Dividend Investing Supplements Passive Income

I’ve written before about the various passive income streams available, but up until now I have largely ignored the concept of dividend investing. That was until the recession caused interest rates to drop to levels that don’t even keep pace with inflation. As I searched for higher yields, I was introduced to the concept of dividend investing.

A Quick Introduction to Dividends

If you are not a stock investor, or regularly dig into your mutual fund statements, you are probably like me and are unfamiliar with the concept of dividends. Basically, a dividend is a cash payout by a company to its to stockholders. Companies that raise a lot of cash, and are fairly stable (meaning not growing rapidly or in financial trouble), reward stockholders by returning a sum of cash to them on a per share basis, usually in quarterly payments.

Most companies raise or lower their dividend after quarterly earnings results are released. A handful of companies have long histories of increasing dividends over time, and now offer a healthy dividend yield.

Where to Find the Best Dividend Stocks

AT&T often appears on lists of best stocks to own for dividend investors. They have a long track record of paying dividends. In fact, they have increased their quarterly dividend for 26 consecutive years. While there is no such thing as a sure thing, this kind of long track record is what I’ll look for when selecting single stocks for our dividend portfolio.

How to Calculate a Stock’s Dividend Yield

AT&T (T) last declared a quarterly dividend of $0.42 per share, or $1.68 annually, in December 2009.  At the time of this writing, their stock price is 24.86 per share. Dividing the annual dividend dollar amount by the current share price provides the annual dividend yield of 6.75%. Not too shabby, considering most online savings accounts are yielding around 1.30%.

AT&T Pays for My Netflix Membership

That sounds a little strange, so let me explain how this all works. AT&T doesn’t really pay for my Netflix membership, but the dividends I receive from AT&T stock alone cover that expense. That’s the way I look at dividend investing. Each time I add to my portfolio, and increase the amount I receive in dividends, it covers another expense. One day, it is not unthinkable that dividends alone could cover all of our basic living expenses.

I recently signed up for an online brokerage account and purchased 80 shares of AT&T to begin my dividend portfolio. Every three months, AT&T will return a dividend of $33.60 ($0.42 per share dividend x 80 shares). That works out to about $11.20 a month. After taxes, that is just enough to cover my $9.62 monthly Netflix bill. As long as AT&T continues to pay the dividend (and Netflix keeps its price steady) I’ll have our movies-at-home budget category covered.

Dividend Investing for Early Retirement

Last year, I wrote about the concept of an early retirement freedom chart to track passive income, active income and monthly expenses. It was an idea I got from my favorite personal finance book, Your Money or Your Life. In the book, the authors advocate creating a wall chart to track monthly expenses, actively earned income (from an employer, for example), and passive income (interest accumulation, dividends, etc.). I’ll actually track this in Excel, where I do most of my budgeting. I’ll plot our income, expenses and passive income each month.

As our income increases and we can invest more money, our passive income will rise. If we reduce expenses, or keep them flat, eventually the passive income line and monthly expenses line will intersect at a cross-over point. It is at this point where our living expenses are covered without the requirement to earn more active income. Hello financial independence!

The book’s author achieved this point by investing in Treasuries, but this was back in the early to mid 1990s when they were yielding an attractive six to seven percent. These days, that rate is much harder to find.

We plan to use a mix of cash-based accounts and dividend stocks to get to our cross-over point. We’ll diversify into 10-15 stocks across a range of sectors from utilities to telecom to consumer goods, and try to add a little to our positions each pay day. Slow and steadily, we will be building a portfolio of dividend stocks with the potential for lifestyle-sustaining income for the years ahead. That’s an exciting prospect!

If you are interested in learning more about dividend investing, I highly recommend the book The Ultimate Dividend Playbook from Morningstar (written by Josh Peters).

Disclaimer: Please do not buy any stock mentioned here at Frugal Dad just because I mentioned it. Do your own research and buy positions that match your risk tolerance and income needs. One more note, single stock investing is risky, so aim to keep single stocks a relatively small percentage of our overall portfolio. We have 100% of our retirement funds in mutual funds, but I’ll dabble in single stocks for dividend investing.

Comments

  1. Welcome to the neighborhood! :)

    I personally call them Dividend funds, and they are great (at least to date).

    For the past 6 months, I’ve created a lunch dividend fund (currently made up of 2 stocks). The dividend yield has been so high that already the dividend I receive is enough to pay for 1 of my lunches outright per week. Once I get my lunch fund setup, it will be like free lunches for life (and yes I have inflation built into the fund too).

    I plan to apply the same principal to all my expenses! Truly a win-win!

    Don’t forget overseas companies too (They have an ADR fee, but it’s usually small)!!!

  2. Dividend investing is great, I am a long lover of building dividend portfolios. However if you are planning on building a stock portfolio, it will take a lot of time and effort you also need to have a large portfolio to diversify it adequately. An alternative could be looking at dividend paying ets and index funds.

  3. Another thing to consider is automatic reinvestment of dividends. If you don’t need the cash flow right now, most brokerages let you automatically take the dividends and repurchase shares of the same corporation. It’s one of the best ways to automatically increase your investing power.

    You can multiply the earnings power of your original investment very quickly for a couple of reasons.

    1) you’ll have more shares (dollar cost averaged automatically for you)
    2) your dividends will increase (because you have more shares)
    3) you’ll again have more shares

    Interesting idea though to use dividend funds as a way to provide an income stream to pay for known expenses. I would be careful comparing to a savings account though as you can lose money very easily. Dividends can be slashed and your original investment can lose its value.

  4. Good topic. Generating enough passive income to live off of is the goal of any retirement or financial independence plan.
    Dividends are great, but if your goal is to earn a lifestyle sustaining income using this strategy it’s going to take a long time and a pile of cash. I don’t know what your long term needs are, but if Family X could live on $50,000 per year after taxes, it would take around $1 million of stocks paying at the 6.5% rate. As you mentioned, dividend stocks are not typically growth stocks, so the value of compounding really doesn’t apply as much here, only the dividend yield. Mom and Pop X would literally have to sock away around $1 million dollars out of their own pocketbook. I’m going to suppose that if Family X requires $50,000 a year to live on, they’d probably invest no more than 20% ($10,000) of their income into dividend stocks per year. If they spent their monthly dividends on NetFlix (or lunch or whatever), it would take 100 years to save $1 million. Even with a dividend reinvestment plan (i.e. DRIPs) at 6.5% yield, it will take close to 30 years to accumulate $1 million, and by that time inflation has eaten away a large portion of the purchasing power of that $50,000 yearly after-tax dividend.
    Family X will have to go for something with a higher rate of return to jump start this plan. Growth stocks are probably going to be one of the few ways to make this strategy work in a reasonable time. Find a set of funds averaging 10 – 12% over the past 30 years and pump up those account balances. Never touch principal or any income produced by these stocks/funds. At 10% return, you get your $1 million in 25 years. At 12% it takes about 22 years. Then move over to dividend stocks to reduce volatility, but keep some in growth to keep pace with inflation. Doing a Roth IRA would of course help out since Family X wouldn’t have to pay any taxes on the earnings, but they’d be stuck until age 59 ½ to avoid penalty for early withdrawal of earnings. Then again, unless the yearly Roth contribution limits are raised, the DRIP would be the only way to use compounding. Not all Roth plan administrators allow DRIPs or they charge a fee that will reduce the final yield (which of course increases the time to reach the tipping point).
    Not trying to “poo poo” your strategy, but it makes sense to follow these types of long-term predictions to their end to see what must be done to achieve the desired result. It’s not a simple (or cheap) as it sounds.

  5. @Sid: Your point is well made. I will likely rely on this dividend fund to cover expenses (or at least a portion of our expenses) until I can tap the retirement funds at 59 1/2 – which are invested heavily in growth stocks, as you suggest.

    @Scott: I am investigating dividend reinvestment with my broker now. It’s my understanding that some brokers allow reinvestment without a fee, which could be a low-cost (or no-cost) way to add more shares.

    @Ray: For ultimate diversification, a dividend ETF, or even an index fund, could be the way to go. At this point, I like single stocks because I am forcing myself to do the research before buying. I may not always have adequate time to devote to research, and at that point, would definitely turn things over to a fund.

    @Don: I love the “lunch fund” idea – great concept! Will check out some international stocks, as you suggest.

  6. I am a great saver, but not the best investor of our money because of how foreign the playing field is for me. I am going to have to talk to my hubby tonight and see if we can come up with some safe investments to pay for our extras in life :) Thanks so much for the idea!

  7. That is a wonderful idea. I am planning to invest in dividend stocks in our Roth IRA when our retirement account is over $250,000 because conventional wisdom says do not invest more than 10% in a risky fund and I will be buying individual stocks. I plan to use a Roth IRA at Wells Fargo because they have no fees if you have $25,000 with them.

  8. My husband loves those dividend stocks!

    Most of our Scottrade account is invested in dividend stocks and our second Roth IRA will be invested in them as well…my hubby favors Pepsi and Johnson & Johnson, but we have some AT&T as well.

  9. If you add to your position every paycheck don’t the broker fees eat into your earnings rather quickly?

    Assuming a $7-$10 fee each trade is going to eat one month of your netflix. Is there a minimum quantity of shares you buy to offset the fees?

  10. @Tony: Excellent, excellent question! I would definitely recommend setting a minimum investment amount at which you are willing to place and order an absorb the fee. For me, that’s around $1000. I should have pointed out that I add to my cash balance for investing each pay day, but don’t pick up more shares until I reach this threshold.

    On a related note, I decided to sign up with my broker’s dividend reinvestment plan, which allows dividends to be reinvested in additional, fractional shares without a fee. This means I’ll have to pay for my own Netflix account for now, but it should help grow the number of shares I own much quicker.

  11. I owned DRIPs in the mid 80s after I joined the NAIC (National Association of Investors Corporation) and was able to buy the first share free with free reinvestment. I think they are called Better Investing now. I wish I hadn’t sold them. Of course this was pre internet and more cumbersome to track. My luck with mutual funds is below market returns so far. I will look into sharebuilder at $4 per trade with automatic investing. My results with Lending Club has had the first loan charged off and 4 are 31-120 days late. I stopped investing and will pull out the cash that I get from that savings idea and see where I stand after all the notes are paid/charged off in 3 years time.

  12. Great plan, Sid had some great contributions as well. I hope this works and if you could provide an update down the line, it would be much appreciated. I am going to be getting back into actively investing again soon, so this was definitely a good read for me!

  13. There is good reason AT&T’s stock is yielding over 6%. A big chunk of their revenue is subject to technological obsolescence– the cooper wire business, their cash cow. Cell phones and the internet are killing the traditional phone company. The generation of kids being raised today will never have a wired telephone in their house. AT&T’s future is in cell phones and TV, stiff competition in those areas.

    I’m all for dividend investing, but would prefer to buy a low-cost basket of stocks rather than individual issues to minimize risk, and not have to deal with all those DRIP plans. It can be a real pain to unwind those plans, and the companies often change the terms.

  14. The key point of investing is knowing what stage you are in. A younger investor who can take on more risk can probably make more than the 6% elsewhere. Also unless you are going to be making serious cash and using that to retire early, start a business, etc…you should ALWAYS reinvest your dividends – to Don@Moneyreasons – that $7 a week that you are cashing out has an opportunity cost of $2000 over the next ten years or $3.83 a week (assuming a 6.5% yield and 1.5% growth after inflation). For a netflix membership (assuming $9.95 a month) it is $5.39 a month which increases the membership by over 50%!

  15. Investing in individual dividend-paying stocks is my own favorite strategy. I like the research, so I prefer this even over ETFs (although I have some ETFs, too). There’s a whole world of info to learn once you get started in div investing and it’s all exciting. AT&T is a good, somewhat defensive pick to get started. And I totally agree with your strategy on using each payment to cover a specific monthly cost – it’s a great way to measure progress!

  16. Great article FD! Coupled with the comments above, I find this site inspiring and informative. I’m very new to the game and researching as much as can. I just agreed to a personal loan and only purchased my first lot of shares (diversified) for investment. I would have setup DRIP’s for the dividend’s to build wealth and borrowing power but instead I’ll use the dividend’s to pay off the personal loan and ultimately switch to margin lending. Margin loans are more beneficial to purchasing shares as the interest rates are lower and you have tax benefits.

  17. Sid,

    Just because a company pays a dividend, doesn’t mean it is not growing. Most dividend growth stocks that I focus on raise dividends annually and have done so for many consecutive years. They could only afford to do so because their earnings are increasing. So in effect these companies are reinvesting some of their earnings back into the business, but also distributing the excess to shareholders. As these companies grow their business, it becomes more valuable, which translates into higher stock prices over time. Companies like Johnson & Johnson (JNJ) or Procter & Gamble (PG) have managed to raise dividends for over 48 and 53 years respectively, while also delivering double digit total returns.

    The problem with most novice dividend investors is that they simply focus on the dividend yield component. Thus they purchase the stocks with the highest dividend, which is seldom a good idea as those excessively high dividends are seldom sustainable and are cut or eliminated. Instead dividned investors should purchase stocks like Johnson & Johnson or Procter & Gamble that not only pay a rising dividend payment, but also deliver strong total returns.

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