adding the Rotation portfolio, reduces the volatility and drawdowns of the entire portfolio to a great extent and improves the overall returns. In fact, this is the most important chart of this analysis because it highlights so clearly the dangers of sequential risk from the S&P 500 while the three-basket portfolio prospered in the same environment.

Concluding Thoughts

In the last three years, we twice had a serious market decline. First, during the fourth quarter of 2018, we had a near 20% correction and barely avoided the bear market. Then, last year, we experienced a 35% correction resulting from the coronavirus pandemic, even though it turned out to be one of the shortest bear markets and the market had a V-shape recovery. More recently, there has been heightened volatility and the market has dipped significantly in the last week from its highs. However, it is nowhere near correction territory, but fear is palpable.

Obviously, the future is never certain, and more so with the stock market. But we are fairly certain that whatever the market may do, whether it goes up, declines from here, or stays flat, our diversified multi-basket portfolio should perform reasonably well in good times and bad. Sure, if the markets decline big time, our buy-and-hold portfolios will decline as well, but most of their dividends will not. Our hedged part of the portfolio (rotational) acts as a counterbalance to the buy-hold part and should cushion any downside impact. Moreover, one can be assured of the constant and reasonably high-income stream that would not be impacted much by any recessionary times. We have presented a view of the model of how it can provide peace of mind during any crisis while not being short on growth during good times.