My investment goals have changed over time. I used to focus on appreciation to grow my assets because I was less concerned with generating consistent income while I still had income coming in from my job. I think it’s appropriate during early phases of trying to achieve financial independence to invest in higher-risk/higher-reward assets if you know enough about the investment or the underlying business to lower the risk. I have invested in some of these riskier investments and most of the time they ended positively for me. However, I’ve moved into trying to maintain my financial independence and I have changed my focus to more stable, cash generating securities. I still want exposure to the equities markets (i.e., stocks) but I want even this allocation of capital to generate passive income for me.
At the beginning of 2019, a large part of my investments in the U.S. stock market was held in a fund that mirrored the S&P 500 but it did not generate any dividends or distributions. This investment was intended to be less volatile than the S&P 500 without significantly underperforming the S&P 500 and it was part of my portfolio managed by my financial advisor. He’s done a great job with a lot of my investments but this investment performed poorly relative to various benchmarks. I recently sold this position and have decided to build a portfolio of dividend paying stocks and ETFs. I’m going to self-manage this portfolio.
The amount a company pays in dividends is measured by its dividend yield. A dividend yield is the ratio of a company’s annual dividend payments divided by its share price. Companies with higher dividend yields provide higher dividend payments relative to the company’s share price. The median stock in the S&P 500 has a dividend yield of approximately 1.8%. The highest yielding S&P 500 stocks can have dividend yields in excess of 7%, and close to 20% of S&P 500 stocks pay no dividend at all (meaning no passive income is generated from holding these stocks). I want total return, measured as the increase in a stock’s price plus any dividends, but I am going to emphasize passive income in all of my investments going forward since I don’t have consistent income coming in from my job. I may sacrifice some growth/appreciation but I’ll generate cash flow with an asset class (stocks) that has previously generated very little cash for me. Here are the main reasons I like dividend stocks/ETFs so much and why I will be allocating capital to build a dividend portfolio.
Why We All Should Build a Dividend Portfolio
Dividend-paying companies have historically outperformed non-dividend paying companies and with less risk.
Certain asset management firms have published articles showing that over the long-term dividend paying stocks outperform non-paying dividend stocks and are subject to less market volatility. These studies have looked at 40-50 years of data to support this conclusion. If you think about this conclusion it makes sense for various reasons including that a dividend paying company needs consistent cash flow from its business to pay a dividend and therefore is usually a more established company in a more mature industry (meaning less volatility). You won’t hit too many homeruns investing in dividend paying stocks but you will avoid the strikeouts that smaller and money-losing companies can generate. As I move towards maintaining my financial independence I want to reduce volatility and avoid the strikeouts.
Dividend-paying companies have recently underperformed non-dividend paying companies and their valuations appear more favorable.
Investments focused on dividend yields have underperformed the S&P 500 in 2019 (by 5-7 percentage points). Dividend paying companies have traded below their historical average for much of 2019 and are trading at a discount relative to the S&P 500. I’ve purchased some of these stocks recently and seen 20%+ returns in less than a few months. I’m not saying this is what I expect to occur going forward but there are some dividend-paying companies that are trading at reasonable valuations while the S&P 500 seems to be trading at some pretty high valuations relative to company earnings.
Dividend payers have historically performed well in recessions compared to non-dividend paying companies.
Studies factoring in recessions between 1979 and 2018 have shown that dividend paying stocks outperform non-dividend paying stocks immediately prior to and during recessions. If you are planning to add to your equity positions at this time then dividend stocks have shown to be less volatile heading into late stage economic cycles and during recessions.
Dividends are a source of passive income that generates cash even when company stock prices become volatile or go down.
I’ve noticed that when I focus on generating passive income with an investment I am more likely to hold it during a recession and benefit from the growth cycle after a recession. I’m more likely to panic sell if my main investment thesis for an asset is appreciation/growth and what I see is long periods of stagnation or sharp periods of depreciation. By holding dividend paying stocks I should still see stable or growing cash flow even during periods where the stock price drops due to market corrections/economic downturns. Of course, dividends are at risk of being cut during economic downturns and I recommend you actively manage your portfolio (see below).
Certain dividends receive favorable tax treatment from the IRS.
A company’s dividends can be classified as “qualified dividends” if the company trades on a major U.S. exchange and you own the company’s stock for a certain period of time. Qualified dividends are taxed at the long-term capital gains tax rate, which is much lower than the regular federal income tax rate. For 2019, the regular federal income tax rate on ordinary income ranged between 10% and 37%. The long-term capital gains tax rate during 2019 is between 0% and 20%. That’s a big benefit to long-term holders of dividend-paying stocks.
Applying a conservative options trading strategy with your dividend portfolio can significantly boost the passive income generated from your dividend portfolio.
I’m going to write a separate post on conservative options strategies to boost your cash return on stocks you own using covered call options and cash-secured put options. By selling these options I have been able to increase my annual cash returns on my portfolio by a little over 5%. The dividend stocks I hold currently have a weighted-average dividend yield of just over 6% and I’m adding another 5% annualized cash return by implementing a very conservative options strategy. I’m not doing anything crazy, it takes just a few hours a month, and I’m doubling my cash yield. Pretty cool stuff. More on that later.
Some Active Management is Necessary by You to Optimize Your Dividend Portfolio’s Performance
Trust but verify.
I am going to hold my dividend stocks for long-term performance and I am going to choose companies that have a significant history of paying consistent or growing dividends and that appear to be in a good position to continue to pay these dividends. With that said, a dividing-paying stock can see a meaningful drop in its stock price if investors experience a dividend cut by a company or expect one to happen. You should make sure you have adequate time to monitor individual stocks and sell them if there is a meaningful change to the business that could reduce cash flows and cause dividends to be reduced or cut altogether. I have set-up Google Alerts for the stocks I own or want to own and I have also put them on my watch list on my phone. I also try to listen to their earnings calls every quarter. You should come up with your own way to monitor any stocks you own or want to purchase in the future.
Not all dividends are created equal.
WARNING – Do not just buy the stocks with the highest dividend yields! First, higher yielding companies generally align with companies that have to pay most or all of their cash flows to investors (REITs and MLPs) and certain industries that are more mature with less growth prospects. The other reason a stock may be paying a higher dividend relative to industry peers is some specific risk to that company’s business performance (which could impact its ability to continue to pay those juicy dividends). You need to evaluate these things. Historically, companies paying a forecasted dividend yield of greater than 7% have actually provided a much lower actual dividend yield (more like 4%). Just be mindful of the stocks you are picking and ask why a dividend yield is so high if it is exceeding what other companies in the same industry are paying.
I’ll be Your Huckleberry.
I currently have $100,000 earmarked towards building a dividend portfolio and by 2024 I want to have a $500,000 dividend portfolio that generates at least $40,000 annually in cash. I will be providing quarterly updates to you on what has gone well (and not so well) with my dividend portfolio strategy.