Chapter One – Introduction
Chapter Two – We Need a Better Way
Chapter Three – Asset Allocation
Chapter Four – The Perfect Strategy
Chapter Five – What is a Dividend, Again?
Chapter Six – Dividends in Action
Chapter Seven – What Returns Can I Expect?
Chapter Eight – Will It Beat the S&P 500 Index?
Chapter Nine – Why Not Bonds?
Chapter Ten – How To Manage Your Portfolio
Chapter Eleven – Are Dividends Right for Me?
Chapter Twelve – Thank You!
Chapter Thirteen – About the Author
Copyright © 2016 by Nathan Winklepleck, RP®
No part of this document may be reproduced in any manner, in whole or in part, without the prior written permission of the author. This information is provided with the understanding that with respect to the material provided herein, that you will make your own independent decision with respect to any course of action in connection herewith and as to whether such course of action is appropriate or proper based on your own judgment, and that you are capable of understanding and assessing the merits of a course of action.
Limit of Liability/Disclaimer of Warranty: This document is for information and illustrative purposes only and does not purport to show actual results. It is not, and should not be regarded as investment advice or as a recommendation regarding any particular security or course of action.
Opinions expressed herein are current opinions as of the date appearing in this material only and are subject to change without notice. In the event any of the assumptions used herein do not prove to be true, results are likely to vary substantially. While the author has tried to provide accurate and timely information, and have relied on sources the author believes to be reliable, the book may include inadvertent technical or factual inaccuracies. The author does not warrant the accuracy or completeness of the materials provided, either expressly or impliedly, and expressly disclaims any warranties or merchantability or fitness for a particular purpose.
All investments entail risks. There is no guarantee that investment strategies will achieve the desired results under all market conditions and each investor should evaluate its ability to invest for a long term especially during periods of a market downturn. No representation is being made that any strategy will or is likely to achieve profits, losses, or results similar to those discussed, if any. The author will not be liable or have any responsibility for any loss or damage that you incur as a result of using information contained in this book. You should consult a professional investment advisor before making decisions. The information contained in this book is for information purposes only and is not intended to replace or act as investment advice.
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This book will take the average person approximately 63 minutes to read from start to finish. I believe these could be the most valuable 63 minutes of your life (financially speaking). Over the next hour or so, I’d like to introduce you to the most powerful investing strategy of all-time (if you can find a better one, I’d like to be the first to know about it). If you follow it, it will help you grow your wealth consistently and reliably over time.
My goal with this book is to improve your future investment returns by at least 1% per year. What would an extra 1% return mean for you? Let’s assume you currently have $0 invested. You earn $3,000 per month and spend $2,000, which leaves you with $1,000 left over to invest each month. If you continue to contribute this $1,000 (no more) for 30 years - I’d reckon an additional 1% return would be worth approximately $185,000 for you.
And far more if you have anything more than $0 to invest right now. At a starting value of $500,000, this book could well be worth $1 million over the next 30 years. But Amazon wouldn’t let me charge that much, so we’ll settle for $2.99. You’re welcome.
Since this book is only going to take you 63 minutes to read, you’re currently on track to earn about $2,936.51 per minute. So kick back, relax, and enjoy!
Like most people, you are probably new to the stock market. If you have invested before, you’ve probably been investing in mutual funds or index funds. If so, good for you! Few people take the initiative to start, let alone to educate themselves about different investment strategies.
Most personal finance books will give you a cheery outlook for the future of investment returns. I’m not going to do that. Stocks are not likely to produce 12% per year over the next 30 years. They aren’t even likely to return their long-term average of 10%.
According to non-profit investment firm Vanguard, the outlook for the stock market is to return somewhere between 5% and 8% over the next ten years. And the outlook for bonds is 2% to 3.5%. If you’re following the typical index fund strategy, that means you probably are “diversifying” your portfolio with some stocks and some bonds. Below are the expected returns for different portfolio mixes of stocks/bonds over the next ten years:
An investor in the “traditional” 60% stock and 40% bond asset allocation is looking at a best case scenario of roughly 6.2%. And that’s assuming no additional investment fees, which is not the reality for most people. The majority of Americans invest their money in actively managed mutual funds, which charge an additional 1.2% per year on average. The average mutual fund investor might end up with just 5.0% per year after taking out these fees.
Most people also hire a financial advisor to manage their investments and provide other services like financial planning. The advisor adds another 1% to 1.5% charge is on top of the 1.2% charged by any mutual funds. That brings the average return down to 4.0%. And that just assumes there are no other fees involved, which is rarely the case. Load fees, account fees, commissions, and other random charges could reduce that figure even more.
When we also consider that inflation is likely to average somewhere between 2-3% over the next 30 years, the majority of your friends and family members who invest in mutual funds are looking at a whopping 1.0% to 2.0% “real” total return on their investments.
With the average American’s extremely low savings rate and high debt load, it will be nothing short of a miracle if the bulk of Americans will be able to retire at all. Let alone by the typical retirement age of 65.
I don’t want that fate for you.
If you follow the investment strategy outlined in this book, you can earn returns equal or better to the stock indices even while taking less risk than the average investor. If you can stick with this strategy for an extended period, it will be nearly impossible for you to lose money.
Later in this book, I'll show you how you could earn 5.3% per year over the next 30 years - even assuming the stock market goes to $0.
As it turns out, it’s not all that exotic. There are no option strategies. There are no complicated mathematical formulas. In fact, anyone who made it past junior high school math has already conquered the complexity needed to follow this investment strategy.
You don’t need to have a Ph.D. in finance or a fancy MBA from Harvard. In fact, those things might even get in your way. Wall Street has a tendency of taking simple things and making them extremely complicated. This strategy is not for Wall Street types. It’s not a get-rich-quick scheme. It won’t require you to spend hours watching the markets or pore over hours of news every day, week, or even month.
All it will require is a few decisions on your part and a lot of patience. You don’t need to be an amazing stock picker or call the next Microsoft or Google. You can invest in companies that are already household names.
If you’re looking for investments that are going to double overnight, this book isn’t for you. The strategy outlined in these pages is just about as boring as watching paint dry. But, I assure you, the profits will be exciting enough.
This book is for people who:
If that sounds like you, then I hope you’ll join me for the remainder of the book. You’ve already endured 6 minutes. Just 57 more to go!
If you’re reading this book rather than searching the help wanted ads, I’m going to assume you do some paid work for some number of hours each week. Your paycheck goes towards paying your monthly bills.
At some point in the future, those paychecks you are currently getting will go away. Perhaps your company downsizes or health issues that prevent you from working. Or, on a more cheery note, perhaps you get tired of working and decide to stop (what we call “retirement”).
The retirement age is somewhere between 62 and 70 years old for most people. Most people work 40-50 years to build a nest egg that they will use to pay bills when the paychecks stop. Most investment advisors today will recommend that you sell 4% of your nest egg each year to fund expenses. To illustrate this strategy, let’s follow a hypothetical couple named Jim and Sally.
Jim and Sally have worked their entire lives and are now ready to kick back, relax, and enjoy time with their kids and grandkids. Both turned 65 this year and will be soon be collecting Social Security benefits. They’ve saved all of these years and have built up an investment portfolio of $500,000.
To supplement their Social Security income, Jim and Sally need to take $30,000 per year out of their investment account to cover their bills. Jim and Sally’s financial advisor tells them that the stock market has returned an average of 10% per year in the past, so they can expect to earn 10% in the future.
A 10% return on a $500,000 account would be $50,000 per year. As long as they just take out $30,000, they will have $20,000 left over to re-invest into their account. Over time, their account will grow, and they’ll be able to take even more out.
In theory, this makes a lot of sense. As long as their portfolio grows by 10%, Jim and Sally have nothing to worry about in retirement. Unfortunately, Jim and Sally haven’t met Mr. Market.
Legendary investor Ben Graham describes a character named Mr. Market in his book “The Intelligent Investor”. Mr. Market is the person on the other end of all of your stock market trades. Every day, Mr. Market will quote you a price at which he will buy your shares of stock or sell you some of his.
The problem is that Mr. Market is manic depressive. When Mr. Market is in a good mood and is willing to pay you high prices for your stocks. When Mr. Market is in a foul mood, however, he will often quote you low prices for your shares. And his mood often fluctuates dramatically.
One day, Mr. Market might be willing to pay you $40 for shares of Coca-Cola. The next day, he might say $45. Then a few months later, just $25. You don’t have to take Mr. Market up on his offers, but he will always quote you a price. Every single day.
Since Jim and Sally are retired, they are going to need to start selling $30,000 worth of their stocks to Mr. Market so they can pay their bills.
Let’s see how it works out for them.
In the first year of their retirement, Jim and Sally are pleasantly surprised when Mr. Market quotes them a price a full 15% higher than the year prior. Their account balance grows to $545,000 even after they take out their $30,000 to pay bills. Jim and Sally were able to pay all of their expenses and still saw their investment account grow by $45,000.
In year #2, Mr. Market continues to be in a good mood. Their account increases in value by another 15% or $51,750. Since inflation has increased the cost of their groceries and other expenses, Jim and Sally take out $30,900 this year instead of $30,000. Once again, the account grew even after paying their living costs. Jim and Sally are so pleased with their advisor. The plan is going even better than expected!
Year #3 and #4
Unfortunately, Mr. Market gets into a bad mood the next couple of years. The economy falters, and Mr. Market quotes Jim and Sally a full 25% less for their stocks. While the market takes a nosedive, Jim and Sally still have to pay their bills. Which, by the way, continue to increase. Jim and Sally still have to sell nearly $32,000 worth of their stock to Mr. Market. With market prices low, Jim and Sally have to sell almost twice as much stock to cover the same level of expenses. By the end of year #4, Jim and Sally’s account was down to less than $280,000.
At this point, Jim and Sally are panicked. Their advisor assures them that they should stick with the plan. The stock market will go up eventually to make up for the major losses over the past few years.
Sure enough, the market ends up increasing by 20% each year for the next two years and then consistently churns out 10% returns for the next 15 years -- just like their advisor predicted.
Despite the quick recovery of stock prices, however, Jim and Sally’s portfolio continued to be eroded. Since they had to sell stock at the bottom, they locked in losses that they were not able to recover. Their portfolio runs out of money in Year #22.
If Jim and Sally could travel back in time, they might have invested a little differently. Rather than relying on Mr. Market, they might have decided to invest in something that didn’t depend on Mr. Market’s mood swings.
Fortunately, Jim and Sally have a time machine. So they go back in time and explain to their investment advisor that the stock market is just way too risky. “Why should we own stocks at all?,” Jim asks, “They are too volatile. We need something safe!” Their advisor explains that they should purchase bonds instead of stocks.
When you buy a bond, you are essentially becoming the bank. You lend money to a company or government in exchange for some interest payments and the promise that you will get your money back at the end of some period. When you buy a bond, you know what return you are going to get at the time of purchase. As a result, bonds don’t fluctuate in value nearly as much as stocks do.
Jim and Sally’s advisor finds them a bucket of bonds paying 8% interest per year. That’s great! 8% of $500,000 is $40,000, which is enough to cover their withdrawals each year and also have some left over.
Since Jim and Sally no longer own stocks, Mr. Market’s manic-depressive mood swings are of no concern to them. They love their advisor’s new plan! A 100% bond portfolio is surely the way to go
Unfortunately, there is a trap even more sinister than Mr. Market. It’s called inflation. In any given year, the prices of goods and services will increase. The rise in prices makes the real purchasing power of every $1 bill in your pocket less each and every year.
On average, inflation runs about 3%. So a $1 bill today will be able to purchase about $0.97 worth of groceries next year. And then just $0.94 the year after that. Over the next 25 years, the value of every dollar in your pocket will only purchase about $0.50 worth of groceries and other goods.
That means Jim and Sally have to keep taking more and more out of their account each year to keep up with rising costs. Jim and Sally were earning an 8% interest rate on their bonds, which was $40,000. However, this income is fixed. As their expenses rise with inflation, their bond interest does not.
The chart below shows what happens.
Jim and Sally watch their expenses (blue line) increase each year, while their bond interest (red line) does not. Eventually, they need to take out more than twice as much as their bonds are producing.
They would then have to sell some of their bonds to Mr. Market. That is a problem because it reduces the amount of bonds they own, which reduces their interest. The cycle repeats itself until Jim and Sally either run out of money or adjust their spending lower.
Soon their question they hear most at restaurants will go from “Would you like white or red?” to “Would you like fries with that?”
Fortunately, Jim and Sally still have their time machine. Once again, they go back in the past and tell their advisor that stocks are too volatile and bonds don’t keep up with inflation. What else is there?
Jim and Sally’s advisor tells them about a financial product called an “annuity.” The advisor likes annuities because he makes an enormous commission for selling them. If he can convince Jim and Sally to buy an annuity, he will make a big 7% payday!
Annuities come loaded with fees, which is why many financial advisors sell them. Guess who pays the bill? You do! And annuities are incredibly easy to sell because they promise “guaranteed” income for life.
They are supposedly “safe” and offer retirees an “endless stream of income” until they die.
Unfortunately, annuities don’t solve any of Jim and Sally’s problems. In fact, they make it worse. Here’s why:
In the last chapter, we saw that Jim and Sally faced two enemies threatening their retirement:
1) Mr. Market. Jim and Sally planned to live off of the price increases of their stocks, but that didn’t work out. Mr. Market was in a bad mood, and they were forced to sell him some of their stock at low prices so they could pay their bills. As a result, they ended up running out of money after just 22 years.
[*2) Inflation. *]Jim and Sally’s expenses increased each year, while the income from their fixed bond investments and annuities did not. As a result, they ended up not having enough money later on in life.
These are the two fundamental problems facing all retirees and future retirees. Fortunately, this issue has been thought about by a lot of smart people in academia. The solution they have come up with is to own a broadly diversified portfolio of different asset classes.
A portfolio of 100% stocks is too risky. A portfolio of 100% bonds is not risky enough, putting it at risk of falling behind inflation. The solution is to own some of both. How much of each should you own? Don’t worry. There is a simple rule of thumb for that…
The primary goal of “asset allocation” is to maximize the amount of return you get while taking the least amount of risk to get it. According to the academics, “risk” is defined as fluctuations in market prices. Most investors would prefer a portfolio goes up every year without ever losing any value compared to one that experiences wild fluctuations (also called “volatility”).
You would probably agree. Let's say a hypothetical Portfolio A produces 2% and never loses value. Portfolio B also provides an average return of 2% per year but has the potential to lose 20% in any given year. Which portfolio would you prefer? Of course, you would choose the first. A risk-free return is better than a risky one.
Things get a little more complicated, however, when you start thinking about the possibility of earning a higher return in exchange for taking more risk. A 100% stock portfolio may double your money once every 7-10 years while a 100% bond portfolio might only double every 20 years. If both had equal risk, you would certainly invest in stocks. But they don’t.
Stocks tend to go up in most years and up a lot over ten year periods. However, they can fluctuate wildly in any given year. A "normal" year in the stock market might be somewhere between +30% and -20%. The big down years are what scare most people away from earning the higher return.
Bonds, on the other hand, rarely have years where they lose money. Even when they do, bonds tend only to decline by 10% or less. Most people feel much more comfortable with risk in this area.
Since stocks can have wild and crazy years, academics and financial advisors have landed on an incredibly well-thought-out way to determine your asset allocation: your age! But is this really the best way to determine your investment allocation?
Most advisors would argue that a 20-year-old should invest in more stocks (“more risk”) than a 60-year-old because they have 40 more years to recover if the stock market hits a bad spell. The younger you are, the more of your portfolio should be in stocks. The older you get, the more you shift your portfolio to bonds. Simple right?
To determine your ideal asset allocation, the only variable you need is age. All you have to do is take 100 to 120 and subtract your age. That percentage should be in stocks, the rest in bonds.
For example, a 30-year-old would own 70-90% stocks and the rest in bonds. An 80-year-old would have 40-60% in stocks and the rest in bonds.
In theory, this concept makes a lot of sense. An older person can’t afford for their portfolio to decline in value by 50% because they are selling off chunks each year to pay bills. Bonds help keep the portfolio stable, even when the stock market gets ugly. A younger person has a longer period to invest, so they can afford to take more risk in search of higher returns.
As simple as the age-based asset allocation model is, the fact is that it is terrible advice. Let me illustrate.
Let’s say a woman walks into a car dealership. She doesn’t know much about cars, so she finds a sales manager and asks him if he can make a recommendation for her. The sales manager asks her how old she is. She tells him that she is 30 years old. “Ok,” he says, “I know just the right car for you.” He walks her over to the minivan section and recommends a 2015 Toyota Sienna.
Just because the woman is at the right age to be married with kids to drive to soccer practice doesn’t mean she needs a minivan, does it? If you were making a recommendation for someone to buy a car, don’t you think you would want more information than just their age?
Perhaps you would also want to know who would be riding in the vehicle, how they planned to use it if there were any safety concerns, special modifications, and several other things.
Making investment recommendations for someone is far more important than a car suggestion, yet the vast majority of investment “experts” and financial advisors are still relying on age alone to allocate someone’s investment assets. It’s a bad recommendation for several reasons.
1) Age is not the only variable.
There are more factors to involve than just age. What about:
All of these things would be considerations in determining what percentage of their portfolio should be in bonds.
[* 2) Just because someone is “young” doesn’t mean they should necessarily be in 100% stocks. *]
A 25-year-old person that has never invested in stocks before may still want to own some bonds. If the market falls 50% after they invest, what are the chances that they are going to stick with this 100% stock strategy? Probably none. Especially since most young people (and older people, for that matter) don’t know enough about stocks to hold to their strategy in tough times. Just ask any 25-year-old that put 100% in stocks before the Great Recession of 2008-09.
The most overused (and obvious) investment advice is that you should “buy low and sell high”. Unfortunately, our human emotions get in the way of us doing that.
If you had invested $100,000 in an S&P 500 index fund in October 2007, your portfolio would be worth $47,000 in May of 2009. Would you have been able to watch your account fall by more than 50% in a matter of just 18 months and still held on? Or would you have panicked and sold at the bottom?
I know a lot of people that did the latter. The same people that were telling their friends to “buy low and sell high” ended up doing just the exact opposite. They sold when the market was down 53%. And now that the S&P 500 index has recovered by 250%+, they still haven’t bought back into stocks…
The biggest risk for young people is not that a bad market will hurt their portfolio. They have time to recover all losses and then some. The most major risk is that a stock market crash will rock their confidence in investing in general, which means they’ll miss out on all future benefits that it offers.
[*3) Lower volatility (“risk”) also comes with lower returns. *]
Over an extended period, stocks will virtually always outperform bonds – often by a wide margin. So adding bonds to your investment portfolio will only naturally serve to reduce the future returns that you can expect to make.
As we saw in the last chapter, stocks will likely return between 5% and 8% per year over the next decade. A traditional 60/40 portfolio will likely return just 3.8% to 6.2% per year. The difference between 6.2% and 8.0% is unbelievable. At an 8% return, a $1,000 per month investment grows to $1,490,359. At 6.2%, it grows to $1,043,816. By adding 40% of your portfolio to bonds, you would have experienced “lower volatility” but also missed out on more than $400,000 worth of investment gains.
The “asset allocation” strategy is all about trade-offs. It does better at some things and worse for others. As a result, it ends up being just an OK solution with lukewarm results. There has to be a better way…
So far, we’ve seen how different investment strategies fall short in one way or another. Let’s imagine for a moment that we could design the perfect investment. What would it look like? How would it act?
If I could design it myself, I would ask the perfect investment to accomplish these four goals for us:
1. Provide high enough returns so that we could build wealth and grow our money faster than inflation.
2. Be less volatile than the stock market so we can sleep well at night.
3. Provide cash income to our accounts regularly.
4. Grow that income at least as fast as inflation so we can continue paying our bills even as prices increase.
5. Be simple to understand and relatively easy to follow.
Is there an investment strategy that meets these goals? There is! Let’s go through the four requirements:
1. This plan would have grown an initial $1,000 investment to nearly $60,000 from 1972 to 2015. This investment approach has also earned higher returns than the S&P 500 index - something 99% of mutual funds fail to do. Does it provide high enough returns for us to build wealth? Check.
2. This strategy is far less risky (as measured by price volatility) than investing in an S&P 500 index fund. In 2008, the S&P 500 index fell by 39%. This strategy was down by just 25%. A portfolio of index funds would have had to own 30% bonds just to reduce risk by that much. Does it let us sleep well at night? Check. Ok, maybe just a bad dream or two.
3. A $1 million initial investment would produce more than $30,000 per year in income. That income does not depend on Mr. Market or any other factor. The cash gets paid each and every year. Does it provide reliable income? Check.
4. That $30,000 per year in income will continue to grow faster than inflation each year. This $30,000 income each year will likely increase to more than $150,000 in 30 years. Does the income grow faster than inflation? Check.
5. This strategy does not require you to watch a computer screen all day. There are no complicated formulas. And there is no MBA or Ph.D. in Finance required. You can mostly “set it and forget it” so you can spend your life doing things you’d rather do than worry about your investments. Like hanging out with your friend and family and enjoying retirement. Is it easy to follow? Check.
So what is this strategy? It’s called dividend investing. We’ll talk about what makes it such a powerful strategy over the next few minutes.
Before we get too far, we need to cover the basics of what a dividend is and from where they come. To illustrate, let’s follow a young man named Johnny as he finds some investors for his lemonade stand.
Johnny is an enterprising young man that would like to start earning some money. He watches his mom make some lemonade one day and decides he wants to launch a lemonade business. He needs $200 to build a stand and buy a one-month supply of lemons and sugar, but his penny bank is empty.
To raise the money required for his business, Johnny has three options:
[*Option #1: He could borrow the cash. *]
Johnny could approach his neighborhood friends Jim and Tim to see if they would lend money to his business. Of course, they wouldn’t do this for free. If Jim and Tim both gave Johnny $100 each, they would expect that he would pay them back in a few years plus pay some interest.
In this scenario, Jim and Tim would purchase a “bond” from Johnny’s business. As long as Johnny’s lemonade stand stays in business, Jim and Tim will get their original money back and also some interest.
Bonds are considered safer than stocks for two reasons.
First of all, they rank higher in priority if the company goes out of business. If Johnny’s business goes belly up, Jim and Tim would be able to take over and sell assets (like the stand, lemons, sugar, etc.) and try to get as much money back as possible. Johnny wouldn’t get any money back until Jim and Tim had been paid in full.
Secondly, bonds have a known rate of return at the initial purchase date. If Jim and Tim buy $100 worth of 5-year bonds from Johnny's Lemonade Stand at a 7% interest rate, they know for sure that they will make $7 per year for the next five years. At that point, they will get their original $100 back and make a total 35% profit.
Option #2: He could sell ownership in his future business.
Instead of borrowing the money, Johnny could go to Jim and Tim and offer to sell them a part of his business. Under this arrangement, Jim and Tim would purchase shares of stock in Johnny’s business for $100 each. They would be entitled to a portion of all future profits as part owners. Unlike the bond arrangement, Johnny’s Lemonade Stand is not required to pay Jim and Tim back.
We will focus on this arrangement in the next section.
How Does a Stock Make Money for Me?
A stock represents part ownership in a real business. But how does this “stock” make money for you? And where does that money come from?
Let’s say Johnny decides to sell stock to fund his new business. He divides the ownership stake into four pieces and sells one of those pieces to Tim and one to Jim. Since there are four shares, we can say that each share is worth 25% of the overall business. Here is the current share structure:
Jim – 1 share (25%)
Tim – 1 share (25%)
Johnny – 2 shares (50%)
Let’s see how this plays out over a few years if business.
In the first year, Johnny uses the investors’ $200 to build his lemonade stand and buy lemons and sugar. These costs add up to $500 for year #1. Johnny also sells $500 worth of lemonade. After subtracting for his expenses, Johnny’s lemonade stand earned $0 profit.
In the second year, Johnny’s lemonade becomes even more popular. His sales increase by 2x up to $1,000. His raw materials (sugar/lemon) expenses also increase to match the growing demand. However, he doesn’t have to pay to build a stand this year. Total costs in year #2 are only $800, which leaves him with a profit of $200.
Johnny now faces a decision. He needs to decide to do with his $200 profit. He can either (1) re-invest that money back into the business or (2) pay it out to his shareholders as a “dividend”. Johnny decides to re-invest the $200 back into the company and build a second lemonade stand across town.
In the third year, Johnny builds a second location and doubles his sales again from $1,000 in year #2 to $2,000 in year #3. Now that Johnny is selling more lemonade, he strikes a deal with local grocery stores to sell him lemons and sugar for 10% off. This decrease in the cost of his raw materials allows Johnny to earn even more per cup of lemonade sold. His expenses increased to $1,600 in year #3, which left him with a $400 profit in year #3.
Once again, Johnny faces a decision. He has a $400 profit that he needs to do something with. Should he pay it out to shareholders as a dividend or put it back into the business?
Johnny decides to re-invest half of the money back into the business and the other half he will pay out to his shareholders as a dividend.
The $200 dividend payment is split up by the total number of shares, which is four. $200 divided by four = $50 per share.
Jim gets $50 × 1 share = $50
Tim gets $50 × 1 share = $50
Johnny gets $50 × 2 shares = $100
Johnny’s lemonade would write a check to each shareholder for the amount of shares they own. If Jim and Tim held Johnny’s Lemonade Stock in their investment account, their $50 dividend payments would show up on their investment statement. They could then take that $50 out to buy a new bike or keep it in there to invest in other ventures.
Dividends are one way that a stock makes you money. If you invest in a company that pays a dividend, you will periodically receive cash in your investment account.
Take Apple (AAPL) as an example. Apple is currently paying $0.52 per share to shareholders each quarter (4 times per year). For each share of Apple’s stock you own, you receive $0.52 × 4 = $2.08 per year in dividends. If Apple makes more money in the future, those dividend payments will continue to increase.
Most people don’t think much about dividends when it comes to investing in stocks. The big hoorah surrounds fluctuations in the value of a particular stock on the open market. These changes happen every day. Sometimes stocks go up and sometimes they go down. Over the long run, they will likely go up. Why is that? Let’s check back in with Johnny and his lemonade stand to find out.
Let’s say ten years have gone by and Johnny’s lemonade stand has continued to increase its profits year-after-year. Johnny’s lemonade now has a presence in multiple cities with many lemonade stands. Johnny has partnerships with several restaurants in these cities that all sell his products. In the most recent year, Johnny sold $5,000 worth of lemonade and earned profits of $1,000.
Now let’s assume that one of the investors, Tim, decides he would like to sell his shares. Tim approaches Big Mike from across town. How much do you think Big Mike will offer to pay Tim for his shares? That depends on several different factors:
1) How much could Big Mike earn on other investment opportunities? If the bank is offering a 5% rate of return, Big Mike will require a higher rate of return from Johnny’s Lemonade Stand since it represents a bigger risk than the bank. Higher interest rates mean investors can make more money investing in bonds and other fixed income securities, which makes them less attracted to stocks. When interest rates are low, like today, stocks tend to increase in value as the opportunities elsewhere are diminished.
2) What is the future growth of the company? Will Johnny’s Lemonade Stand continue to expand and sell more lemonade? Is there a threat that a competitor might come in and take some of Johnny’s business? All of these are factors Big Mike will consider. A growing company is much more valuable to Big Mike than a static one.
3) The financial stability of the company. Would you rather own a company that makes $1,000 per year with $0 in debt or $1,000 per year with $10,000 in debt? Of course, you would prefer a company with lower debt.
Let’s say Big Mike has done his homework on Johnny’s Lemonade Stand and he expects the company will continue to earn profits of $1,000 or more each year for the foreseeable future. He also expects the company management to continue paying a dividend each year to the shareholders. Big Mike has some other investment opportunities that are offering him an 8% return, so he believes if he can buy stock in Johnny’s Lemonade Stand and earn a 10% rate of return, that would be a good deal for him.
To calculate how much he is willing to pay for a share, Big Mike estimates how much his dividend payment would be in Year #1. He starts with the total company profit of $1,000 divides it into four parts – one for each share. That means his share of the profits will be $250. If half of that goes back to the business, that leaves $125 to be paid out as a dividend.
If Big Mike thought his cut of the dividend payments would remain at $125 forever, he would be willing to pay $1,250. At that price, Johnny’s Lemonade Stand would have a “dividend yield” of 10%, which was what Big Mike wanted to earn on his initial investment. To calculate dividend yield, simply take the dividend per share ($125) and divide it by the price paid ($1,250). $125 / $1,250 = 0.10 or 10%.
However, what if Big Mike expects Johnny’s Lemonade Stand to continue to grow its profits each year? In this case, he would be willing to pay a lot more for his shares. Why? Because of an important concept: dividend growth.
If Johnny’s Lemonade Stand were to grow by 6% per year, it would pay out $125 worth of dividends in year #1, and then $132.50 in year #2, $140,45 in year #3 and so on. Naturally, the higher dividend payments make it a more attractive business to own. Therefore, Big Mike is willing to pay a lot more for the shares than $1,250 if he believes the dividend will continue to grow.
How much would he be prepared to pay? He could calculate it all on a spreadsheet, but the math department at his school offers a simple solution. Mike wants to earn a 10% return. Since he believes Johnny’s Lemonade Stand will grow by 6%, Mike aims for an initial dividend yield of 4% or more. If he can get a 4% dividend yield and 6% dividend growth, he will get a 10% rate of return.
Since the dividend is $125, all Mike does is take that divided by 4% to get $3,125. A $125 dividend in the first year would be a 4% return on his initial $3,125 investment.
If Big Mike thought dividend growth would be 3% instead of 6%, he would pay less for the shares. In this case, he would want to get an initial dividend yield of 7% to compensate him for the lower growth rate. Here is an important concept: investors are willing to accept a lower dividend yield today in exchange for future dividend growth. To calculate what you can expect to earn on a stock over the long-term, you can simply take dividend yield + long-term dividend growth.
In this example, we can see that Big Mike paid a hefty premium for the promise of future dividend growth. Without any growth, Big Mike was only willing to pay $1,250 for a share of Johnny’s Lemonade. Big Mike was ready to pay an additional $1,875 for a growing dividend. Why is dividend growth worth so much? We’ll find out in the next chapter!
Johnny’s Lemonade Stand was a hypothetical example of a company that paid a dividend each year to its shareholders. There are hundreds of real businesses that do the same thing. Out of the S&P 500, approximately 410 companies currently pay a dividend to their shareholders.
Unlike a bond, however, dividend payments are optional. The company is not contractually obligated to pay. If the business runs into hard times, the dividend may be reduced or stopped altogether. Company management does not want to cut the dividend because it often leads to disaster for their stock price, but there are certain cases where management has no choice.
In 2015, Kinder Morgan (KMI) paid out over $2 per share in dividends each year. In early December 2015, their stock price plummeted to $15 per share, making their dividend yield a staggering 13.3%! Unfortunately, the yield was high for a reason. Kinder Morgan announced a 75% dividend cut, which reduced their dividend from $2 to $0.50 per year.
If you had 100% of your portfolio invested in KMI and were depending on its dividend checks to pay your bills, you would have been pretty disappointed by the 75% reduction in your income, right? That’s why just finding companies that pay dividends is not enough. The best strategy is to look for companies that not only pay a dividend but those that have a high probability of continuing to pay one in the future and grow it each and every year. Those are the companies that will build long-term wealth for you and me!
There are currently 52 companies that have paid and raised their dividend each and every year for 25+ years. These are the types of stocks that we can use to build incredible wealth over time.
Let’s say Jim and Sally pick up a copy of this book and decide dividend investing is for them. They tell their investment advisor to sell their high-cost mutual funds and instead invest that money into a portfolio of high-quality dividend growth stocks. If their advisor is not an expert in this area, they can transfer the money to someone that is or try to manage it themselves.
Jim and Sally end up buying shares in 100 high-quality dividend growth stocks. Their portfolio consists primarily of companies that they know and love. They both used Office products at work (Microsoft), take Tylenol for headaches (Johnson & Johnson), and use cleaning products (Clorox). They feel confident that they own some of the most significant and high-quality companies in the world.
They love all of these companies even more since they receive annual dividend payments of $18,210 in the first year alone. The dividend checks come monthly in the form of cash. Jim and Sally set up a $1,500 per month automatic transfer to their bank account -- just like a paycheck.
The stocks in Jim and Sally’s dividend portfolio have historically grown their dividends by nearly 10% per year. Even if they can just manage to increase their dividends by 6% per year over the long-term, Jim & Sally’s retirement income will grow faster than inflation. In year #2, Jim & Sally receive a 6% pay increase. The $18,210 worth of dividends last year increases to $19,300 next year. And then it grows again in the 3rd year. After 30 years, the dividend income produced by their portfolio has risen substantially. See the chart below:
Inflation more than doubled Jim and Sally’s expenses over 30 years. This time, however, their income kept up. The dividends from their portfolio more than quadrupled over that same period. Growing income is a compelling reason to choose high-quality dividend growth stocks over bonds, annuities, or other fixed income investments.
Now that Jim and Sally are relying exclusively on dividend income, they have no need to worry about Mr. Market. He still offers them a new price on their dividend stocks every single day, but they never take him up on it. They are content to hold onto their shares of high-quality dividend stocks and keep collecting the cash dividends month after month.
By employing a dividend growth strategy, Jim and Sally have been able to grow their income faster than inflation and sleep well at night. They have taken care of their expenses regardless of what Mr. Market’s mood is on that particular day. Not only that but Jim and Sally have never touched the principal. That means they will have a substantial inheritance that they will be able to leave to their children.
How much could that be? We’ll find out in the next chapter.
Let’s re-visit the Coca-Cola example above. You purchase the 25 shares of Coca Cola’s stock at $40. You get the same $33 worth of dividends in the first year. And that dividend income grows by 6% each year regardless of what happens to Coca Cola’s stock price. The only difference is that rather than taking the dividend out to spend it, you re-invest the $33 back into Coca Cola’s stock. This is called “dividend reinvestment” or “DRIP” for short (dividend re-investment plan).
In the first year, your $33 worth of dividend income allows you to purchase an additional 0.83 shares at the current price of $40. The extra 0.83 shares entitle you to an extra $1 of dividend income.
In Year #2, you now have 25.83 shares plus Coca-Cola raises their dividend by 6%. So you’ve increased your income to $36.14, which allows you to purchase an additional 0.90 shares.
And in Year #3, the same thing happens. Your dividend reinvestment buys an entire share. Over time, these extra re-invested shares start to add up and compound.
By year #20, your dividend re-investment alone has allowed you to increase the number of shares you own from 25 to just over 73. So not only has Coca-Cola been growing its dividend, but you’ve been growing your share count. That means you are entitled to even more dividends.
You received $2,238 in total dividend income over those 20 years, which is more than twice what you would have received if dividends were not reinvested. The income from your dividends alone would have produced an annual return of 4.1% each year for 20 years. And that’s not even counting market value!
If we assume the price of Coca Cola’s shares remains at $40, the market value of your 73.6 shares would be $2,944. But I doubt the stock price stays at $40. As we know, Coca Cola’s stock price will increase as their dividend increases, so the chances are you would make even more than that.
Even assuming Coca Cola’s stock price didn’t budge, the market value increases merely because of the additional shares you were able to buy with your dividend re-investment. Even though the stock price performed terribly, you would have earned a $1,944 profit – tripling your original investment in just 20 years.
Please don’t miss what just happened here. You invested in one of the safest, most stable companies on Earth. That company did not grow their dividend all that fast (6% isn’t impressive). Not only that, but the stock price didn’t go up a single dollar! Despite your “bad pick”, you still made a 194% profit over a 20 year period. The pure genius of the dividend strategy is that you don’t have to be good at picking stocks. You don’t even have to be average at it. You can be the worst stock picker on Earth and still make an impressive profit!
Yeah, this is exciting stuff.
And now I’m going to tell you something that I don’t want you to talk about ever again. When the dinnertime conversation shifts to investing, do not repeat what you read in this section. Your friends will look at you like you’ve lost your mind. And they will legitimately think you have. But you haven’t.
Here’s the shocker: If you are a dividend investor, you actually would prefer that the stock market falls in value. Please don’t stop reading this book now. Let me explain.
In our example above, we assumed that your re-invested dividends went to purchase more Coca-Cola stock. We also assumed that Coca Cola’s stock price remained at $40 for each of those 20 years. Now, let’s make the assumption that stock prices have fallen by 50%, and they never come back. Not for 20 years.
First of all, can you imagine the chaos this would cause on Wall Street? Account values halved with no hope for any positive returns. But you? You’d be jumping for joy. Here’s why.
Since dividend income is independent of stock price, your dividend checks from Coca-Cola would continue to come in. $33 in the first year and growing by 6% per year. By now, you know the drill.
When the stock price was $40, your $33 of dividend income was able to purchase 0.83 additional shares of stock. If Coca Cola’s stock price were to fall by 50% down to $20 per share, now your dividend re-investment would now purchase twice as many shares. An extra 1.65 shares after year #1. Another 1.86 shares in year #2. The amount of shares you were able to buy increased dramatically.
When you re-invested at the higher price, you were only able to increase your share count from 25 to 73.6. With the stock now selling for half of what it was before, you can increase your share count from 25 to 203.5! And all of those shares all pay a growing dividend stream, which looks positively absurd by now.
In this example, you would collect $4,381 in total dividend income. In Year #20 alone, you received $812 - an 81% return on your initial investment! While the dividend income was impressive, the most shocking part is what happened to your market value.
The market value of your shares at the end of year #20 is higher than it would be if the stock had remained at twice its market price. Since you own so many more shares, the market value of your Coca-Cola stock would still be $4,069 – quadruple what it was at the beginning.
Do you see the absurdity of this? The dividend strategy is so powerful that the overall stock market could fall by 50%, and you would multiply your initial investment by more than 4x! While all of the mutual fund managers and Wall Street analysts are weeping in their pillows every night because they’ve lost half of their initial investment, you are laughing your way to the bank.
If you’re reading about this strategy for the first time, you might think it sounds too good to be true. It’s not. In fact, it gets better.
Not only do dividend stocks provide the opportunity to earn above average returns, but you can do it with an incredibly high degree of success.
You’ll hear financial media talk about how to triple your initial investment by investing in [insert social media, technology, pharmaceutical stock here]. The problem is that you’re trying to hit home runs. How likely do you think you are to pick the next Microsoft, Facebook, or Google? Not good. And even if you do pick the next big stock, how many other stocks did you pick that didn’t fare nearly as well?
Trying to pick big winning stocks is like gambling at the casino. You might hit it big once or twice, but the longer you play -- the more certain you will lose.
The great thing about dividend investing is that you don’t have to pick winners before they become winners. You identify companies that are already winning and buy them for their growing dividend income stream. You aren’t going to triple your money overnight with these companies, but you will eventually.
In our example above, you were able to triple your investment over a 20-year period with extremely high probability. We didn’t assume anything wild. All we did was say that Coca-Cola is going to continue growing their dividend over the next 20 years. That seems like a shoe in considering they’ve raised the dividend for 52 consecutive years. Why would the next 20 be any different?
We didn’t assume any crazy growth levels, either. Coca-Cola has grown the dividend by significantly more than 6% in the past. No one applauded Coca-Cola for their dividend in any of those years. Their CEO was never on CNBC promoting the next big product launch. It was just boring and predictable.
Maybe I’m an oddball, but I’d prefer my investments to be boring and predictable rather than exciting and unpredictable. If you could guarantee yourself an 8% return each year and never have to mess with Wall Street again, you’d probably take that, right? Dividend investing allows you to do just that. It takes the pressure off of you to make good stock picks and lets the power of growing dividends do all the work for you.
It doesn’t take a rocket scientist to buy stock in Coca-Cola or many other dividend stocks and hold on for 20+ years. You don’t even have to be a good stock picker. Coca Cola’s 6% growth rate is likely to be far worse than some stocks, but you still made a quite handsome return.
It is possible for you to multiply your initial investment(s) many times over without riding the roller coaster that it is the stock market. A consistent and growing stream of dividend income is the investment answer that you have been seeking.
There will be doubters out there that will tell you that owning a portfolio of individual stocks is pointless. “You should just buy an index fund and forget it about it,” they’ll say.
I’ll be the first to admit that owning a portfolio of diversified index funds is a great strategy. Over an extended period, a portfolio of index funds will beat the pants, shoes, shirts, and socks off of 99% of your friends who invest in mutual funds, particularly if those funds come with sales loads and recurring investment fees charged by the advisors that sell them (err... recommend them). If you are someone who doesn’t want to spend any time on your investments each year, then an index fund strategy is an excellent strategy for you. They key is having the discipline to continue investing in both good times and bad times.
Before we entertain the idea of whether or not a portfolio of dividend growth stocks will “beat the index” or not, let’s first take a step back and see whether or not we care about beating it.
What is the goal of your portfolio? Is it to beat the index? If if the S&P 500 index returns 15% next year and you only get 13%, will you feel like the year was a failure? The goal of every mutual fund and Wall Street analyst is to beat the index, but that doesn’t mean that should be your aim.
As usual, the needs of Wall Street do not meet the needs of Main Street. Your goal is to replace your paycheck one day with a stream of growing dividend income. Whether you earn a 7% return or a 12% return is irrelevant as long as you can pay the bills each month, increase your income at least as fast as inflation, and sleep well at night without worrying about your portfolio.
Ok, so I’m skirting around the original question: Can you beat the S&P 500 investing in dividend growth stocks?
I believe the answer is a resounding yes! You can outperform the S&P 500 index with a portfolio of high-quality dividend growth stocks. Now, there will surely be people out there who point to the countless research articles out there that show mutual funds underperform index funds over the long-term. That is true. If you have to decide between an actively managed mutual fund and the index fund, I will take the index fund 100 times out of 100.
If a highly trained mutual fund manager can’t beat the index, how on Earth is it possible for you to do better than them? It’s a lot more likely than you think. As an investor in individual stocks, you have several significant advantages over Wall Street’s mutual fund managers.
[*1. No fees *]
Just in case you haven’t heard: investing in mutual funds is expensive. It’s doubly expensive if you have an investment advisor choosing which funds to buy. And it's triply expensive if those funds come with sales loads that can cost you between 5% and 8% of your initial investment. According to Morningstar, the average mutual fund costs about 1.2% per year. If you add an investment advisor’s 1% fee on top of that, you’re looking at 2.2% per year. And that doesn’t even include commissions, sales loads, account fees, or anything else associated with your investments.
By purchasing individual stocks, you automatically have a head start on the average mutual fund manager. And if you stick with high-quality stocks like the ones recommended in this book, it will be incredibly difficult for you to underperform the S&P 500 index too severely over the long-term.
You have less of a head start over the average index fund, which typically charges around 0.20% per year. Nevertheless, a 0.20% head start is still relatively significant. On a $500,000 investment, 0.20% is still a cost of $1,000 per year in fees.
2. Direct ownership
Another tremendous benefit of owning individual dividend stocks is that you get to own the stocks directly in your investment account. That means you get to control what you own.
When you own a mutual fund or index fund, you have no idea. I’m always shocked by how many advisors tell their clients that owning 20 mutual funds makes them more “diversified” than if they were to own just one. Owning multiple mutual funds just make it increasingly less clear which companies are actually in your portfolio and which ones are in your portfolio multiple times.
Direct ownership also allows you to receive your dividend income directly into your investment account. An index or mutual fund collects income and then distributes once every three months, and you don’t own the underlying companies. You just own the vehicle that owns them. If you own a portfolio of 30-50 individual stocks, you will get paid somewhere between 120 and 200 dividends over the course of a year.
More frequent payments means two things:
(1) It’s easier to pay your bills. If you’re retired and living off of your dividend income, would you prefer to get four paychecks per year or 200? The more checks -- the better.
(2) Faster compounding. This monthly income also lets you re-invest the dividends faster than you would if you only received the index funds’ quarterly distributions. The difference between monthly and quarterly compounding can be a big deal over time. A $500,000 investment compounded monthly would grow $16,000 larger over a 20-year period.
3. Higher income
The average mutual fund offers a dividend yield somewhere in the neighborhood of 2% before fees are taken out. After the 1.2% average fee, most investors end up with a dividend yield of just 0.8%. And that return can quickly be eaten up by any advisor fees on top of the mutual funds. In the end, the actual investors are left with few, if any, dividends after paying all expenses.
Unfortunately, buying index funds doesn’t offer much help. The SPDR S&P 500 index fund (SPY) currently offers a dividend yield of just 1.92%.
Our friends Jim & Sally were able to build a custom portfolio that yielded roughly 3.8% per year. Their portfolio produced $18,200 annually. Their same investment into an index fund would have only provided $9,600 per year. The dividend yield generated by index funds and mutual funds simply isn’t going to cut it.
Even if you’re not using the income to live on, dividends can provide tremendous benefits. That additional dividend yield allows you to underperform the market on price and still come out ahead. In other words, you don’t have to predict which company will come up with the next big thing to beat the S&P 500 index. Even if you choose bad stocks, the higher dividend yield will make up the difference.
Not only that, but higher income means you don’t need to save as much to reach financial freedom. If you want to live entirely off of the income from your portfolio and never touch your principal, you would have to save up 33% more with a dividend yield of 2% compared to one with a yield of 3%.
4. Own higher quality stocks
The primary argument for investing in index funds is diversification. The idea is that you should not “put all of your eggs in one basket.” Your portfolio won’t be impacted by a significant drop in one particular stock if you own a small quantity of everything. This makes sense from a mathematical perspective, but not from a business perspective.
Think about all of the companies in your hometown. Do you believe all of those businesses are created equal? Of course not. Some companies make money hand over fist, while others barely scrape by. Some have a loyal customer base while others struggle to get people in the door. If given the choice between owning a little bit of all the businesses (both good and bad) or holding only the most profitable, which would you choose?
Of course, you would prefer to own just the best businesses. By owning the best, you’ll earn higher profits over the long-term.
Research backs this up. High-quality dividend-paying companies tend to fall less in bad markets. During the Great Recession of 2008-09, the S&P 500 dropped by nearly 40% while dividend stocks decreased by just 25%.
By investing in companies that persistently raise their dividends year-after-year, you’ll automatically be selecting from the highest quality stocks available. Of the roughly 6,000 different stocks available for purchase, there are just 52 of them that have increased their dividends each year for 25+ years. That means you are automatically selecting from the top 0.8% of all stocks out there.
5. Dividend stocks outperform non-dividend-paying stocks
Since 1972, companies that paid a dividend have dramatically outperformed those who have not.
A $100 investment in non-dividend payers would have lost money – down to $99. Those who had paid a dividend but cut or eliminated it fared better, but not much – growing $100 to $264. The dividend payers who paid a dividend but did not increase it grew $100 to $2,199. The difference between paying a dividend and not paying a dividend was 10x! The chart below shows the difference between dividend stocks and dividend cutters or non-payers over time:
But it gets even better. Those companies that not only paid a dividend but increased it in that year grew a $100 investment to $5,997!
Standing here today, which would you rather invest in? You could buy every single stock in the market – including non-dividend-payers, dividend cutters, or stagnant dividend companies. Or you could only select from the companies that consistently grow their dividends year-after-year.
6. Think longer term
I feel sorry for mutual fund managers. Not because they don’t get paid enough (believe me, they are doing fine), but their jobs are hard.
The culture on Wall Street is to obsess over performance numbers. If a mutual fund underperforms its index in a given year (even three months), the mutual fund manager is in danger of investors moving their money to a different fund. They could be fired if that fund underperforms the index for two years in a row. This focus on short-term results forces mutual fund managers make decisions that may compromise results over an extended period.
If you own a portfolio of individual stocks, you are free from the pressures of Wall Street. You don’t need to answer to anyone about your performance over a three month or 1 year period. That allows you to make decisions focused on the next 3, 5, ten years.
A long-term focus lets you ignore a company’s short-term results. If a business misses Wall Street’s expectations for its earnings per share by even 1 penny, it could have its stock price crushed by 5% or more in a day. An “earnings beat” could drive the stock the other way in just a matter of seconds. As a dividend investor, you aren’t a slave to earnings reports or short-term fluctuations. Over time, these things will even out.
Focusing on the dividend allows you to think about the thing that will drive the stock price over the long-term: dividend growth over the next 5, 10, 20 years. A 10% increase in the dividend indicates that management is confident that it can continue to pay that dividend indefinitely and continue to grow it. If management were not confident in the future, they would not increase the dividend. That makes dividends a natural indicator of a company’s long-term outlook.
7. Minimal trading costs
Mutual funds and short-term investors (“traders”) are always buying and selling stocks. All of this activity leads to high trading costs and lower returns. A long-term focus allows you to reduce trading costs to virtually nothing.
Trading costs come in two forms: (1) commission charges from the brokerage firm and (2) bid-ask spread costs.
The commission charge is typically somewhere between $5-10 per trade. That doesn’t sound like much, but it adds up over time. A mutual fund might make tens or hundreds of trades each day. This adds up to thousands of dollars in costs that are paid by who, exactly? You, of course!
Another cost of trading is called the “bid-ask spread.” When you make a transaction on the stock market, there is always a small difference between what price the buyer is willing to pay and the seller is willing to sell. This spread means both the buyer and seller take a cut off of each trade. This cut is often just a few pennies. Over time, however, these pennies add up to big bucks.
Research shows that the average mutual fund incurs total trading costs approximately equal to 1% for each 100% they turn the portfolio over. In other words, if a mutual fund trades every stock in its portfolio at least once in a year (which they often do even more), the hidden cost paid by investors is 1%.
If you own individual dividend stocks, you’ll pay a $5 or $10 commission when you or your advisor purchases the stock, but you may not pay another cent for another 10, 20, even 30 years! Over the same period, a mutual fund manager would rack up hundreds of thousands of dollars in commission costs and an extraordinary amount of bid-ask spread costs.
While the fund managers frantically click on their trading screens, you’ll be swimming in the ocean of dividends and taking long naps on the beach.
8. Lower taxes
If you own a stock for longer than one year and then sell it, you pay taxes at the “long term” capital gains rate. Ordinary income tax can be up to 50%, while long-term capital gains are taxed at a special discounted rate. The most you can pay is 20%. And if you are in a 15% or lower tax bracket, you don’t pay anything on capital gains or dividends!
If you own a stock and sell it within the one year period, it counts as “short term” capital gains. These short-term gains get taxed at your ordinary tax rate instead of the tax-advantaged long-term rate.
Mutual funds and index funds have no real incentive to watch out for your tax bill. Their performance numbers don’t consider the tax implications of their constant trading and short-term gains. They only care about what return they get before taxes. That is the number that gets reported in all the investor brochures. As an investor, you shouldn’t care about the headline number. The only thing that counts for you is what your net return is after you pay all taxes and costs. On a 10% gain, you might only see 8% of that after taxes.
If you have a portfolio of individual stocks, you can be more strategic about when to buy and sell for tax purposes. That could save you between 10 and 15% on your taxes each year. You can also use what’s called “tax loss harvesting” to offset gains with losses – meaning you’ll be making money but not paying a dime in tax!
9. Ignore Mr. Market
Let’s consider a mutual fund manager that does a detailed analysis of Google and decides that the stock is worth $700 per share. If the stock is trading at just $500, the mutual fund manager would consider it a “buy” and add it to the fund’s shares.
The problem is Mr. Market doesn’t always agree. If Google misses their next earnings numbers, Mr. Market might only offer $450 per share. If Mr. Market gets extremely pessimistic, he might push Google’s stock price to $250 or lower.
It’s hard to stare down Mr. Market as he continues to price your shares lower and lower in value. Since Google doesn’t pay a dividend, the investment does not become profitable unless someone else is willing to pay more than $500 in the future. Will that happen? Maybe. But it also may not.
As a dividend investor, you can insulate yourself from Mr. Market’s mood swings. If you buy shares in Coca-Cola at $40 per share, and Mr. Market re-prices those shares to $35, you don’t mind. You’re still receiving $1.32 per share in dividend income each year. And that income continues to grow even if the stock price falls! Even if Mr. Market never changes his mind about Coca Cola’s share price being only worth $35, you are content to continue collecting your dividend checks year after year.
[* 10. Get 100% of your dividend income *]
When you invest in individual stocks, you are the direct shareholder in the company. That means you are entitled to all dividend income directly to your brokerage account. When Coca-Cola pays its $0.33 quarterly dividend, you receive that on the pay date and not a day later.
If you purchase shares in an index fund or a mutual fund, those dividends first pass through the fund. So Coca Cola’s dividend checks go to the fund first and are then distributed to the shareholders at the fund’s discretion. And after paying fees, of course. So rather than receiving checks directly from the companies, you have to wait until the fund pays once every three months or so.
11. A growing income stream
When you own individual dividend growth stocks, you can virtually guarantee that your dividends will increase month after month, year after year. When you invest in a mutual fund or index fund, those payouts don’t always go up.
Take a look at a dividend chart of Vanguard’s Dividend Appreciation Index (VIG) or S&P 500 Index Fund (SPY). You’ll notice that the payouts tend to go up over time, but can vary significantly from quarter to quarter. In other words, you can’t always guarantee that your dividend income won’t go lower rather than higher. With a portfolio of individual stocks, you can.
Let’s assume just for a moment that you can look into the future and see that your portfolio of dividend stocks will underperform the S&P 500 index. Even if that’s the case, I am willing to bet that you will still earn a higher overall return in your portfolio than you would following the typical fund strategy promoted by most investment advisors and other experts.
How is that possible? I’ll show you.
Let’s say you are 40 years old starting with a $250,000 portfolio. A traditional index fund strategy would have you put your age (or age minus 20) into a bond index fund and the rest into a stock index fund. According to this rule of thumb, a 40-year-old would put somewhere between 20% and 40% of their investment portfolio in bonds. The other 60% to 80% would go into stocks. Each year, the investor would reduce their stock allocation by 1% and move that into bonds -- getting more conservative over time.
Let’s assume that the S&P 500 index fund returns 8%, and the bond fund returns 3%, both in line with Vanguard’s estimates for the next ten years. A portfolio starting with 60% stocks and 40% bonds would grow by 5.70% per year. A portfolio of 80% stocks and 20% bonds would increase by 6.75% per year.
As a dividend investor, your 40-year-old self isn’t interested in bonds at this point in your life. You want to grow your future dividend income so that it eventually will cover your expenses. Bonds are going to slow you down. So you go with 100% dividend stocks.
And let's assume that your dividend stocks underperform the S&P 500 by a full 1% -- returning just 7% per year instead of 8%. That would be disappointing, but you would still achieve a higher realized return than the index fund investor. Why? Because the index fund investor owned bonds that only produced around 3% per year, dragging down overall returns.
Not only that but dividend stocks tend to be far higher quality and less volatile. So the dividend investors’ portfolio of 100% dividend growth stocks would have likely been less volatile than the index fund investors portfolio -- even without any bonds!
If the dividend growth investor were able just to match the index, they would have outperformed the index fund’s 8% return, they would have exceeded the recommended index fund strategy by a whopping 1.25% per year.
One of the key advantages you have over a traditional indexing strategy is that a dividend investor has little need for bonds. We’ll talk more about that in the next chapter.
Over an extended period (5+ years), I believe it is possible to outperform the S&P 500 index. Will you or I beat the market over the next 1, 2, or even five years? I don’t know. What I do know is that you will have collected a ton of cash over that period, and that dividend income will continue to grow.
The use of bonds is quite common amongst financial advisors and investment “experts” out there. Bonds can be useful for investors in some cases – particularly if they have shorter time horizons (less than ten years). The reality is, however, that most people own too much fixed income (bonds) and not enough stocks.
As a result, the average investor will likely experience worse investment returns than they should. Bonds hold back long-term returns. And adding gold to your portfolio hurts. You can see why below:
As the chart above shows, a $1 investment in gold would have grown to $32.84. Not bad, especially considering that it still doubled inflation. A $1 investment in short-term Treasury bills increased to $5,061, much better than gold. Longer-term bonds grew to $18,235. But all of these results pale in comparison to stocks. A $1 investment in the S&P 500 index rose to an unbelievable $12.7 million.
Stocks can be extremely volatile. Up 2% one day, then down 3% the next. Rinse. Repeat. Stocks can and have fallen by 50% over the course of 12-18 months. Most people can’t handle the emotional roller coaster ride. Watching your lifetime savings fall from $500,000 to $250,000 is more than most can stomach.
Adding bonds to your investment portfolio can smooth out the ride while still providing decent long-term returns. The idea is certainly sound, and it has worked for many people. The downside to putting bonds in your portfolio is that your future returns will be much lower than they would if you had invested in 100% stocks.
A dividend investor, however, has no real interest in reducing the volatility of his or her investment portfolio. Since dividend income is entirely separate from stock prices, someone relying just on dividends can ignore -- even take advantage of -- low market prices. That means anyone who is regularly adding to their portfolio or withdrawing less than it produces each year has absolutely no need for bonds at all.
1. Dividend stocks are already less volatile than the average stock.
If you invest in a portfolio of high-quality dividend growth stocks, the volatility of your portfolio will already be dramatically lower than the same portfolio invested in an S&P 500 index fund.
In 2008, a portfolio made up of the “dividend champions” (10+ years of dividend growth) would have fallen by approximately 25% compared to the market’s decline of 38%. To reduce the volatility of the S&P 500 index fund to the same level as the dividend portfolio, you would’ve needed 30% of your portfolio in bonds.
By owning 100% high-quality dividend stocks, your portfolio has the same return expectations as the S&P 500, but takes significantly less risk and you don't need to own bonds!
2. Higher returns
A 70% stock and 30% bond portfolio may have the same risk profile as a 100% dividend stock portfolio, but the future returns are far lower. A 70/30 portfolio is likely to produce about 6.5% over the next ten years - assuming stocks return 8%, and bonds return 3%.
Even “bad” performance from a 100% dividend portfolio would likely outperform the typical index fund strategy. Why? Bonds hold it back. A “passive” index fund strategy of 70% stocks and 30% bonds will probably fail to keep up with a 100% dividend stock portfolio over the next 10+ years. Even if you don’t pick “winners.”
3. Dividend income grows, bond income does not
Having 30% of your portfolio invested in bonds essentially makes a large part of your portfolio “dead”. Bond income is fixed. So a 3% interest rate on bonds is not the same as a 3% dividend yield on stocks. The dividend income is growing. The bond income is not.
Consider Vanguard’s Long-term Bond Index (BLV) which is currently yielding 3.9%. You could fairly easily design a dividend portfolio with a dividend yield of 3% that is growing by 6% per year. Over time, the difference between the income on the bonds and the dividends is dramatic. See the chart below:
After just five years, the dividend investor would be receiving more income than the bond investor. And the difference continues to grow over time.
Over the span of an average retirement period (30 years), the dividend investor would have collected 2x as much income as the bond investor. Not only that, but the market value of the dividend portfolio would have likely quadrupled to $400,000+. On the other hand, the value of the bondholder’s principal would remain right at $100,000.
4. Dividend income is higher than bond income
Bonds have historically produced higher income than stocks. Today that is not the case. The yield on a 10-year U.S. Treasury bond is well below 2%. More than half of the companies in the S&P 500 have a dividend yield greater than 2%. You could put together a dividend growth portfolio producing a full 1% higher than that and rising over time. After just ten years of 7% dividend growth, your dividend portfolio would be yielding 6% on what you originally paid for it!
If you need even more income, you could construct a portfolio of stocks yielding around above 3%. Although you would be sacrificing future dividend growth, you would be able to match the yield produced by even long-term bond funds – and your income would likely keep up with inflation.
I’ve been hard on bonds in this book, but I’m not suggesting that bonds are bad or that you shouldn’t own them. Bonds can be useful for getting a modest rate of return on money that you need to spend over the next 5-10 years. Even a high-quality dividend stock portfolio can experience losses over a short period.
Let’s say you need $10,000 to buy a car in 3 years. You can’t afford for the market value to drop to $7,000. Anything you might need within five years should be in short-term investments such as bonds, CDs, or a high-yielding checking account and not in stocks -- not even dividend stocks!
If you have some medium-term goals (5-10 years), a portfolio of 50% bonds and 50% dividend stocks isn’t a bad bet.
You should invest any money that you don’t plan to need for another 10+ years in a portfolio of 100% high-quality dividend growth stocks. The likelihood that you won’t handily outperform bonds over that long of a stretch is small, particularly if you re-invest the dividends. It could happen, but I doubt it.
If you have money that you need over the next ten years, bonds may have a role in keeping that money safe. But if you’re still contributing to your accounts or are living entirely off of the dividend income produced by your portfolio, you should seriously consider whether you need to own any bonds at all.
Owning a portfolio of individual stocks is clearly an excellent way to build long-term wealth and pay for retirement. However, there is still one glaring issue: You don’t have time to spend hours every day following the news, tracking the markets, researching investments, and poring over financial statements. `
Well, I have some good news for you. While managing a portfolio of dividend stocks can be time-consuming, it is far less so than most investment strategies. Once you have created a portfolio of high-quality stocks, your portfolio will do most of the work for you.
Still, you should understand that there will be some serious time commitment involved with managing your own portfolio of individual stocks. If you neglect your portfolio, even just a few bad choices can really hurt.
If you aren’t interested in spending any time managing your portfolio, you’ll have to pay someone else to manage it for you. Some investment firms will build an individual dividend stock portfolio for you, but they are few and far between. Most advisors are more interested in selling products like mutual funds or insurance and not in managing individual investments for you. Many of those folks are, quite frankly, unqualified at best and downright unethical at worst.
At the same time, having an investment advisor that is honestly looking out for your best interests can be one of the most beneficial professional relationships you will ever have.
Keep in mind, however, that these services are not free. The typical investment advisor will charge around 1% per year for their services. On a $100,000 portfolio, you will be paying a 1% fee or $1,000 per year. That adds up! So be sure they are achieving performance roughly in line with the stated benchmarks.
It is also a plus if the advisor can add some additional value, such as financial planning or some other service that will help you increase your net worth beyond investing. If they can help you achieve better investment returns and save taxes, plan for retirement, and save for your children’s college – then having an advisor can be well worth what you are paying them in fees. Just choose carefully.
You should also make sure that they are investing you in either individual dividend growth stocks or index funds. Don’t ever put your money with anyone that recommends that you buy actively managed mutual funds. Over time, you’ll be losing at least 2% or more each year to fees and possibly an additional 5-8% up front in sales loads. That’s too much.
Also keep in mind that an advisor can help you stay the course in bad markets. Research shows that the average investor woefully underperforms the index funds because of constant buying and selling. Even if your advisor only earns 8% per year when you could have made 10% in the index funds, it beats what you might have done on your own always jumping in and out of stocks!
Here are just a few questions to be sure you ask before hiring an advisor to help you with your investments. If I were you, I would recommend you get the following items documented in writing.
If an advisor can pass all of these tests, they are probably a good bet to help you build wealth over the long-term. Select wisely!
If you’re interested in researching and building a dividend growth portfolio on your own, be prepared to put in around 10 hours per week. Your time will include screening for new ideas, researching potential investments, and monitoring your existing portfolio.
The big trick to reducing your time is to cut down on your potential investment ideas to a more manageable list to choose from. You can use free stock screeners online to filter out everything that doesn’t meet your criteria. For example, if you want a portfolio with a dividend yield of 3%, you can screen out everything with a dividend yield less than 2.5%. You can also filter by Return on Equity (ROE), 5-year revenue growth, projected earnings growth, and more.
This book is not meant to tell you exactly how to choose dividend stocks. There are other books for that. I do have just a few basic points to make. If you want more information on how to manage a dividend stock portfolio, read Josh Peter’s “Ultimate Dividend Playbook.”
If you do decide to manage your own portfolio, be sure to monitor your overall investment performance relative to an index such as the S&P 500. You don’t need to meet or beat the index every year, but you should be holding somewhat close.
If you notice that your portfolio is consistently underperforming by 3% or more, you should seriously consider hiring an investment advisor to help you. Even after paying their 1% fee, you’ll be 2% or more ahead of where you would’ve been on your own.
In all of my 10+ years of investment experience, I have yet to find a strategy that works nearly as well buying and holding a portfolio of high-quality dividend growth stocks. It offers investors several key advantages that we have touched on in this book.
Outperform the S&P 500 index. Since 1972, companies that have grown their dividends outperform the average stock by more than 3x.
Less price volatility. In 2008, the S&P 500 fell by 39%. The Dividend Achievers (10+ years of dividend growth) decreased by only 25%. To achieve the same risk profile with index funds, you would have to own 30% bonds, which reduces future returns.
Higher realized future returns. Since a dividend investor doesn’t need to own bonds, they can outperform the average investor, even if they don’t do a good job of picking stocks! A 100% dividend stock portfolio that underperforms the S&P 500 index by 1% per year is still likely to beat an 80/20 stock/bond portfolio of index funds!
Higher current income. The S&P 500 index produces a dividend yield of approximately 1.9% at the time of this writing. A high-quality dividend portfolio would generate close to 3% or more. That’s more income to live on now or re-invest into ever more streams of growing dividends.
No fees. Even low-cost index funds charge fees that erode your returns over a long period. By owning individual stocks, you’ll pay a one-time commission charge of $5-10 and never have to pay another fee again!
Little chance of losing money over the long-term. If a dividend growth portfolio starts with a dividend yield of 3% and grows by 6% per year, it has little chance of losing money over a 20 year period.
Income that grows faster than inflation. Dividend growth stocks continue to increase their dividends year-after-year, usually faster than inflation. Bonds and annuities, on the other hand, have flat income.
[*Emotional anchor. *]Focusing on dividends rather than market prices helps you stick with your strategy when stock prices are down, rather than panicking and selling at the bottom like so many of your friends will do.
Is building a dividend growth portfolio worth it? You bet it is! Focusing on increasing stock prices is not a good way to invest. A dividend investor can look through the daily fluctuations of stock prices and look towards building a stream of consistent, reliable and growing income. These dividend payments can be reinvested to produce great masses of wealth or used to fund your living expenses once you stop earning a paycheck.
Thanks for taking the time to read the book! I hope it has given you insight into dividend investing and how it can benefit your financial future.
If it has helped you in any way or if you have any questions about dividend investing, I’d love to hear from you! You can e-mail me at [email protected] or give me a call at (812) 421-3202. I would also sincerely appreciate it if you would take 30 seconds to leave your honest review on Amazon. That would help me out tremendously and also help prospective readers decide whether or n
ot the book would be beneficial for them.
Nathan Winklepleck, RP®
Nathan Winklepleck is a Portfolio Manager at Donaldson Capital Management, a fee-only registered investment advisor located in Evansville, IN. Nathan got his Bachelor’s of Science in Finance and Economics. He is a Registered Paraplanner through the College for Financial Planning and is currently a CFA Level III Candidate.
During the day, Nathan helps people like you build portfolios of individual dividend growth stocks to accomplish their financial goals. He also offers comprehensive financial plans including cash flow analysis, retirement income projections, and tax minimization strategies. If you would like to know more information, you can contact him at [email protected] or by phone at (812) 421-3202.
When he’s not helping people dominate their finances, he enjoys cheering for the Indianapolis Colts, avoiding spiders, buying things on Craigslist, and hanging out with his beautiful wife and 10-month-old daughter.
Hundreds of people have read about the powerful investing strategy shared in these pages. Here are just a few of their comments: "The book is well written and understandable for anyone with even minimal investing experience." -JCS "One of the best books on dividend growth investing. I wish I had known about this 10 years ago as I compared my tax-free bonds versus dividend growth investing would have doubled my portfolio if I had followed his books advice." -David "Thank you for clarifying my thoughts about individual stocks. My stocks have more than quadrupled over the mutual funds which I have had to use the proceeds to live on in my retirement." -Gloria "An investment strategy that makes sense. The book is short and to the point. Reading it will be time well spent. " "Dividend investing is an overlooked strategy, and the author makes a very powerful case for why it's the safest way to invest in stock market. It's not a get rich quick scheme, and it's not about speculating which stocks will double their values. It's about investing in stable, historically high-performing companies that pay their earnings out to shareholders. Companies like Johnson & Johnson, Coca-Cola, and others. I'm already employing the strategy in my own investments, but this book gave me a lot of confidence that I'm absolutely doing the right thing. It is short, but there's every bit as much content as a much longer book." What's it all about? In this book, investment professional Nathan Winklepleck, RP® will show you a better way to invest. Through easy-to-understand examples and practical tips, Nathan will show you how anyone can achieve financial independence and investment success through dividend investing. In these pages, you'll discover: - Why traditional investment strategies fail. - The most dangerous investment strategy out there right now (and how to avoid it). - How to dramatically improve your investment results while taking less risk. - How to outperform most "passive index" strategies. - How to practically guarantee a positive investment return over the long-term. If you want to improve your investment returns, spend less time worrying about your money, and strive for complete financial independence - this book is for you!