If you’ve been hanging around financial independence forums, you might have noticed two competing approaches to financial independence.
The first advocates accumulative a large portfolio of shares and sell those shares as income during retirement. And the second — known as the Thornhill Method — advocates accumulating a growing dividend stream and living off dividend income during retirement.
You may have noticed that there is a growing number of people advocating the Thornhill Method. It makes sense. The approach is quite intuitive and easy to understand, and seemingly overcomes challenges with the original approach to financial independence (e.g. sequence of returns risk).
However, there hasn’t really been a serious, objective analysis of the Thornhill Method and its implications for retirement. It’s a big topic, so in this first post we’ll take a deep dive into dividends to compare dividend income and selling shares for retirement income.
What is the Thornhill Method?
In it’s simplest form, the original approach to finance independence suggests that we should accumulate a large portfolio of shares and sell those shares as income when we retire. As long as we sell fewer shares than our safe withdrawal rate, that nest egg should last us throughout retirement.
The Thornhill method is an alternative approach to retirement income. The three main components of the approach are:
- Dividends are preferable to capital growth. Instead of accumulating assets and selling those to fund our retirement, we should accumulate a portfolio with a growing stream of dividends and live off the dividends during retirement. No selling shares needed.
- Industrials are the best source of dividends. We should aim to purchase high yield shares in the industrials sector, as they provide the most reliable and consistent dividends.
- Purchasing LICs is the best way to access industrials dividends. We don’t need to pick individual high yield shares, as purchasing LICs gives us a diversified portfolio of high yield industrials shares.
There is no difference between selling your shares and living of dividend income during retirement
The big argument that we regularly hear from Thornhill die-hards is that dividend income is somehow better than selling your shares to fund your retirement. In fact, the following quote is from Peter Thornhill himself (via StrongMoneyAustralia):
If, however, you are cashing shares to supplement your income you will be exposed to the fluctuations in share prices which may see you selling shares at a less than ideal time…. GFC anyone?!
Eating the seed corn is how civilisations implement Darwin’s theory by self-selecting themselves out of the human race.
Ouch! At first glance, this feels like a very compelling argument. Why would you want to sell your shares during a bear market? You’d have to sell more shares to maintain your income (as their price is lower) and you’d be locking in losses.
But dig a little deeper and you realise that there’s a fallacy at play.
Here Thornhill is saying that we’d be worse off selling our shares during a market drop, so the counterfactual is that we’d be better off (i.e. achieve better returns) with a dividend-based strategy. In other words, Thornhill is contrasting column 1 with column 2 in the chart below.
Let’s conduct a thought experiment. Imagine that we invested $1,000,000 a company called Dividend Ltd and $1,000,000 in a company called Growth Ltd. These companies are identical in every way and they grew by -4% in the last financial year. This means we’d have portfolio loss of $40,000 in each of our companies.
In addition to that, we need $60,000 to live off for that year of retirement. Dividend Ltd will pay $60,000 in dividends but we’ll have to sell $60,000 worth of Growth Ltd shares to fund that year of living.
Here’s the dodgy math. People mistakenly believe that the total loss of Dividend Ltd is $40,000 (capital loss) but the total loss of Growth Ltd is $40,000 + $60,000 (capital loss + selling of shares). They forget that dividends have to come from somewhere!
This is how it actually works:
The missing piece is this: if Dividend Ltd pays out a dividend, that is reflected as an additional capital loss (we will illustrate this phenomenon with actual Wesfarmers data in the next section). So in the example above, both Dividend Ltd and Growth Ltd have a final portfolio value of $900,000. This is correctly contrasting column 1 with column 3 in the earlier chart.
Unfortunately, Mr Thornhill does not seem to recognise that selling part of your portfolio at a market dip is no different than not re-investing your dividends in the dip!
Any ‘benefit’ of dividends is immediately arbitraged away
In the last section we explained that there is no difference between dividend income and selling shares as income. Now we’ll show how this works in practice.
In the real world, if there was some incremental benefit for holding high yield shares, that benefit would immediate be arbitraged way. Otherwise, it would make no sense for investors to hold anything but high yield shares.
For example, the market would immediately start selling off capital growth stocks (thus pushing the price down) and purchasing high yield shares (thus elevating the price). At some point, the market would reach a price that reflect the total value of each type of share. And there we have the efficient market.
We can actually see this in the real world! The chart below shows the movement of Wesfarmers’ share price around their 2018 final dividend. Westfarmers announced their 2018 final dividend of $1.20 overnight on the 14/15 August. This signaled that there is additional value in owning Wesfarmers shares, so investors purchased the share and drove up the price to reflect this additional value.
Generally speaking, the price increases by approximately the value of the dividend. In the case of Wesfarmers, the price shot up by $1.38 then landed $0.89 above the pre-dividend high. There are a bunch of potential reasons why it didn’t exactly land on +$1.20, including:
- natural variability in the day’s trading
- the fact that Wesfarmers dividends are regular and investors may have partly ‘priced in’ or assumed a dividend was coming even before it was announced
- that Wesfarmers financial results were announced on the same day and other factors may have put downward pressure on the share price
But the important point here is that, once the dividend is paid, the price then plummets back to pre-dividend levels. This means that the owner of the share cannot have their cake and eat it too. They can either receive the dividend and suffer the immediate drop in capital growth, or they can sell their share and lock in the capital gain, but not receive the dividend.
Even if dividends were somehow ‘better’, they can still be cut!
The last thing we need to keep in mind is that dividends are not a sure thing. Dividends are distributions of company earnings. When times are tough and companies aren’t earning, they can (and do) decide to reduce their dividends.
That’s exactly what we saw during the GFC. If you were living off dividends at the time, you’d be in for quite the shock. In the table below, we calculate divided income for Wesfarmers through the GFC and beyond. Note that we adjusted the required retirement income to grow at inflation.
Although dividends would have covered our required income before the GFC, they certainly fell short during the GFC. In fact, on an inflation-adjusted basis, even 11 years later they haven’t fully recovered and are still short by 20% of what we need during retirement.
In short, dividends are not a guaranteed income, they don’t always keep up with inflation, and it can take an extremely long time for them to recover to their previous peak. It would be tough to survive years on an income level below what you require.
You may argue that Wesfarmers could just be an outlier with particularly high cuts to dividends and that’s a fair argument. But take a look at this RBA research paper. ASX total dividends were cut significantly during the GFC and didn’t recover for three years. And it looks that those figures aren’t inflation-adjusted, so they likely didn’t recover in real terms for even longer.
And yes, I know there are a bunch of people yelling “what about LICs!?”. It’s true that a number of LICs didn’t significantly cut their dividends during the last financial crisis. But there’s a good explanation for that, which I’ll leave for the next post that focuses on LICs.
Are you still clutching onto the dividend delusion?
There is one way to put this debate to bed once and for all: run a simulation.
For this exercise we simulated total portfolio returns for an Australian ASX300 index fund (VAS) and an Australian high yield index fund (VHG). As far as we can see, VHG is the only extant high yield fund that was around pre-GFC.
The chart below plots indexed nominal returns (i.e. not adjusted for inflation) with dividends reinvested from immediately pre-GFC (May 2007) to today.
As you can see, there is little difference in the performance of the high yield fund when compared to the ASX index fund. The high yield fund did outperform the index fund from 2011-14 and then the index fund outperformed from 2014-18. These performance differences are most likely due to inherent differences in the underlying assets in each fund (e.g. the different sector mix). In any case, we don’t see the high yield fund consistently and reliably outperforming the index fund.
It is particularly noteworthy that there is almost no difference in the performance of the funds during the GFC (2007-09), which clearly illustrates that that there was no incremental benefit of dividends over capital growth even during a bear market.
But dividends aren’t bad, they’re just not better
To be clear, there seems to be nothing wrong with a dividend-based approach to investing for financial independence — it’s just no better than a capital growth-based approach.
Instead of trying to split hairs between dividends and capital growth, it makes more sense to measure total returns (i.e. capital growth plus dividends). And when we view the numbers through the total returns lens, we don’t see much difference between each approach.
As we mentioned earlier, Thornhill advocates purchasing LICs in lieu of individual high yield shares. On face value it looks like LICs don’t suffer from some of the same challenges as we described above, so in the next article we’ll take a closer look at LICs and whether they are a better alternative as a means to financial independence.