Passive income dividend investing involves much less time and risk than other passive income strategies. Learn how to create a passive income dividend strategy for your portfolio.
Income investing through dividend stocks is closer to the true intent of building a passive income than the previous strategies we’ve covered, blogging and online stores. While start-up costs are considerably higher, the time it takes to see cash flow is much faster, and there is little ongoing work to be done to continue reaping the rewards. There are still risks involved in passive income dividend investing, though and the returns on income investing can be lower than that of other income strategies.
While income investing through dividend-paying stocks is the most popular among investors, other investments offer good passive income potential, including master limited partnerships (MLPs) and real estate investment trusts (REITs). This article will provide an overview of dividend stocks while leaving MLPs and REITs for a future article in the passive income series.
This post is the second in a series where I will look at the four most popular investments for passive income potential:
- Income Investing
- Real Estate
Passive income is technically an income you regularly receive that involves little or no effort on your part. You get paid every month, quarter, or year but do not participate in the management or contribute work in the investment. Few investments offer absolutely passive income with at least some ongoing maintenance and analysis involved, but some income is more passive than others.
Passive Income Dividend Investing Basics
Running a business means regularly deciding between investing profits back into the business for growth or cashing out some of those profits to the owners. Smaller companies' growth opportunities outweigh the short-term benefit of a cash return to owners. As the company matures and growth opportunities become more scarce, the scale shifts to favor returning some of the cash to owners. When a company has issued shares, it returns that cash as dividends to stock owners.
For most companies, dividends are paid every three months according to a fixed amount for every share you own. Some companies pay dividends twice, once a year, or even twelve times a year, but these are the exception rather than the rule.
Investing in these companies that pay regular dividends is likely the most popular passive income strategy. Depending on how much you have invested in dividend-paying companies and how much the company pays per share, you can build a high income without having to do much of anything.
One of my favorite new ways for dividend investing is through Motif Investing and its innovative way to buy stocks online. Through Motif, you can buy 30 stocks for one commission and instantly lower your risk compared to buying individual stocks. Investing in the group of stocks, you smooth out the ups and downs and avoid panic selling your investments.
With Motif, you create your dividend fund by grouping different stocks. Each time you invest more, you pay one commission to buy all the stocks in the fund. You’ll get your dividends from each stock deposited in your account and can reinvest periodically.
How to Set up a Passive Income Dividend Strategy
Understanding some basic terminology will help us start setting up a passive income dividend investing strategy.
A stock’s dividend yield is just the annual dividend divided by the price of the shares. If the company pays a $1 dividend each quarter ($4 per year) and the stock price is $120, then the yield would be 3.3% ($4/$120 = 0.033). The dividend yield is how much cash return the stock is going to provide every year. It may increase or decrease slightly depending on movement in the share price, but most companies try to maintain a reasonably consistent yield.
Be wary of dividend stocks with super high yields above 8% annually. Some companies, like MLPs and REITs, pay out higher yields to keep tax advantages, but most companies pay a dividend yield between 1% and 4% a year. If the company is paying out everything in dividends, it won’t be able to grow as quickly or at all.
The payout ratio is the percentage of a company’s profit or the net income it pays out as dividends. If a company earns $20 per share over a year and pays out $12 in dividends, then the payout ratio is 60% ($12 divided by $20 = 0.60). The payout ratio is important because it reflects how much the company keeps back to reinvest in growth. A company that pays out nearly everything in dividends may not be able to grow the business or the stock price. I generally limit my search to companies that pay between 30% and 70% of their income as dividends. This ensures that management is serious about returning profits to shareholders and wants to keep the business growing.
Dividend stocks in the S&P 500, the largest U.S.-based companies, pay an average dividend yield of around 2% though it ranges from less than a percent to double-digit yields. Stocks with a yield below 2% probably will not be very attractive to a passive income dividend strategy, while stocks offering yields above 10% may not be able to support the payment. I would stick with stocks that pay between 3% and 6% annually.
More than 800 publicly listed companies trade on the New York Stock Exchange, the Nasdaq, and the American Stock Exchange that pay dividends. I have made a living as an investment analyst, telling people who are the best dividend stocks for your portfolio, but the fact is that it isn’t that difficult to pick suitable investments if you take a long-term view.
A simple stock screener tool will get you started with basic dividend fundamentals to search for. I like starting with dividend stocks that yield over 3% with payments for at least five years. You can check dividend payments on Yahoo Finance by clicking on the Historical Prices link in the left-side menu.
I also look for companies that pay out between 30% and 70% of their income as dividends from the initial list. The payout ratio is also available on Yahoo Finance by clicking Key Statistics and then scrolling down to the lower-right under Dividends & Splits.
Using just these two criteria will leave you with an extensive list of potential dividend stocks in which to invest. I generally also limit my search to companies with a market capitalization, the value of all shares, of at least $5 billion to ensure I am looking at large companies with some financial power.
I also compare the price-to-earnings (PE) ratio and operating margin among stocks within each sector and industry. The PE ratio is the stock’s price divided by the company’s net income over the last four quarters. It is a crude measure because management often uses several tactics to manipulate earnings, but it is easily understood and can give a good idea of value. The operating margin is the earnings after operating expenses divided by sales, a good measure of how well management is running the company. The PE ratio and operating margin are relative measures, meaning they are only useful when compared against the stock’s historical average or other stocks.
That brings us to one of the most important ideas in passive income dividend investing; more important than picking individual stocks with high dividends, you absolutely must pick stocks from different sectors and industries.
Every company in the stock market belongs to an industry that shares a relatively common product type. Google, Yahoo, and Facebook are all website companies within the internet information providers industry. Industries that share common characteristics are grouped into technology, healthcare or energy sectors.
This is important, especially when building your dividend investing portfolio, because each sector reacts differently to the economy and other market forces. The utility sector reacts negatively to higher interest rates because cash flows to public utilities are relatively fixed, while higher interest rates are generally a good thing for stocks in the financials sector.
Calm down; you don’t have to become an economist to determine how each sector reacts differently or build a portfolio. The key idea here is that you must ensure you have a good mix of stocks from each sector. That way, when the economy or news headlines are playing havoc with a specific sector, you’ll have stocks in the other eight sectors to keep your portfolio steady. The nine sectors are: consumer staples, consumer goods, energy, technology, healthcare, utilities, materials, financials, and industrials.
This is where Motif Investing comes in with the ability to buy a group of stocks for one commission fee. Buying all the stocks in a portfolio individually means spending hundreds of dollars in fees each time you invest. Put all your investment in one stock, and set yourself up for all the risk in that company. With Motif, you can diversify cheaply each time you invest by buying a group of stocks.
Another critical idea is that when comparing price-to-earnings ratios and other fundamentals like the operating margin, you have to do it among stocks in the same industry. Measures like value and profitability can vary widely by industry. Only choosing stocks with a certain PE ratio or profitability above a certain percentage will likely leave you with a portfolio of stocks concentrated in a few industries or sectors. This concentration is excellent if you’re lucky enough to pick a hot sector but not so great when that sector falls and your entire portfolio crashes.
It can be a lot to take in, but you don’t have to be an expert overnight. A simple strategy of picking stocks from a few criteria and each of the sectors, holding them for at least five to ten years, is generally best. Resist the urge to “buy low and sell high” or to listen to brokers with a hot tip.
Passive Income Dividend Investing Tips
- Be wary of stocks with dividend yields of 10% or higher. It might just be a function of a falling stock price and a weak outlook for the company. The dividend is likely unsustainable and could be cut.
- Make sure you hold at least 20 stocks in your portfolio, and no one stock should account for more than 5% of the total value. That way, even a total loss in one stock will not devastate your investments.
- Don’t forget the dividend stocks of foreign companies for international diversification.
- Putting all your money in stocks leaves you at risk of another market crash, no matter how diversified you are in different sectors. A well-rounded portfolio includes fixed income, real estate investments, and other strategies.
Exchange Traded Funds (ETFs) offer a great way to diversify your portfolio with one purchase and are one step further into passive income territory. You don't even have to watch the fundamentals for each company because the fund manager will do it for you, buying or selling stocks that fit the fund's criteria. ETFs are like mutual funds but trade like stocks and are usually much cheaper. For passive income dividend investing, check out these three ETFs:
- iShares International Select Dividend (NYSE: IDV) provides exposure to 103 companies in non-U.S. developed markets and pays a 4.9% dividend yield
- iShares Emerging Markets Dividend (NYSE: DVYE) provides exposure to 102 companies in emerging markets and pays a 4.1% dividend yield
- Vanguard High Dividend Yield (NYSE: VYM) holds stock in 435 U.S.-based companies and pays a 2.9% dividend yield
Returns to a Passive Income Dividend Investing Strategy
With bonds paying next to nothing on historically low-interest rates, dividends have become the next best thing for income investors looking for stability and safety. While you’ll find newer companies that pay dividends, most are relatively large and mature corporations with less volatility than the average stock.
Dividends have historically accounted for about a third of the total return on stocks and sometimes as much as half of the return when the market tumbles. The change is primarily due to the volatility in return on price appreciation against the stability in dividends. While price appreciation amounted to a bigger slice of the market return in the 90s, many investors didn’t have a chance to book those returns before the internet bubble crashed prices. The lesson is that even when stock prices are soaring, don’t neglect a solid passive income dividend investing strategy in your portfolio. If those stock prices crash lower, you’ll be happy you're stuck with dividend investing.
Not only is dividend investing an essential part of the overall return to stocks, but dividend-paying companies have historically beaten other stocks on return. Over the four decades to 2012, dividend-paying stocks that regularly increased their dividends returned 9.5% on an annual basis compared to a return of just 1.6% for stocks of companies that paid no dividends. Even companies that did not increase their dividend payment offered a 7.2% annual return.
There is a good reason why dividend stocks tend to outperform other stocks. Paying out a regular dividend requires cash management and spending discipline, which a lot of corporate management lacks. The need to consistently pay and even increase the dividend means that management needs to be more selective of the projects it wants to support.
The favorite disclaimer in the stock market is that “past performance is no indication of future returns.” That means you can’t look at past returns and expect to get the same thing in the future. It’s generally true, but dividend investing has consistently proven a strong strategy over other stocks.
Over a long period of investing in dividend stocks, you should see between 2% and 3% annual return from dividends and about 4% or 5% return on the share price. A cash return of 3% is likely not going to be enough to cover all your expenses if you are living off dividends as a source of passive income, but it is a return for which you didn’t have to do much to earn.
While we’ve yet to cover fixed-income bond investments as part of our passive income series, dividend investments carry two distinct advantages over bonds. Rising interest rates drive down the prices of bonds since their coupon rate is fixed but generally denotes a healthy economy, a fact that helps push stock prices higher. This means that dividend stocks do well when interest rates increase, while bond investments may not do as well. Inflation will also decrease the value of a bond since payments are fixed. Dividend stocks offer a better hedge against inflation than bonds since companies can pass some higher costs through to customers.
Younger investors will want to reinvest their dividend payments to buy more shares, building the portfolio and potential income for the future. Older investors may need to gradually sell some of their shares to supplement dividend payments and cover living expenses.
Risks to a Passive Income Dividend Investing Strategy
The most significant risk to a passive income dividend strategy is that the company will cut its dividend payment or will not have the cash flow to grow the dividend. A dividend that doesn’t grow over the years will not help you much against the constant loss of inflation and lower purchasing power. With the drop in oil prices at the end of 2014, many energy companies rushed to protect cash flow and cut their dividends, but payments in other sectors like healthcare remained stable. Holding a diversified group of dividend stocks across different sectors will help avoid problems related to more significant economic issues.
Choosing stocks of companies with advantages in size and scale also helps avoid problems with dividend growth. It’s not to say that giants like General Electric cannot fall on hard times, but the company is less likely to run out of cash than companies that don’t benefit from worldwide scale and billions in cash reserves.
Another risk to your passive income dividend investing strategy is the difference between qualified and non-qualified dividends. The distinction isn’t well known among investors but can save you a ton of money at tax time. Qualified dividends are taxed at a lower rate and may be tax-free for investors in lower income brackets. Non-qualified dividends are taxed at your personal income rate, which can eat into nearly half the return for high-income investors.
To make sure your dividends are ‘qualified,’ you need to hold the shares for at least 61 days within the 121-day period around the date when the company declared the dividend. This usually isn’t a problem for most investors, but you’ll want to take note if you buy and sell your dividend stocks frequently.
True Passive Potential: Passive Income Dividend Investing
Dividend investing is one of the few genuinely passive income strategies we’ll cover in this series. Unlike blogging and online stores, income investing will begin to cash flow almost immediately as companies pay out their regular dividends and distributions. Unlike real estate investing, income investing takes relatively little ongoing work to maintain a stream of income.
Start-up costs of an income investing strategy are the principal drawback compared to other strategies. A cash yield of 5% is considered suitable for a diversified mix of dividend stocks, MLPs, and REITs but would only provide an annual income of $5,000 on a $100,000 portfolio. That is prohibitively high for some people and much higher than the amount you might put down on real estate or the upfront costs to start a blog. The upside to passive income dividend investing is that there are no ongoing costs other than regular deposits to your account to grow the portfolio.
The time commitment required for a passive income dividend investing strategy is very low compared to other passive income strategies. You can spend hours analyzing dividend stocks and other investments, but it isn’t necessary. An annual check on the business fundamentals for each investment is more than enough, and some investors may not even choose to do that.
Income momentum is strong for passive income investing because your dividends and distributions can be reinvested into the investments until income is needed to pay expenses. Do this for a couple of decades, and the income you earn from prior dividends can be substantial. Besides reinvested payments, companies generally try to grow their payments as business improves, which can boost your dividends significantly over the years.
Continuity is also an advantage of income investing. As long as the companies you choose do not go bust or you do not sell out of the investment, you should continue to see regular payments throughout the year.
The scale below presents my passive income potential for income dividend investing. Each of the four factors is scaled reverse, with one being the worst or the most unfavorable to a true passive income investment. Since startup costs are relatively high for income investing, it receives a three on the scale, not quite as negative as bond investing since some leverage is available.
Time commitment is low for income investing, with an (8) or the lowest next to investing in fixed-income bonds. Income momentum and continuity are also perfect for income investors and help to make it the most passive income strategy overall.
Overall, passive income dividend investing is a good source of passive income and a critical part of your investment portfolio. Even if you don’t need the current cash payments from an income portfolio to pay expenses, the standard cash yield can be reinvested to grow the portfolio and secure a stronger income in the future. While income growth may not be as high as business-related strategies like blogging or real estate, the risk and time commitment are much lower.