Learn More About Dividend Investing
Episode 122R
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Understanding Dividend Investing: Strategies for Financial Independence
Dividend investing is often viewed as a reliable path to achieving financial independence. By providing a source of passive income, dividends can serve as a backbone in an investor's portfolio. However, it is crucial to delve deeper into this investment strategy, considering both its potential benefits and pitfalls. Here, we will explore actionable insights on dividend investing that challenge traditional narratives and empower you to make informed decisions about your financial future.
What is Dividend Investing?
At its core, dividend investing involves purchasing shares of companies that pay regular dividends to shareholders. A dividend is a portion of a company's profit distributed to its shareholders, often reflecting the company's financial health. This investment strategy appeals to those seeking regular income, especially during retirement. However, it's essential to understand that dividends do not guarantee a stable income stream.
The Nature of Dividends
Many investors mistake dividends for assured returns similar to bond interest. Unlike bonds, dividend payments can be cut or eliminated at any time. This unpredictability introduces additional risks that require careful consideration. When investing in high-yield dividend stocks, it's vital to recognize that high yields can often signal underlying weaknesses within a company.
For example, a company offering a 10% dividend yield may be doing so because its stock price has fallen significantly. In this case, the dividend merely reflects a portion of the company's profit distribution and does not inherently signify a growth opportunity. Instead, it may be a forced selling of shares, meaning the dividend payout could result in a net loss over time.
Assess Your Risk Tolerance
Understanding your risk tolerance is crucial when considering dividend stocks versus other investment strategies, like index funds. If you are risk-averse or nearing retirement, dividend stocks may offer more stability. However, younger investors focused on long-term growth might prioritize broad equity exposure through index funds, potentially yielding higher returns over time.
Key Consideration: Tax Implications
When investing in dividend-paying stocks, the tax implications shouldn't be overlooked. Dividends are often taxed as ordinary income, which might not be ideal for high-income earners. You might consider deferring this strategy to a lower-income period, especially if you plan to retire early.
Exploring Dividend Growth Investing
Dividend growth investing involves purchasing stocks that consistently increase their dividends over time. This strategy appeals to those seeking to generate income without liquidating their principal investment. However, the success of this approach is contingent upon selecting the right companies. Researching dividend aristocrats—companies that have increased their dividends for at least 25 years—can offer a foundation for this strategy.
Balancing Stability and Growth
While seeking stability through dividends, don't neglect the potential growth in your overall investments. Many index funds provide a stable dividend yield while also fostering equity growth. By simply investing in these funds, you can achieve a balance between receiving dividends and benefiting from capital appreciation without the intensive research required for individual stock investment.
Identifying Suitable Candidates for Dividend Strategies
If you're contemplating incorporating dividend stocks into your portfolio, consider the following:
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Interest in Research: You must have a genuine interest in researching companies and staying informed on market trends.
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Time Horizon: Assess how quickly you want to grow your wealth. If you're in your 30s with a long investment timeline, the benefits of dividend stocks might not outweigh the advantages of pursuing higher-risk, higher-return investments.
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Income Needs: If you're nearing retirement, a dividend strategy could play a crucial role in generating income without the need to sell your investments during a market downturn.
Enhancing Your Investment Strategy
To maximize the effectiveness of your investment strategy:
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Diversify Your Portfolio: Spread your investments across different asset classes to mitigate risk. Consider a combination of dividend stocks, index funds, and potentially growth stocks.
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Be Mindful of Company Selection: Look for companies with strong fundamentals and track records of increasing dividends. Resources like dripinvestor.org provide valuable data to identify stable dividend payers.
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Regularly Review Your Investments: Market conditions change, and companies may alter their dividend policies. Make it a practice to review your investment portfolio, ensuring it aligns with your evolving financial goals and market realities.
Final Thoughts
Dividend investing can be an effective strategy for generating passive income, but it requires a nuanced understanding of the associated risks and rewards. By assessing your risk tolerance, considering tax implications, and identifying suitable investment candidates, you can make informed choices that align with your long-term financial goals.
As you consider your approach to financial independence, remember: investment strategies should be tailored to fit your unique circumstances and preferences. Whether you lean toward dividend stocks or opt for broader equity funds, prioritizing ongoing education and market research is essential in building and maintaining a successful portfolio in today’s dynamic financial landscape.
Engage with the community, seek advice, continue learning, and evolve your strategies as needed. Your journey toward financial independence is a marathon, not a sprint—so prepare accordingly.
Brad and Jonathan are joined by Brian Feroldi and Karsten from Early Retirement Now. With the goal of gaining a deeper understanding of dividend investing, Brad and Jonathan ask the hard questions. As the devil's advocate, they uncover more information about dividend stocks from passionate investors.
If you are ready to learn more about dividend investing, then let's dive in.
[elementor-template id="143609"]What Is A Dividend?
The first thing we need to understand is exactly what a dividend is. According to Feroldi,
"A dividend is when a company takes cash out of its bank account and give it directly to its shareholders. Normally, that is done directly out of profits."
When a company earns a profit, it has to decide what to do with that profit. Paying out dividends to investors is just one of those options. They could also reinvest that money into the business, leave it in an account, buy back stock, and more.
Related Episode: The Unfair Advantages Of The Individual Investor With Brian Feroldi
Will The Stock Price Drop With Each Dividend Payout?
In Brad's example, when a company paid out a dividend, the stock price dropped to match the payout amount. The result was no gain in net worth when he received the dividend. This was a high yield dividend stock, so it is fairly common that this type of dividend stock will take a hit in the stock value each time a dividend is paid out.
However, not all dividend stock prices drop with their quarterly payouts. For example, a company was earning $25 million a quarter and only paid out $12.5 million in dividends. Overall, the stock price would still increase.
When the business pays out in cash dividend payments, the shareholders receive a more direct benefit from the profits of the company. Otherwise, profits will stay within the business and not necessarily benefit shareholders in a direct way. The dividend is actual income through which the shareholder can realize an immediate cash return without any stock price increase.
How Are Dividends Different Than Bonds?
With a dividend stock, there is no guarantee that the company will pay out dividends every single year. Unlike a bond, there is no maturity date on a dividend stock and no promise that you will get your principal back.
Dividends are not guaranteed like bond interest... [A] 10% dividend stock differs from the 10% bond in two important ways. First, there is no maturity date on a stock and even if you sell... there is no guarantee that you get that principal back. And then on top of that, there is no guarantee that this company will pay 10% dividends every single year.
The companies that pay out dividends are under no contractual obligation to pay out dividends. The dividend could be cut or completely eliminated at a moment's notice. One example is Century Link that recently cut its dividend percentage dramatically after decades of steady payments.
In American companies, most companies set up a dividend policy that outlines a percentage of the stock price payout each year. However, most foreign companies do not necessarily set a number instead they set aside x% of the profits.
Related: Intro To Dividend Investing
Where To Find Good Dividend Investments
Of course, your goal as a dividend investor is to build a portfolio that provides a stable income stream over time. However, your information about a company is all looking into the past. With resources like DRIP Investor and the Aristocrat's List, you can see how companies performed in the past. Past performance is not a reliable indication of future performance.
With a lot of backward looking bias I can come up with a great list of companies that were stable dividend payers over the last 10 years, 20 years, but the problem is that we have to do this in real time. We have to determine today which ones are the stocks that will be really stable going forward.
The biggest challenge is that it will be difficult to determine which company will be doing well in the next recession and which will be forced to but all of its dividends. You cannot determine future winners and losers by today's list of winners.
Related Episode: Sequence of Return Risk With Early Retirement Now
Is Dividend Investing Similar To Stock-Picking?
Brandon from Mad Fientist, had this to say about dividend investments,
"Dividend investors often feel they aren’t stock pickers but that’s exactly what they are. They are taking individual companies and taking on a unique risk because they feel that certain companies can offer something that others can’t. Its an insane version of stock picking though. Even though I don't do it myself, it is easy to see why some people would try to find the next Amazon or Google. They are happy risking a tiny portion of their wealth for incredible returns. Dividend investors, however, take on the same individual company risks but do it for companies that have limited upside potential. A company that returns most of its profits to shareholders through dividends is obviously not focused on growing their company exponentially."
Is Dividend Investing Worth The Effort?
When you build a dividend investment portfolio, you will need to put in a lot of time and effort. The goal is to create a nice income stream, but you are really putting a lot of emphasis on your ability to pick companies that will perform well into the future.
Instead, why not consider setting up something similar in your index fund. As an index fund investor, you do receive a dividend yield of just under 2%. If your goal as a dividend investor is to raise your dividend return rate to 4%, then it is not a guarantee that you can achieve that.
Related: DRIP Investing: A Low-Cost Automatic Way To Save
What About Total Returns?
In episode 122, Craig mentioned that he was not focused on keeping up with the market. Instead, he is focused on building a reliable income stream. Not only would you be putting the time to build this portfolio, but also not keep up with the market.
You may have a different opinion of this based on different stages of life. If you are close to retirement or in retirement, then you care more about the volatility of the market and drawdowns. With dividend investing, you may be able to create total returns that are less volatile.
With less potential volatility and the ability to build income now, it could be a good option for some. If you were retiring with no retirement savings, then dividend investing would be an extremely attractive option.
For Karsten, although total returns may be slightly less, that's not the dealbreaker. The dealbreaker is that it simply takes too much time to build an maintain a dividend portfolio.
Who is Dividend Investing Best For?
First and foremost, a dividend investor must be interested in learning more about these companies. If you do not have the time or interest to keep up with the market, then dividend investing is not a good fit. Index funds are simply easier and offer attractive growth.
You must have an interest in building a passive income that could meet your needs. When the next recession comes, dividend income could help to cover your expenses if you lost your job but do not want to sell off your plummeting stock.
The right choice for the vast majority of people the vast majority of the time is index funds.
In your 20s or 30s, then the tax consequences alone may be enough to deter you from building a dividend investment portfolio. Even Warren Buffet warns that the tax consequences dividend payment programs are inferior to sell off programs in his 2012 letter to the shareholders.
However, if you are closer to retirement with a tax-deferred account to work with, then you may consider transitioning into more dividend stocks. You may think of this as an alternative to bonds. Or a way to keep more of your portfolio in equities.
The key to potential success in a dividend portfolio is that you need to have a strong interest in individual businesses. Without that, the potential income stream may not be worth the time and effort it takes to build it.
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