In addition to investing in total market ETFs, the only other investing strategy I strongly adhere to is dividend investing. Of the many potential passive income streams that one could build, dividend investing is among the most effective because of its consistent, predictable gains and the minimal effort required to maintain it.
To understand dividend investing, let’s first take some time to understand terminology. (If you’re already familiar with the terms, skip to the next section).
Interest: money paid regularly at a particular rate for the use of money lent, or for delaying the repayment of a debt. (Source: Google)
For example, when you leave money in the bank, you earn interest on it (but the current interest rate on a standard checking account is nearly zero). Also, if you take out a loan, you need to pay it back with interest, which serves as their compensation for giving you money for a period of time.
Compound interest: interest on interest.
Imagine you plant an orange tree. Instead of eating the oranges and tossing the seeds in the trash, you decide to replant the seeds in order to grow more orange trees. After many years, you end up with an acre full of orange trees. Compound interest works in much the same way, using the interest earned to earn more interest.
Dividends: the “interest” earned on certain stocks.
Many companies (particularly large, mature companies) incentivize investors by paying monthly or quarterly dividends. These companies pay out cash from their profits to their shareholders to reward them for continuing to hold onto their stock. Some examples include JPMorgan, Coca Cola, and McDonald’s. By contrast, most growth companies do not pay dividends, because they are still experiencing strong growth, and are better off reinvesting their profits into the business.
Dividend Terms: Here is a useful article summarizing the timing of dividend payments and how to receive a dividend. Basically, in order to receive your dividend, buy the stock before the Ex-Dividend date, hold it until after the Record Date, and then receive the dividend on the Payment Date.
Dividend investing is a great tool for a few reasons:
1. Dividend payments are very consistent and predictable.
It’s about as plain vanilla as investments get. Most dividends payments are monthly or quarterly, and the amount and date they will be paid are typically largely the same.
Look at the following chart for PGX:
There is clearly minimal variance in the amount or timing of the dividend payments. Just like a paycheck, it’s nice to know when and how much to expect in your next payment.
2. It’s a purely passive source of income.
Literally all you have to do is buy the shares, and they will pay you for being a shareholder. If you are invested in a dividend ETF (again, it is good principle to be invested in a basket of stocks rather than individual stocks), you don’t need to worry about a company discontinuing dividend payments or going out of business.
3. Dividends are paid in cash.
Admittedly, this is both an advantage and a disadvantage. The plus side here is that you do not have to sell principal (your shares) in order to receive the benefits. On the other hand, if you own a stock like Google, and it appreciated in value from $1,100 to $1,200, you would have to sell the share to gain $100. If you choose to keep holding, you may benefit more from continued rise in share price, or the shares might drop from any market factor (overall recession, changing marketplace, major litigation, etc). Either way, you have to eventually make a choice.
While the earning potential on dividends is generally less than that of growth stocks, you know exactly what you’re getting. Think about it like this: You’re going out for dinner, and you’re picking a place to eat. On the one hand, you could go with something familiar, like In-N-Out. With In-N-Out, you know exactly what you’re getting (cheeseburger with no onions, fries well-done, and a Coke). While it’s not fine French dining, it’s undoubtedly delicious. On the other hand, you could check out the new Korean-Mexican fusion restaurant that everyone’s been talking about. You might be mindblown by their bulgogi tacos, or you might walk away shaking your head in disappointment because the hype wasn’t real. This is basically dividend investing vs. growth stocks in a nutshell.
The other downside is taxation (when are taxes ever a positive? Hah). Dividends are realized gains, therefore they need to be recorded as taxable income.
Let’s throw some realistic numbers in the mix:
First, it’s pretty evident that just throwing your money in the bank is not the best use of your cash, assuming that you don’t need it immediately. There are some savings accounts that pay nearly 2% in annual interest, but there are usually conditions attached like a $10K minimum balance, limited number of withdrawals, and fees for going under the minimum balance.
Next, you can opt to just use the cash earned from dividends for your daily life. An extra couple of dollars each month can help with your expenses. You can smugly tell friends that your dividends paid for your Netflix subscription.
However, the best option, especially for young people that still have a long time to invest, is to reinvest the dividends to take advantage of compounding. In the example above, $10K invested over 10 years results in a $7,835 gain (excluding taxes) from doing essentially nothing. The key to dividend investing is ultimately time and patience. The initial amounts received are admittedly tiny, especially with balances under $10K. But let’s say you’re 25, and you’re able to aggressively build up a balance of $100K in dividend ETFs over the next five years. At that point, you would be receiving about $500 in monthly dividends. While it’s not enough to be able to quit your day job, it absolutely can go a long way in helping your financial position. End up quitting or losing your job? You can still rely on your dividends to help you instead of having to pay purely from your savings. But to get to this point, you must be disciplined in saving up and resist the temptation to sell off shares when different circumstances come up.
Okay, you’ve convinced me. But how do I choose what to invest in?
As I’ve mentioned before, a passive investor should almost always invest in an ETF rather than an individual stock. There are quite a few dividend ETFs to choose from, and it can feel a bit overwhelming with the options. There are a few factors to consider:
People can run into problems if the fund is small (in my definition, less than $1B). Small funds may cause problems with liquidity (ie you can’t find a decent price to sell your shares because there aren’t enough traders). Small funds may also not be as well diversified, which leads me to my second point.
If the portfolio is comprised of just a few companies, or “overweight” one company (high % is in just one company) then one company finding itself in troubled waters could drag down the entire ETF. Any portfolio with large positions in GE, FB, or PCG probably got demolished this year. Also, if you discover that you don’t recognize any of the names in the top holdings of the portfolio, that’s probably an issue. It’s like eating a “mystery meat” chicken nugget. You know from the ingredients list that the meat definitely isn’t just chicken breast. Still tastes good, but questionable enough to make you second guess whether or not you should be eating it.
Just because an ETF has a very high dividend yield does not mean it’s “better”. Markets are fairly efficient, so a higher yield almost always means higher risk as well. That ETF with 8% dividend yield might look very attractive, but it could be a trap.
It’s always good to check the expense ratio, which is the percentage of your investment that will be taken out as part of the admin fees associated with the fund. Two funds may look largely similar, but one may have a higher expense ratio than the other, making it less profitable.
My personal preference is for PFF and PGX because they are large, well-diversified portfolios of preferred stock. I recognize all of the top holdings (mostly banks and energy companies). There are many other options out there, including DIV, SDIV, SRET, VIG, VYM, etc. These all have different focus (US, non-US, real estate, etc), and track to different indices.
When investing, check to see whether your brokerage allows a dividend reinvest plan (DRIP). If so, you will be allowed to automatically reinvest your dividends to purchase more shares (including partial shares). I personally use Vanguard, which has the option to enroll in DRIP.
Ultimately, dividend investing is an excellent way to build up passive income. It’s not the most lucrative or the flashiest option in terms of investing, but there is a lot to benefit from the consistent approach found in dividend investing.