Building A Dividend Snowball To Fund Your Early Retirement
It’s times like these when investor’s thoughts begin to turn to dividend snowballs. No, not because it’s winter! Snowstorms and frigid temperatures do come to mind, but I’m talking about the times when the bull market takes a nosedive.
Suddenly capital appreciation doesn’t seem like a “sure thing”, and dividends begin to matter again.
Yes, it’s true — the good times don’t always go on forever! Stocks prices don’t just march consistently upward in straight lines to infinity! Sometimes there can be long breaks when capital appreciation doesn’t happen.
In the interim, good old-fashioned dividends can play a vital role in funding your early retirement. Not only that, but they can help ensuring that wealth snowball continues to grow well after your last paycheck.
Building A Massive Dividend Portfolio
Probably the most frequently asked question I get emailed is, “How can I build a portfolio that spits out crazy levels of dividends like yours?”
Yes, we earn some pretty big dividends these days… so I get why people are asking me.
It’s a good question, because numbers like ours are fairly unusual. By comparison, most popular index funds only have tiny dividend yields — The S&P 500 index now sports a dividend yield of 1.73%.
Small potatoes! To create an S&P index fund portfolio that funds a reasonably comfortable early retirement lifestyle (say $50k in dividends annually), you’ll need $2,890,173 invested.
That’s a really big pot of gold, and for many people it looks like an impossibly huge goal! Thankfully, you don’t need nearly that much…
Building a portfolio that generates a livable income from dividends isn’t difficult, but it does require dedication! I’m living proof that it’s possible!
The hardest part is living by a few principals religiously…
Principal 1: Start Early And Always Save
Just like rolling-up that snowball in real-life, it helps to have a lot of time for compounding to work its magic.
For me, I first learned about investing in my 20’s, but really didn’t get serious until I was 25 years old (after I paid-off all my student loans).
Thirteen years later (when I was 38), I finally had a large enough portfolio to never work again. More importantly, dividends more than cover our core expenses.
We live a pretty damn good life, traveling to distant locations, basking on sun drenched beaches, eating delicious meals, and enjoying a simple family life with our two kids.
I started investing fairly early, but I certainly wasn’t a record breaker…
Time was a factor, but I can’t stress enough how important it is to save consistently. During my “saving” period, I managed to save money and put it into my portfolio every single paycheck. Rain or shine the money went in. If I didn’t have enough to go on a vacation AND save, I just skipped the vacation.
Saving always came first.
I never stopped saving to buy a car, a house, or take a fancy vacation. My savings was not “deferred spending” to tap into whenever I needed it — When I lost my job and lived on unemployment benefits during the Great Recession, I still managed to save (albeit a much smaller amount).
During the most difficult years (when work was almost impossible to find), I only managed to save $10,000.
Not all years were that rough of course — most of the time Mrs. Tako and I saved 50% or more of our income.
In simple terms — the snowball should always be growing. In the early years on the road to financial independence, this is primarily done by saving. Saving is more important than investing when the snowball is small.
Principal #2: Always Be Compounding
Savings gets the snowball rolling, but in the long run it’s going to be compounding that doubles or triples your money. It’s “money earning money” that’s the secret-sauce to growing your wealth snowball REALLY big!
Contrary to what many people think, the stock market itself doesn’t compound your money. The stock market is simply a place to buy and sell stock, nothing more. The actual compounding happens elsewhere.
In general, there are 4 main methods by which compounding happens for investors:
- Reinvested Interest. Interest earned on loaned money is reinvested and then that money earns interest. Rinse and repeat. Interest is typically derived from savings accounts, CD’s, bonds, and other private loans. This is the most common form of compounding, but also earns the lowest current returns.
- Reinvested Trading Profits. Trading profits derived from buying low and selling at a higher price can compound when continuously reinvesting in either more trades or larger trades. The biggest problem with compounding trading profits is doing it continuously. This is by far the most speculative form of compounding.
- Reinvested Dividends. Dividends earned from part ownership in a company can be reinvested to buy a larger ownership stake, OR they can be reinvested in other companies to build another income stream. Both options lead to larger total dividend payouts.
- Reinvested Earnings. A company (in which you have an ownership stake) earns profits derived from assets. These earnings are not passed to investors, but are instead reinvested in the company by building or acquiring more assets. The company can then earn even larger profits derived from those new assets.
(Note: If real estate is your game, substitute the word “company” with “building”.)
Sounds pretty simple right?
In reality, it’s a little harder than you might think to compound continuously — Loan defaults happen, trades go bad, dividends get cut, and companies waste money on bad investments all the fricken time.
In my opinion, keeping your money compounding continuously is the hardest part of investing.
It’s not always clear when your investments are actually compounding. If you invest in a basket of stocks via an index fund, half of those stocks might be compounding your money in a positive way, and the other half might be completely wasting those shareholder dollars.
Remember: Compounding is about new incremental dollars being invested, not about investments made in the distant past.
One example of a questionable compounder might be Tesla — The company sells more and more electric cars every year, it’s extremely popular with the public, but also continues to rack up losses year after year. Is the company compounding shareholder dollars?
The answer isn’t simple! Depending upon your definition of compounding, the answer could vary widely. (We could argue about this one for days! Feel free to put your arguments for or against it in the comments.)
The only kind of compounding an individual investor can be absolutely certain of, is the interest you reinvest, or the dividends you reinvest to buy more shares.
Principal #3: Don’t Chase Yield
A lot of investors new to dividend investing make a classic mistake that I call “chasing yield”. They invest in companies with the highest yields possible, attempting to increase their dividend income quickly.
This is exactly the WRONG idea. While everybody loves a bargain, investors chasing yield often end-up in poor quality companies with excessive debt levels.
That’s trouble city and you’re in town for a visit.
More often than not, stocks that have high payout ratios won’t be able maintainable to maintain the divided over the long term. They’re often just a single economic blip away from a dividend cut!
Instead, I wait for the yield to come to me! I select investments based upon their ability to grow dividends well into the future.
For example, let’s say you invested in a bank that paid a 3% dividend yield and the bank grows that dividend 5% annually. In 7 years your “yield on cost” would be 4%, and in 12 years that investment would yield 5%!
You don’t need to chase yield when it comes to you!
Finding good dividend growers is the key. If you want to learn more, try meeting the Dividend Achievers.
A Word About Taxes
Any post on dividend investing wouldn’t complete without a discussion on taxation. Yes, in most countries, dividends are taxed. That tax level varies from country to country and person to person (typically depending upon your income level). It’s important to do your homework and understand tax rates for your own personal situation before you invest.
For individuals with large incomes, it might make sense to hold dividend paying investments in tax-deferred accounts to allow those sweet-sweet payouts to grow tax-free until you’re ready for retirement.
In my case, we live in the United States and dividends can be taxed at a rate that varies from 0% to 37% depending upon your personal tax bracket and the kind of dividend.
Qualified dividends recieve preferred tax treatment and are usually taxed in the 0% – 20% range, whereas non-qualified dividends are taxed at regular income levels (again, these numbers will vary based upon your personal tax bracket).
It’s also worth noting that REITs (Real Estate Investment Trusts) can pay out different kinds of dividend distributions with a variety of tax rates. In some cases, lower or higher rates than you find for qualified dividends.
Recent tax reform changes also benefits REITs, allowing the first 20% of REIT dividend income to be deducted from your income taxes. Sweet!
Taxation of dividends can be complicated, don’t gloss over this subject! Take the time to study strategies to reduce dividend taxation in your country, and at your income level. It might take a little more work, but there can also be significant tax advantages for careful investors.
As always — Do your homework, and enjoy that growing dividend snowball!
[Image Credit: Lantern, Safe Yield]
38 thoughts on “Building A Dividend Snowball To Fund Your Early Retirement”
Good point on the taxes Mr. Tako.
It wasn’t until much later in the game that I realized it was more beneficial from a tax aspect to buy US dividend stocks in my RRSP and Eligible Canadian dividend stocks in my regular investment account . I would have saved on taxes earlier if I had known!
There’s all kinds of neat strategies to avoid taxation. Even in years where Mrs. Tako and I get hit by taxes, it really isn’t all that bad. Now that I’ve quit my 9-to-5 job, our tax situation has gotten a lot nicer.
Great rundown on dividends Tako. Thanks for pointing out to folks that compounding only really works when you reinvest interest and dividends. I had this discussion with a colleague at work, and he wanted to get paid out on the dividends in a mutual fund he bought. His logic was that he wanted to “reap the benefits” of the investment. But I explained to him that he’s killing the real benefits by taking payouts. In the end I think he just wanted the money to buy stuff, but when I explained the math I “think” he got it.
Lots of people forget about compounding when they get “money in hand”. It’s such a simple principal, but hard to implement continuously.
Thanks for the great tips, Mr. Tako! Having a passive investment that can cover our core expenses is probably everyone’s dream. But like you said, it requires sticking with some important principles, so it’s not always easy.
You’re a great example for others to follow in building their own dividend income! 🙂
Thanks for the always kind comments Ms. FAF!
I’m embarrassed to say that I don’t pay huge attention to dividends. This, I’m sure, will change when I stop working. My properties spin off cash though, and these are tax deffered do to depreciation. Thanks for informative read!
In a sense, you can think of the cash that comes from your properties as a dividend. (See my note about replacing the word ‘company’ with ‘building’)
Focusing on your ever increasing dividends or share count is a great way to offset your uneasy feelings when stocks take a tumble like they did this week. If you can imagine a portfolio of say $2,000,000 could easily drop 30% during a correction and then would be worth $1,400,000. Ouch $600,000.00 loss but you really haven’t lost anything. Your dividends would likely be unchanged or even go up, also your share count with dividends re-invested would certainly increase. Also you would notice that your portfolio yield would increase, which is a good thing if you are still in the accumulation stage. All are good things to focus on when there is a lot of red and fear in the market.
Absolutely Bob! It’s a very logical way to invest in my opinion!
Well said Mr Tako. Income producing investments are a great way to live a financially free life, early retired or just free of money worries.
I recently ran the numbers on the impact of dividend reinvesting over the last 30 years. It accounted for more than half the S&P500 total returns over that time period!
I’ve read similar analysis in The Future For Investors. I totally believe it.
I’m newer to your blog, so maybe you can direct me to a prior post if you already covered this. Do you have only individual stocks? Are there any ETF/Mutual funds you would recommend? I think even VDIGX is yielding only 1.86%.
I have always been a big fan of dividend investing but I get slammed for being “naive” or “uninformed” whenever I write about it. I do have friends who live off dividends, so it doesn’t look too silly to me!
How would you advise someone who already made millions through growth stock investing? Cash in and buy individual dividend-producing stocks?
Hi Wealthy Doc. We have a mix of individual stocks, ETFs/Index funds, and some preferred shares. Oh, and a bunch of cash right now. 😉
If you’re not comfortable with buying individual stocks, there are high yield dividend funds… but I’d check their holdings closely for instances of “chasing yield”. I’m familiar with a couple. They’re just OK.
In general, we try to match our expenses with dividends and then have “a little left over” for regular compounding.
This is all good stuff. Having a good set of dividends to reinvest every quarter or year definitely is an important part of compounding until you can flip the switch and use those to live off.
Dividends make a huge difference. My yield on cost is over 4% if I look at just the principle invested without the reinvestment of dividends. If I include the latter then the YOC is about 3.7% or so. Yield on the portfolio is about 3.4% so there has been residual capital appreciation. The growth of the dividends plus fresh capital and the reinvestment of dividends make a huge difference.
My 2017 dividends came in at about $75K USD and this year will come in north of $81K but may be less if I sell off a few positions and stay in cash. We will see. It’s a nice safety net and basically an invisible worker that doesn’t have any expenses and is at the service of the household.
Impressive. What are you invested in? ETF? individual stocks? I’m wondering how so many here are getting more than the 1.9% or so from most stock portfolios?
Hi Wealthy Doc,
It’s a mix of about 30+ individual stocks that were bought over the past 3.5 years when I saw valuations looking interesting. Mostly blue chips stock with a track record for growing dividends but also some REIT’s and a few flyers too. I try to balance yield by pairing a high yielded purchase like T with a low yielded but fast grower like V. Looking for yield and healthy raises together.
It works but you have to be patient!
Hi Wealthy Doc,
I was just re-reading this post and boy it’s amazing what a few years of growth can do in dividend income.
In 2018 we ended up with $91K of dividend income (as more was being invested throughout the year along with dividend raises.)
2019 was $110K and I also went into semi-retirement that year.
2020 was $122K
2021 is looking to be a bit north of $142K.
All dividends are being reinvested plus some fresh cash is being used to buy more stocks when available. It’s at a much lower level now since I’m not working full time.
It’s a robust strategy that I’m happy with. How can you not be psyched with hitting new records each year with little effort on your own part besides researching and finding out what next to be buying.
Great post Mr tako and congrats on all your success!
Great point about the compounding, drips are my favorite part of dividend investing at the moment. ( im in accumulation phase)
New to your blog, it looks nice. Keep it up
Thanks for visiting Rob! Come back and visit again sometime!
Wow, only saving $10,000 in your worst year? I’m a little embarrassed at my own savings rate…
It’s a hard lesson for many people to learn about chasing high yields vs sustainable yields – I’ve been a sucker myself once or twice in the past. You’re spot on – they are usually crappy companies with lots of debt, and priced low for a reason!
I love the dividend tax system in Australia – Franking credits are a great little bonus on top of the dividends, especially if you manage to invest in a low-tax account. Those little one-percenters sure add up significantly over time!
Indeed they do!
From what I understand, the Franking system avoids double taxation of dividend dollars. Sure wish that existed here!
Under most situations taxation in the States can be quite low, or even 0% if your income falls under 77k.
Very good post! I wish I could be that informative about taxes in my resident country. But how can I know the taxes in my country? I am from Israel and moved to Romania . I have no idea how much taxes I will need to pay and where to get the information from in English.
Google is probably a good place to start! 😉 Good luck!
Good post, good job, thanks!
I am a dividend investor in Belgium and we all know about taxes over here… the withholding tax on dividends in Belgium is 30% (getting ridiculous as it’s increasing every year and hurting small investor’s a lot) ! I enjoy dividend investing but it sometimes makes you think if it’s the right choice. Keeping the positive vibe though 🙂
Yikes, that’s a very impressive level of taxation. Are capital gains similar in Belgium?
Yes capital gains also high! We even pay around 50% (various taxes) on our monthly salary! Lot’s of disadvantages but it does come with many good advantages as well such as good health care, free school, university ect, ect… depends how you look at it.
Mr tako, thanks about your text. Here in Brazil we do have a challenger : survive against the voracity of our government (lot of taxes), survive paying schools, security and health plans (since our taxes payed do not come back for us as government benefits) and, finally, try to discover a good place to invest the money, since we are at a 3rd world country, that depends a lot of US e China economy.
Very interesting topic.
That’s a subject every investor should know about.
There are many dividend-focused ETFs in Europe that does not distribute dividends. They accumulate and reinvest.
They can be an option for those non-residents that are taxed heavily when double-tax treaties don’t exist.
Great post. I am a reformed yield chaser. I had sagging performance because I was focused mainly on the Canadian index and had a strong home bias. I’m happier with my mix of growth/dividend now (mainly ETFs but a few dividend stocks). I only have two stocks that I DRIP but otherwise, I just reinvest the profits myself.
GYM recently posted…GYM Net Worth Update: $717,100 (+0.5%, +$3450) February 2018
preferred etf’s are taking a beating lately, which is fine if you’re not forced to liquidate at this time and just keep buying shares. i’ve been focusing on “future aristocrats” who will have plenty of cash flow and strong businesses to fund acceleration in payouts in the future. i’ve seen low % yielders like mastercard, activision, and under that radar ones like roper and ross stores with low payout ratios and plenty of cash flow safety net to keep paying as they mature.
it’s also nice that share appreciation often goes hand in hand with increased dividends. a couple of financials with “bonus” large special dividends i bought are CME and PJC. they look better than the stagnant big banks these days if you need some financials.
cheers, tako. nice article.
Tell me the stocks in top 10 (talking about dividend yeld) in US, please.
Greetings from South America
You can find these things with a simple google search. However, I don’t recommend chasing the highest yielding stocks.
There is too much common sense in this post, it almost hurts my head 😉
Isn’t compounding interest a great thing? Love dividends!
You touched upon it, but it can’t be said enough – the foundation of a dividend portfolio has to be rock solid! A simple dividend cut can destroy YEARS of compounded growth and unrealized gains. It really is scary how many people run for the hills on a dividend cut
Evan recently posted…February 2018 Net Worth Update
Hi! Nice job mr. Tako. I’m a dividend investor as you and in my oppinion that point about avoiding corps. with higher DY must be faced in a relative way. In order to offer you a different perspective: https://www.researchaffiliates.com/documents/FAJ_Jan_Feb_2003_Surprise_Higher_Dividends_Higher_Earnings_Growth.pdf
The biggest problem with this study is called survivorship bias. Don’t take such studies at face value.