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.
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!