Why focus on dividend stock investing?
1) This type of investing can be so fun, that you might actually grow to love doing it. And a dividend compounding portfolio can be a very powerful financial asset indeed.
2) It can provide you with passive income that you can (for the most part) plan out ahead of time according to your strategy and objectives.
3) It is an excellent introduction to investing in the stock market; you quickly learn what makes a strong company in terms of its financial valuation, and can carry over those skills into non-dividend stock, should you wish to pursue a dual portfolio strategy.
Investing in index ETFs is often too far removed from the process to allow you to get an understanding of the fundamentals, and day trading is more about tracking the “action” on the trading “floor” and turning profit than it is about investing.
4) If you play the game dilligently, you can easily end up living handsomely on just dividend income, and this, without having to sell any stock or paying taxes on it. (See note and links provided here at the very end)
a) But isn’t investing too risky?
Investing will always carry risk. Investing in bonds and index funds also carries risk, though less so: bonds *generally* do not return you a lower amount than what was intially invested, and index funds are spread out to reduce the individual stock risk (that said, if the entire market crashes, so does the index value).
This is why having a strategy, using the various tools (screeners, lists, portfolio models) at your disposal, and following financial trends/news are key. Of utmost importance is to consider the performance indicators of companies you are investing in, and to keep an eye on your investments. While dividend investing can be a pretty much “hands-off” operation these days with many brokers, especially after you lay down a solid foundation (with only few manual transactions required and a little bookeeping for tax purposes), it will always be important to periodically check on your investments and to check the news ever so often. This will prevent you from getting caught with your pants down in case of a world changing event!
b) But don’t general indexes (i.e S&P 500) outperform stock picking?
Indexes can beat dividend stock in total value, but usually not when it comes to dividend returns.
Here you can find the graph history for the dividend yield of the S&P 500, for reference.
If your goal is to build a compounding dividend portfolio (as this site and many others help doing), as you can see, general indexes like the S&P offer poor performance (with a yield of around 2%). That said, newer indexes have been created to track dividend growth stock to maximize dividend potential. Their track record remains to be proven however, and you do not get the advantage of owning the underlying stock directly (you pay a small percentage in management fees, aka MER). You will find a few of these here, here, and also a more comprehensive list of them here.
This site will eventually track dividend focused ETFs soon, stay tuned for the lists!
c) But don’t experts say that value/growth investing is superior to dividend investing?
While it is absolutely true that you can get much higher overall returns by investing in non-dividend stock versus focusing on dividend stock, you have to be very lucky and/or have very good guidance. An example would be having bought Amazon, Apple, Microsoft and Google in the earlier 2000s: today, you could be worth millions on those four stocks alone. No dividend stock strategy can come close to that kind of explosive growth.
You must also be willing to sell stock to make money from those investments (active strategy, not passive).
This is why most dividend investors recommend having at least two (or more) concurrent portfolio strategies:
- one for your growth strategy (focusing on indivual non-dividend stock and/or index funds, if you are rather conservative in your investment strategy);
- one for your dividend growth strategy.
This way, you can benefit from the growth potential of non-dividend stock (like Amazon/Shopify/FavoriteStocksOrFunds), while also benefiting from accruing passive income from the dividend stock portfolio.
Here you will find an excellent overview of the potential of dividend growth investing using math.
(It uses the Toronto Stock Exchange as an example, but the principles are universal)
Example investment strategy with three portfolios:
The above image showcases an example piechart of an optimized investing strategy composed of four allocations totalling 100% of money invested:
- Market Index or Market Sector ETFs for long-term stable return (40%);
- Undervalued stocks or established/high performing Blue-Chip stock (examples of Blue-Chip are Apple, Disney, Facebook) for profit maximization (explosive growth) (25%);
- Dividend stocks/REITs/MLPs/ETFs/Mutual Funds for passive income stream (25%);
- Finally, money in the bank; always important to have a reserve for emergencies and for being able to jump on opportunities. (10%)
d) Taxes. Some experts will also point out that selling stock is generally more tax advantageous (falls under capital gains tax) whereas some dividends can fall into general income tax if they are unqualified dividends (like they would be in the “dividend capture” strategy). That said, the tax consideration is not a strong argument; remember that:
- the favored dividend strategy is “buy and hold”;
- you can invest in dividend stock through tax-free savings accounts (Roth RIA in the US, TFSA in Canada) and/or retirement accounts; and,
- if your dividend income is your only source of income, the first USD 40 000 – CAD 50 000 will probably not even be taxed at all:
US source: NerdWallet article
Canadian source: FinancialPost article
More links/references soon; upcoming articles will focus on the “Tools of the Trade” and “Accounts and Taxes”