We're often loathe to talk about passive income streams - not only are they often made out to be much more attainable than they are, they're often not passive either! That being said, there are a lot of different ways to make what many would consider passive income. Some people invest in real estate, others create digital products, and still others choose to start their own business and step back from operations to achieve financial independence. But one option that is often overlooked is dividend investing. Dividends are the distributions of a company's earnings to its shareholders - determined by the board of directors, they are often distributed quarterly and are a completely passive form of income.
We will discuss the basics of dividend investing and whether or not it is a viable way to generate enough passive income to make a meaningful difference to your life.
What is dividend investing and how does it work
Dividend investing is the act of investing in stocks that pay regular dividends. These dividends are a form of distribution of a company's earnings to its shareholders, and are thus completely passive income. Many companies have been paying out dividends for decades, and have increased their dividend payments over time. This makes dividend investing a very safe and stable way to cash out of the stock market. It is no coincidence that it is often large stable blue-chip companies who pay the best dividends. To be able to consistently distribute profits to shareholders requires that a company makes very consistent profits, and this is generally not the case for the high growth tech companies that have been popular in recent years.
It's often companies that make basic materials, oil & gas, banks & financial institutions, healthcare and utilities companies which make good dividend stocks. In addition to the predictability of their profits, they often have long sales cycles and strong brand cachet, the sort of companies who will be around almost forever.
Now, when the decision is made to pay out to shareholders, the amount you receive is known as the dividend yield. This can either be paid out in cash or reinvested. On an investment platform, you might see this denominated as INC (for income) or ACC (for accumulation, or reinvestment). Now, accumulation is usually our preferred choice given that in the saving and investing phase of your financial journey you are often aiming to build up your asset base, and taking money out of your investments interrupts the compounding process. However, if the goal is to make passive income, potentially allowing you to invest elsewhere, income options can be beneficial. Do note that you'll have to invest quite a lot to make a liveable income: the average dividend yield for S&P 500 companies ranges from 2 to 5%, depending on market conditions. That means that £100k of invested capital would return £2-5k / year, notwithstanding any capital growth that your investment would make in that time (which, of course will be dampened - distributing profits to shareholders means that there is less capital reinvested into the business). It is a generally accepted finance principle that a dividend payout results in a commensurate balancing change in the share price. Otherwise you could just buy shares before they pay out, collect your yield and then sell them back at the same price.
The benefits of dividend investing
Dividend investing has a lot of potential benefits, but it's not without its risks. The main benefit is that it can provide a source of consistent passive income. This is especially valuable if you are looking to retire early, or just want to have some extra money coming in each month. Unless you have a large capital base, it is unlikely that this will be enough to fund your lifestyle entirely, but it can certainly be a useful source of supplementary income.
In addition, dividend investing can be a great way to diversify your investment portfolio. This is because dividend stocks tend to be less volatile than growth stocks, providing a steadier stream of returns.
Of course, no investment is without risk and there are some potential downsides to dividend investing that you should be aware of. Firstly, dividends are not guaranteed and can be cut at any time by the company. This is especially true during economic downturns, when companies are looking to conserve cash. Secondly, dividends are taxed at a higher rate than capital gains, so you will need to factor this into your overall investment strategy. Note though, that you have a dividend allowance of £5,000 (at time of writing). So it may be worth continuing to invest in dividend stocks until you've maxed this out.
Finally, dividend stocks tend to be more mature companies and may not offer the same growth potential as younger companies in faster-growing industries. However, if you are looking for a steadier stream of returns and are willing to accept lower growth potential, dividend stocks could be a good option for you.
Types of dividend stocks
Now that we've covered some of the basics of dividend investing, let's take a look at the different types of dividend stocks that you can choose from.The first thing to note is that there are two main types of dividends: cash dividends and stock dividends. Cash dividends are paid out in cash (no surprise there) and you will receive them either monthly, quarterly or annually, depending on the company. Stock dividends, on the other hand, are paid out in shares of stock, and you will receive them at the end of each quarter.
Which type of dividend is best for you will depend on your overall investment strategy and goals. If you are looking for a steadier stream of income, cash dividends may be the best option. However, if you are looking for more growth potential, stock dividends could be a better choice.
There are also different types of dividend stocks that you can choose from, depending on the size and sector of the company. For example, large-cap companies tend to have more stable dividend payments, while small-cap companies may offer higher growth potential. And if you are looking for income from a specific sector, you can invest in dividend stocks from that industry.
How to find the best dividend stocks for your portfolio
A great place to start is the Dividend Aristocrat List - as you might imagine from the regal name, these are the blue-chips. To qualify, a company must be in the S&P 500 and must have paid, and increased, its base dividend every year for at least 25 consecutive years. As of 2022, there are 65 companies on the list.
Of course, there are stellar income streams to be had from small caps, but this is where the lion's share of the risk lies, and so it's important to familiarise yourself with the process and what to look for before getting involved with these.
When looking for a great dividend stock, you're often looking for different qualities to one which will be held primarily for capital growth. Price charts, for example, are much less important. Typically these don't take into account dividends, which is part of the reason they can often look flat over the long term. For example, take a look at the chart below which maps the top 500 stocks in the US since 1929, with and without reinvested dividends. Over the long run they make up for a huge proportion of growth, and deciding whether to take them as income or accumulate them is a huge decision.
You're now looking much more for things like stable trends in earnings, macroeconomic factors which may influence long term growth and revenue projections, and whether the security represents good value when compared to similar stocks in the dividend-paying universe, rather than in the same sector.
Final thoughts on dividend investing
The golden scenario is one in which you invest in dividend paying stocks which also exhibit significant capital growth over their holding period, so you can essentially "double dip" your gains. This is certainly possible over the long term, but of course companies with the stable and predictable cash flow to pay consistent and growing dividends, are also not those which are likely to have the capacity or volatility to rocket in value. So it's more of a tradeoff. It's also interesting to consider that many proponents of financial independence consider 4% to be the "safe" withdrawal rate from your retirement fund - the amount you can draw down after retiring from your stock portfolio whilst keeping its value flat. This falls squarely in the middle of the expected payout for dividend stocks, so you might be able to achieve the exact same outcome, but with more stable cash flow: dividends are always positive, unlike capital growth, and are available more readily without selling down assets.
What they are not, is a panacea in investing or a shortcut to financial freedom. It is important to remember that you are making a tradeoff. That being said, especially when considering the tax advantages to including some dividend payout in your portfolio, it makes a lot of sense to have some exposure there. As always, when in doubt you should consult an accountant, perhaps in tandem with a financial adviser to decide what allocation suits you best. Don't forget that you can also track and manage your portfolio balance and income schedule on the Strabo dashboard, so you will never be left in the dark about what you are being paid and how best to put the tax code you are restricted by, to your advantage. We'd love to hear about how you include dividend-paying stocks in your portfolio, and which are your favourite!