Stocks dividends are an easy way to get passive income, but it takes a lot of capital to make a significant amount since dividend rates are low for most stocks.
I bought my first dividend oriented mutual fund at Fidelity Investments almost 40 years ago, and I’ve owned many dividend stocks since then.
Is Dividend Investing Worth It? If you have a significant amount of wealth saved, dividend income may provide enough money to live comfortably in retirement, if you don’t mind the swings in your net worth due to the big, occasional stock market downturns.
The reality is that dividend income is very capital intensive. This means you need to have a lot of money in stocks to get meaningful income.
One big consideration in deciding if dividend investing is worth it is the reality that your net worth will rise and fall along with the stock market. The good news is that for most stocks, the dividend income just keeps coming despite the swings in the market. For this reason, dividend investing can be worth it for investors with high net worth.
Dividend investing has been a traditional source of expected steady retirement income for many decades. Do dividends make sense as a reliable income stream during your retirement? While I can’t answer that question, I’ll address some common questions and important points here about dividend investing that I have learned as an individual investor.
Is Dividend Investing Safe?
Understanding the amount of investment risk you have, and being okay with that level of risk are of primary importance so I’ll address this first.
As a refresher, investors get dividends when a company pays out their earnings to their shareholders instead of investing that money back into the company. Newer, faster growing companies will retain their earnings so they can use the money to expand.
This naturally means that a company that pays dividends has been through the major growth phase and gotten to the point where they can pay out at least some of their earnings to their shareholders. Given this, there is an element of safety with dividend stocks vs newer, higher growth stocks. With high growth stock, investors come to expect that level of growth to be sustained and if it is not, the company’s stock prices can drop like a hot potato.
But the other risk to consider is not whether a single company has reached the point of stability. It is the fact that the overall market goes through bear markets periodically.
Dividend stocks fall right along with the overall stock market. The good news is that dividend stocks, as a whole, generally don’t fall as much as the broad (entire) market.
One reason for this is that investors hold stocks for two major reasons: growth or income. With investors who are invested in stocks for income, the dividends are almost always still paid, even when the value of the stock drops.
This means that income investors have much less reason to sell their stocks (or funds) than someone who has invested in the stock market for growth. If a retiree is paying the bills with dividend income, then they’ll certainly need to hold on to those stocks.
When investors have a good reason to hang onto their stocks, like income investors do, the resistance to sell provides a little bit of a cushion during the occasional bear stock market. This cushion means that dividend stocks typically don’t fall quite as much as growth stocks that don’t pay a dividend.
Are Dividend Stocks A Good Investment?
Whether or not dividend stocks are a good investment depends on whether you want growth or income stocks based on your overall personal wealth plan.
If you are working and earning income from other sources, you probably won’t have the need for dividend income. In fact, you may wish to avoid them, so you don’t have to pay taxes on the income.
Also, you’ll likely want the dividend income to stay in your account and compound over time. This is especially true if you are younger.
It’s important to note that a large portion of the often quoted approximate 10% return from investing in stocks over very long periods of time comes from dividends being reinvested and compounding as shown in the chart below.
In general, dividend stocks are associated with older investors and retirees looking to live off investments while growth stocks are considered better suited for younger, longer term investors. But how valid is this commonly held belief?
To answer this question, let’s see which stocks perform best, non-dividend paying stocks or dividend paying stocks.
Do Dividend Stocks Outperform the Market?
Let’s look at a couple of visuals to see if dividend stocks outperform the market. The chart below shows that stocks categorized as dividends growers and initiators significantly beat the other types of dividend stocks for the time frame shown.
This chart surprised me, but it does make sense: Companies that are just entering the dividend paying stage, or those that are increasing their dividends due to higher earnings would logically outperform other categories. 1.
Keep in mind, however, as with all investment data, shorter or different time frames can reveal significantly different results. (This is a bit of a rant with my financial coaching clients. I always encourage them to look at various time frames rather than the first data they’re handed when meeting with a potential financial advisor or wealth manager.) Note, for example, how the top performing categories came together or even swapped places around 2008.
Look at the chart below that also supports that dividend paying stocks outperform non-dividend stocks. This chart plots data from Kenneth French, a remounted Dartmouth professor showing both stocks that did and did not pay dividends going back to 1927. Seeking Alpha writer and CFA Ploutos valued weighted the portfolios to get more reliable data. 3.
How Much Money Do You Get from Dividends
More specifically, the amount of money you make from dividends on any given investment amount depends on two factors:
- The Amount of Money You Have Invested
- The Yield on Your Dividend Investments
Assume someone with a million dollars invested in dividend paying stocks yielding 3%. Their dividend income (before taxes and investment fees if owed) is $30,000 a year.
Likewise, someone with $600,000 invested in dividend paying stocks yielding 5% a year will make $30,000 a year before taxes.
♦ Wealth Building Tip – There is always magic in the simple math when you step back and look at your investments.There is always magic in the simple math when you step back and look at your investments. Click To Tweet
At this point, you’re probably wondering: How can you make 5% instead of 3% on your dividend stocks? As a general rule, the more risk there is in your investments, the higher the yield.
For example, the yield of AT&T has bounced around between about 1.6% to 1.76% over the past twenty years as you can see in the image I made below. At times when the risk has been considered higher, AT&T has had a higher yield to attract investors.
Below is a chart I made showing Dividend Aristocrat staple Aflac (and creator of the cute duck we all grew to love!) The Aflac dividend yield looks quite boring compared to AT&T, right?
But wait – look at that dividend spike in February 2009 when Aflac yielded almost 5%. Who wouldn’t want to get 5% from a staple like Aflac?
Unfortunately, only the proactive and smart investors who pay attention to broad stock market cycles got the 5% yield. They bought Aflac at that time and got the higher yield since they were buying Aflac at deeply discounted prices after the nasty bear market which ended in March 2009.
In other words, investors who bought Aflac at higher pre bear market prices wouldn’t have gotten that higher yield.
This is because you calculate the dividend yield as follows:
As you can see, the cost that you pay for an asset will determine the yield that it pays you. Therefore, I love to buy cheap assets (along with cheap cars, groceries and clothes!). You get more for your money.
Besides cost, the other factor driving income yield is risk. With more risk, in general, you get higher dividends.
Are High Dividend Stocks A Good Investment
As you saw above, you can earn 3% or 6% or even higher from dividend stocks. Note that most common stock index funds, such as S&P 500 and Dow Jones based funds will pay dividends in the lower range simply because many companies pay out dividends.
On the other hand, there are high dividend stock strategies that specifically focus on higher yielding stocks which can easily yield in the 5% to 7% range as of this writing.
Whether you choose higher risk, higher yielding dividend stocks will depend on how much risk you choose to take.
This will depend on what you have decided after considering how much risk you want in your portfolio from both an investment and an emotional standpoint.
When considering risk, you’ll want to look at your overall risk as an investor by checking the risk level of your all assets that make up your net worth.
There are many factors affecting risk for dividend stocks.
For one thing, if you invest in a fund of dividend stocks vs individual dividend stocks you automatically lower your risk. This is because your money is diversified among hundreds if not thousands of companies. It’s just not probable that all the companies in a fund would go broke, whereas a single stock is more likely to go under, especially one that is paying very high dividends.
For investors who choose to buy individual high dividend stocks instead of funds, one problem is that such stocks sometimes cut their dividends. When this happens, the price of the stock drops usually significantly.
Proactive investors can, however, create their own portfolio of dividend stocks, but it does take more work than simply buying a fund or using a financial advisor or wealth manager to do this for you.
Over the past few years, I’ve gotten quite fond of subscribing to newsletter and services that do the research and provide suggestions for investors.
Alternatives to Dividend Stocks
One group of slightly alternative investments that trade just like stocks but are structured differently from public companies are MLP’s (Master Limited Partnerships) and REIT’s (Real Estate Investment Trusts).
To put these investment yields into perspective relative to typical dividend stocks, many MLP’s and REIT’s are yielding 7% and up while the S&P 500 yields around 1.8%.
Can You Live Off Dividends in Retirement?
Whether or not you can live off dividends in retirement is a factor of the earlier mentioned dividend factors, plus two more.
- The Amount of Money You Have Invested
- The Yield on Your Dividend Investments
- The Cost of the Stock
- How Much Money You Need to Live Comfortably
Put simply, if the amount of dividend income you get (after taxes, if any) exceeds the amount it takes for you to live comfortably, then it looks like there is a good chance that you can live off dividends in retirement should you choose.
If your dividend income does not exceed your lifestyle costs, you can lower your lifestyle expenses and/or create more income streams, as we began doing by adding real estate rentals and online business to our core investments in my mid-40s.
How Do You Buy Stocks That Pay Dividends?
You can buy individual stocks that pay dividends in your regular brokerage account just like you would most other stocks.
Alternatively, you can buy funds that focus on dividend stocks specifically, including both mutual funds and ETFs (Exchange Traded Funds).
Again, be aware that if you are invested in a variety of stocks, or in a major stock index such as the S&P 500, you are probably already invested in at least some dividend paying stocks. In this article, I am more so addressing a stock investing strategy with a focus on dividend income investing rather than simply owing stocks in some companies that pay dividends.
For reference, again, S&P 500 index funds has yielded around 1.75 to 2% in recent years.
You can see the yield on the S&P 500 index in the chart below. Think of this as the overall stock market in the US. A focused dividend investing strategy has a higher yield than the S&P 500.
Financial Advisors with Dividend Income Focus
You can also find financial advisors and wealth managers that specialize in dividend stocks for their clients. I read about a financial advisor whose primary focus is to get a 5% dividend income for her clients, with a goal of getting an additional capital gain of around 3% over time.
This can make a lot of sense for someone who is happy to delegate their wealth management and be in the stock market despite the ups and downs while living off dividends based on a 5% yield. Of course, individual investors can emulate this strategy, but I was impressed with this financial advisor’s individual stock selections and the simplicity of her model.
One popular dividend investing strategy is to buy a fund (or stocks) that are in the Dividend Aristocrats index, which was begun in 2005. One problem with this strategy is that the dividend yield is only 2.64%. The expectation, however, is that you will be able to capture growth (capital gains) through the strong companies you’ve invested in through this strategy.
This is because stocks that can maintain and steadily grow their dividend rate over the years must have their act together. In fact, companies must increase their dividend payouts for 25 consecutive years to qualify as a “Dividend Aristocrat”.
In addition to the 25 consecutive year dividend increase criteria, to quality companies must be in the S&P 500 index and have a market capitalization of at least $3 billion. The list usually has around 50 stocks and is subject to changes as companies become qualified or disqualified to make the list. For example, Chubb, People’s United Financial, Caterpillar and United Technologies were added in 2019.
It’s worth noting that the Dividend Aristocrats outperformed the S&P 500 index over the 10 years ending December 31, 2018 by 1.51%. 2.
As I write this, believe it or not, A&T, even with it’s high dividend yield, is a Dividend Aristocrat. (Side note: I owned AT&T recently, but it got called away with my covered call strategy.
Insight about Dividend Investing
I like dividends but as an investor, but it’s important to remember that dividend investing comes at a cost. The cost is that you are investing in companies that pay out their earnings to their investors. This leaves the company with less money to expand and grow.
Of course, you may not be happy with the way that a company chooses to reinvest their earnings, while you can decide on exactly what to do with their earnings that are paid out to you as dividends. Or you may have just reached that point in life where you’re ready to live off dividends.
So, is dividend investing worth it?
Only you can decide what is best for you based on your life and wealth goals. Living off dividends sounds like a pretty good plan for investors who have accumulated enough wealth and don’t mind the fluctuations in their net worth.
Personally, I like to be diversified broadly by having real estate, online business assets and other alternative investments in addition to stocks. While it’s more work, it has provided diversified income streams as well as diversified assets.
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IMPORTANT Disclaimer: Nothing in this post is meant to be construed as personal financial advice. You are responsible for your own money.