A lot of people view investing in stocks as a way to make a quick buck. People hope they can buy low, sell high, and make a nice return. While this is certainly a great strategy if you can predict the highs and lows, most of us can’t make those predictions and don’t have the time to be trading stocks daily. I believe that true stock ownership is a long-term play. You should identify companies that you like and invest accordingly. At the end of the day, owning a stock is taking a small piece of ownership in a company. When you operate with this mindset, it changes the whole game in terms of stock ownership.
Let’s start with an example. Let’s say a friend tells you about a company that you should take a closer look at. They manufacture hard drives for PCs and are their stock price is down about 25% from their high a few months ago. You think this could be a good opportunity to invest and make a quick buck. While this certainly may be the case, it’s not a certainty. If you’d done a little more digging, you might have found out that this company’s stock price was down due to several quarters of declining sales and product quality concerns. Is this truly a company that you want to invest in?
Another strategy is to look at companies that have a good history of paying and raising their dividends. In a lot of instances, these are business with consistent cash flows operating in industries that have a significant need (think telecom, energy, etc.). The benefit to this strategy is that you can diversify in to several different high-dividend stocks and generate a return every quarter (in a lot of cases around 5%). Where a lot of people get stuck is in trying to figure out what to do with those dividends. Below, I’d like to highlight a few different ideas for how to utilize your dividends effectively:
Reinvest in Stock
One of the best ways to leverage your dividends is to invest in more stock. Let’s say you invested $5,000 in a company that pays a 5% dividend payout ratio. Assuming you reinvested this money into the company’s stock every quarter, you would own almost 30% more of that company’s stock after 5 years without even having to invest an additional dollar outside of dividends.
Another way to look at this is that your dividend payout ratio increase over time. If you eventually doubled your position in the company, you will have essentially doubled your dividend payout ratio based upon your initial investment. Reinvesting dividends in stock also slightly hedges against the stock market value fluctuating. If valuations decline, you at least have some sort of guaranteed money coming in as long as the company continues performing. This consistency is good in times of uncertainty.
Utilize as a Lever for Cash Flow
One great thing about getting a quarterly “bonus” from your stock investments is that it provides options if money were to ever get tight. In a prior post, Eric went in to extensive detail on some different levers for on demand cash flow. Dividends should certainly be one of your levers if you’re ever looking to scrounge up some additional cash.
One risk of going this route is that you become accustomed to having that additional cash in your pocket. It can be hard to stop spending cash that you’ve become used to, so if you do go this route, make sure you’re very explicit as to what you’re going to use the dividends for.
Allocate to Other Investments
While this is similar to reinvesting your dividends into stock it is different in the sense that you are diversifying your investment portfolio by taking returns from one class of investment and putting it elsewhere. This strategy works out well if you have a need to become more diversified, or you don’t feel as comfortable owning a large portfolio of stocks.
One of my favorite things about this strategy is that it allows you to take one pool of money and have it work productively for you across your entire investment portfolio. Depending on how much in dividends you are getting pre quarter, you may not need to have to actively contribute as much to investment portfolio, freeing up cash flow for other uses.
All in all, I would say one of the greatest benefits of owning a lot of stock is the dividends you get on a quarterly basis. This is your reward as an investor, and you shouldn’t let that benefit go to waste. While it may be tempting to spend that money on fun things, you don’t want to overlook the tremendous impact dividend reinvestment can have on accelerating your saving and retirement goals.
Generally speaking, I agree with Patrick’s thoughts around the benefit that dividends can provide to your overall financial well-being. We personally hold a fair amount of high-dividend yield stocks and ETFs in our portfolio because the additional income streams and the ability to use dividend payments to accelerate growing our holdings are super beneficial for where we are in life.
We currently re-invest our dividend payments, but the other two options Patrick outlines above are worth considering depending on your current stage in your personal finance journey.
Using dividends to diversify your portfolio can be a great way to build your holdings across non-dividend paying stocks. When you think about growing companies – think Google or Amazon – they generally don’t pay dividends because they believe they have better uses for the cash in terms of re-investing internally vs paying shareholders. Because of this, if you buy 1 share of Amazon today – you’ll own 1 share of Amazon in the future. But if you hold a mature company paying dividends, you can use that stable company to build your holdings in the more “growth” side of your portfolio.
Thinking about dividends as a stream of cash flow is also a great way to use the money that your holdings spin off. By choosing to not re-invest the payments, you’re able to expand your income which can be incredibly valuable if you’re expecting the need to grow income more than you current need to build your portfolio. This would likely be a great course of action for someone nearing retirement or looking to replace a portion of their previous income.
I recently had a colleague at work transition out of his full-time job into working only part-time. This meant that his salary went from about $80,000 to about $50,000 overnight. He could bridge that $30,000 per year in income, if he had built a dividend-heavy portfolio worth about $600,000 if that portfolio averaged a 5% dividend payout.
Certainly not everyone is in a position to hold $600,000 in stocks, but if you have the desire to reduce your time at work and switch to a part-time position – thinking of ways to bridge the income gap and then executing strategies to get you there can be a great way to achieve that, and dividends can potentially play a role.
The one big caveat to all this dividend discussion is to note that dividends are not guaranteed.
Most companies’ boards approve dividends on an annual or quarterly basis given the current state of affairs within the company. That means that at any given moment, the company that has been paying dividends for decades can cut those payments entirely – leaving you with no income stream.
In very recent history, many companies that have been paying dividends for years suddenly cut or reduced their dividend payouts. And these companies aren’t always small, never-heard-of companies.
Mattel reduced their dividend 60% in 2017.
General Electric (GE) reduced their dividend 50% in 2017.
AB InBev reduced their dividend 50% in 2018.
The above examples aren’t to say that dividend stocks are a bad investment to hold – I’m personally biased toward dividend stocks – but it’s an incredibly important point to raise and to be aware of as you contemplate investing for dividend yield.
If you were counting on Mattel, GE, or AB InBev to spin off cash each quarter to make your personal finance balance sheet add up – you would have been left high and dry. As with all things investing, diversification is critical.