Some Thoughts on Investing in Dividend-Bearing Stocks

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As I’ve mentioned several times recently on The Simple Dollar, one of my biggest areas of thinking in terms of personal finance right now is how to create a secure future for myself and my family. Right now, except for our mortgage (which has a pretty low interest rate), we’re debt free. We own both of our cars and they won’t need replacing soon. Our bills are relatively low. We have a very healthy cash emergency fund. After all that, we still spend substantially less than we earn.

Our question then becomes what can we do with that difference to secure our financial life in the future?

We have several avenues, of course. For one, we could simply accumulate cash in savings accounts and CDs. For another, we could buy highly secure investments that would return a bit more than savings accounts. We could also seek to simply maximize returns by investing in stocks that would give us a large return over the long haul.

However, after a lot of discussion, our biggest interest is in turning that money into a passive income stream while also using that money to support companies we believe in. We’d take our money and put it into a handful of companies we believe in – or at least ones that aren’t involved in businesses we find unethical or problematic – and then use the dividends paid by those stocks as an income stream. Our goal would be to avoid selling those stocks for a very long time, if ever, as the purpose would be to have a steady stream of income via the dividends.

Personal finance 101 here: dividends are small payments given to the holder of each and every share of a company on a regular basis. Many companies do this as a method of encouraging investment in that company and returning value to the people who own the company (the shareholders).

So, how would this work?

Let’s take a look at, say, Coca-Cola (stock symbol: KO). Coca-Cola’s stock pays approximately a 3% yield each year, which means that if the stock is valued at 100 steadily over the course of a year, you would receive $3 over the course of that year in dividend payments. So, if I bought one share of Coca-Cola today (at 67.40) and it held that value, I could reasonably expect to receive $2 over the coming year.

Let’s say, right now, we bought $20,000 in Coca-Cola stock. That would net us about 297 shares of KO, which we would then sit on for the time being. Each quarter, we’d earn a dividend payment of around $0.45 per share or so, based on the historical data, and that amount will likely inch upward over time. That’s a payment, each quarter, of $133.65.

$133.65 every three months? That’s not much, it seems. However, there are a few important things to remember. First, those payments will go out as long as the Coca-Cola Corporation exists and continues to pay dividends. Second, if I want my initial investment back, I can get some significant component of it back by simply selling the stock. If the stock is up, I could make some money just from selling the stock. If it’s down, I still made money from the dividend payments.

There’s also the question about future savings. If I were to continue to invest future savings in other dividend-paying stocks, I could eventually reach a point where the dividend payments are producing a significant portion of my personal income. This is exactly how many older and retired businessmen live – they earn income from the dividends on their stocks, and if you have enough, you can easily live off of them.

Let’s say, for example, we bought $2 million worth of Coca-Cola stock – 100 times as much. That would give us a dividend payment every three months of $13,365.00. That would be a very nice income stream, indeed, especially considering we would just sit back and collect the checks.

Now, what about the future? There are two factors to look at here.

First of all, will the actual stock value of Coca-Cola go up or down? Over the last ten years, the stock has held fairly steady. Even during the stock bubble bursts of 2000 and 2008, the value of KO didn’t drop as much as the overall market, and it’s up about 30% over the last decade. If you go back even further, it’s held steady value for a very long time. Why? People like to drink Coke. It’s reasonable to think that it will continue to hold value. Even more important, the company has been in good financial health for a very long time, with little debt and lots of revenue. It’s stable and steady for the long haul.

Second of all, will the dividend for Coca-Cola go up or down? This is much harder to tell, but one of the big shareholders of Coca-Cola, Warren Buffett, predicts that the yield for KO will go up about 7% per year over the next decade. In other words, Buffett believes that the yield will gradually slide upward from about 3% (where it is now) to about 4%. There’s also the fact that Coca-Cola’s dividend history is very long and very steady.

A final question for Sarah and myself would be whether we would want to invest in Coca-Cola. Are they in a business that ethically bothers us? Do they have business practices we support? That’s still an open question, but it’s a key part of the thought process we would have about any company we would invest in. We want to find dividend-bearing companies that aren’t engaged in businesses that ethically bother us and, preferably, do at least some things that we ethically support.

Is this an avenue we’re going to take? It’s certainly an avenue that’s a part of our discussions right now, along with eliminating our mortgage and focusing on maximizing our savings to buy a home in a different location. All of these have various appeals and, as with most things in our life since we’ve turned our financial situation around, we’re looking at each one before making a big leap.

Since we simply don’t live a lifestyle that involves spending all the money we take in – nor do we have an interest in that – we’re left with the great problem of deciding what to do with the remnants. This is the reward of living frugally and within your means. This is the reward for not buying stuff just because you happen to lightly desire it today.

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32 thoughts on “Some Thoughts on Investing in Dividend-Bearing Stocks

  1. Aren’t dividends pretty heavily taxed?

    Also, wouldn’t it be better to simply allow the dividends to be reinvested to purchase more stock (frequently an automatic option)? Seems you’d gain faster that way.

  2. If you don’t need the income or you want to earn large dividend payments in the future, you need to reinvest your dividends now. This is common knowledge for dividend investors and is the only way to achieve truly compounded returns in a dividend paying stock.

    Additionally, there are great ETF’s and mutual funds for dividend investors. Vanguard offers a “High Dividend Yield” and a “Dividend Growth” fund/ETF, which are both index funds.

  3. Even with the increase in share price, the (taxable) returns here probably don’t beat your mortgage interest rate, and you have to accept additional risk, however minimal. It seems like maybe you just think it is “cool” to be able to invest money, but the returns here don’t justify the risk compared to the alternatives.

  4. Doesn’t sound like you have really researched this or thought it through to well. Generally a total return investment portfolio is a better option. I won’t go into the details here but there are quite a few reasons a dividend based investment portfolio is a poor choice. The other glaring problem that stands out is that you are only considering 3% income as your return. Why not just buy a bond portfolio yeilding 3-4%. Less risk with equivilent return. Not that it’s a good idea just wanted to frame how much further you need to come in your thoughts before you start investing your money. Good Luck…

  5. @Matt: If you are doing taxable dividend investing, here’s the answer to your question. There are two different types of dividends: qualified dividends and unqualified dividends. Qualified dividends are taxed at the long term capital gains rate of 15%, while unqualified dividends are taxed at your income tax rate.

    If you do dividend investing in a retirement account, you’ll have the option to reinvest the dividends or have them deposited into your money market sweep without triggering a tax bill either way.

  6. I think the idea of investing in companies that support your values gets overplayed a bit. It sounds good but you have more impact with your money when you control how it is spent rather than invested (from the company’s perspective). Rather than trying to pick the “good” companies (ethically or financially), I suggest using index funds and spending the rest of your time looking at how and where you spend your money. Also, consider spending time actively supporting your ethical values. These are more effective than investing in the “right” companies.

    I can see why it would bother someone to be invested in a company they don’t agree with, but the argument is pretty weak if your talking about effective ways to support your values.

  7. What about diversification?

    I was reading that, in order to achieve good diversification from a stock portfolio, an investor must hold at least 30-35 different stocks. Keeping track and following 30-35 good picks seems tedious for passive investing when ETFs and mutual funds can expose you to the same kind of growth and dividend return.

  8. @Des – my portfolio yields 7.1% currently, so I’m sure that Trent can pick stocks that do beat his mortgage interest rate, even without a tax deduction.

  9. @Gus – I think Trent has said, in the past, that he has index funds in his retirement account. What he’s talking about now is money that he can take more risks with.

    It’s also worth noting that you can set price alerts on stocks which helps automate the process of keeping track of them.

  10. I’ve been using a similar strategy – looking for dividend stocks with a long history of producing/increasing dividends, and ones with which I engage in business.

    For instance, I have some Verizon stock, which in my mind pays back a little of my cell phone bill each quarter.

    I own a little of a well-known oil company, so I like to think their dividend returns a bit of what I spend at the pump.

    For now, I’m reinvesting those dividends in more shares, but down the line I’ll make the switch to receive dividends in cash and supplement our income.

  11. I can see why dividend stocks are psychologically appealing, but there’s really no difference between receiving annual dividends and annually selling a few shares. Except that you get to control the timing and amount.

    It’s a passive income stream in that you don’t have to take any action to receive it, but it works the same way as selling shares–a small portion of your investment is converted into cash.

  12. I think there’s an important difference between dividends and capital appreciation: dividends are real and capital appreciation is only a paper profit (unless you sell).

  13. I’d love to see a follow up post on the benefits of annuities, esp. charitable giving annuities. It’s a great way for adults at/near retirement age to support a cause they believe in while receiving tax benefits and a steady income for life. Basically, you donate a lump sum to a non-profit organization. You get a tax deduction in the year that you donate for a portion of the lump sum, and based on your age they pay you a certain amount of interest every year for the rest of your life. Some of that income is even-tax deductible! So, for example, if you donated $10,000 in 2011 at age 70 you might get:
    -a $3,000 tax deduction for 2011
    -6.5% (fixed) interest rate = $650/year (paid quarterly) for the rest of your life
    -$400 of that income is non-taxable, $250 is taxable.
    In addition, if you donate appreciated securities (held 1+ year) you avoid capital gains taxes.
    You can also purchase annuities from an insurance company, but the rates aren’t any better, and this way you are helping to support a charity.

  14. @George – Yes, I am aware that there are many ways to beat the return of a mortgage – my point is that what Trent is suggesting here is not one of them.

  15. I don’t really think you should include ethical concerns when picking investments. I mean… it sounds good to say, but it’s really complicated. For starters, you don’t really KNOW if companies are doing “bad” things or not…

    But regardless of that there are other issues.

    For example, in about every post you write, you discuss how most people should just invest in index funds (I agree). Well, those index funds comprise the entire market… the companies that you would consider “good” and those that are “bad.”

    So if you’re using ethics to pick stocks, you shouldn’t really invest in index funds at all.

    Secondly, because most of the stocks sold by these companies are sold to index funds and other large investors, you’re small purchase won’t phase their corporate strategy. It’s not like they’re gonna invite you to the board meetings…

    I think a better strategy is just to maximize your gains and then spend those gains in ways that promote causes you believe in.

    So, for example, you could invest in Exxon if you think they are a fantastically profitable company, but then use the gains to buy a Hybrid car or install solar panels to promote green energy.

    How you spend your money will have more effect than how you invest your money.

  16. Dividends have been a real blessing to my mother in her retirement years. Be careful about “niche” investing without really meaning to. What I mean by that is, utility companies, for example, generally have high dividends. You may find your portfolio too heavily weighted toward one industry if you pursue good dividend returns or only a few companies. The banking debacle of the past few years has showed me in a most painful way not to get too much money tied up into one company or industry. I thought they were safe! Not so much, it turns out….. Good luck, Trent, with your investing.

  17. Coca-cola have been widely linked to violent anti-union actions in South America, through local subsidiaries and other partners. They’re also very controversial in India due to the high water usage of their bottling plants in drought-prone areas.

  18. I’d recommend finding a mutual fund that is tilted towards dividend paying stocks if that is what you want. The risk of just investing in a few dividend paying companies is that they cut the dividend rather than growing it, or worse go bankrupt and the stock goes to zero. A lot of companies that paid good dividends and looked solid ended up not being that way during the recent financial crisis.

  19. I find it ironic that Trent mentions Coke as a possible investment and then talks of ethical investing. HFCS is what is in Coke made in the USA and that is the primary reason for weight gain in our population. Studies have shown this time and time again. I only started investing in one stock through sharebuilder, MCD. And yes, I know eating too much of their products are bad for most of the population. But they have a great dividend and track record. Ethics wasn’t part of my decision. Perhaps after the market goes down I will invest in a dividend growth mutual fund.

  20. I hate to be snarky, but I was kind of irked by Trent’s use of the phrase “older, retired businessmen”….I would assume that some “businesswomen” are just as savvy.

  21. I think a great way to go about this style of investing is to purchase shares of blue chip stocks with a historically increasing dividend. This ensures that the company values the dividend payout and will keep it consistent and on pace or beating inflation. Other commenters have suggested DRIP investing. I think that’s a great suggestion, at least until you need the money. It offers both a no fee way of reinvesting the proceeds and the effect of compounding dividends- one of the best kept secrets in finance.

  22. I think it’s cool to make dividend stocks a part of your portfolio. And I think it’s cool to start buying these before the mortgage is paid off so you can get your feet wet and learn some things the hard way without losing too much money.

    I’ve had two dividend paying stocks–one quit paying any dividend at all (no, not BP) and the other cut theirs in half during the recession and is only now slowly increasing it again. But I’ve heard that many companies go decades without ever cutting their dividends, and as their stocks go up in value, they pay out more dividends per stock to keep the same payout ratio, so yea!

    I researched some high-yield index funds; they don’t seem to pay as much in dividends as the S&P 500. I get even higher dividends from my European index fund.

    We’re in crazy times with interest rates so low that the dividends alone from dividend-paying stocks start to look good compared to treasuries and CDs. So, again I say, why not play with a few dividend stocks with some of your extra money?

    Oh, and about believing in the company. One thing about investing in evil companies is that you win either way. Either they keep making loads of money–and you get some–or you lose money, but it’s because the evil company is going down! Unless you’re buying stocks in the original sale (by the company), you’re not helping them much. Usually you’re buying from other stockholders, some of whom might be company bigwigs with stock purchase plans, but most of whom are not.

  23. Before you invest a single dollar in the stock market, run don’t walk and get a copy of “The Intelligent Investor” by Benjamin Graham. Read it as many times as you need to until you have some understanding about investing. If you want to invest before you’re finished reading, pick an index fund with less than a 0.5% maintenance fee and put your money into that until you think you’re ready to start investing in individual stocks (regardless of dividends.)

    Investing in individual stocks is an extremely time intensive endeavor if you are interested in doing it correctly (i.e. minimizing risks and maximizing gains) and should not be undertaken frivolously. Even then, it’s still difficult. Keep in mind that a money manager that can beat the market five years out of ten is considered a superstar. And that’s their full time job complete with research assistants. Folks like Bogle and Buffett are extreme outliers. If you’re not willing to treat it at least as a part-time job, stick with index funds.

    As far as investing and ethics go, there are mutual funds and etfs that cater to ethical investing. Their returns are crappy, but they exist. Another alternative, as my rich aunt told me once, is to make as much money as you can and then donate to the causes you believe in.

  24. Coca-Cola is a great dividend paying stock and is a company you can believe in. Warren Buffett does and owns 200 million shares. If you are just looking for high dividends, consider Annaly Capital (NYSE: NLY). Dividend yield is 14.4%. If inflation raises it’s ugly head, then NLY dividend will decrease.

    I agree with “Rob”. “The Intelligent Investor” is an extremely good book. If you don’t like researching stocks, stick with low expense index funds.

  25. #21, Amy, wrote:
    “I hate to be snarky, but I was kind of irked by Trent’s use of the phrase “older, retired businessmen”….I would assume that some “businesswomen” are just as savvy.”

    And some people would be irked if Trent felt the need to be very politically correct and write “businessmen and businesswomen” when it’s not necessary to his point. Honestly, the nitpicking in the comments on this site is astounding. If you don’t like the way the absolutely free information here is presented, then find another site! There is no possible way Trent can please everyone all the time, nor should he try.

  26. Writing “business people” or even “businesspeople” (sanctioned by all reputable dictionaries, to save the nitpickers some time) might, I suppose, help to make this free content worth more than its price. It’s silly to worry about ending sentences with “with” or starting them with “but”, but it’s not silly at all to worry about gender bias. How comfortable would you be if Trent had referred to “older, retired white people”?

  27. I like the charity idea, that way the charity gets a better interest rate than they could get from the bank, and so do you.

    Re ethics. I would be pretty unhappy to have stocks in an arms company. Do you really think that has no ethical ramifications?

    Hypothetical what if. What if EVERYONE was financially savvy, or even 50% of everyone. Would there be enough shares to go around for everyone to live well in retirement? What if you have more investment money chasing around fewer investment opportunities. According to some essays I’ve read this was a contributory factory to the crisis and is part of the cause of bubbles, and will make bubbles more and more common, driving up prices of real life things (like commodities and houses) for the rest of us.

    Of course I’m not saying people shouldn’t buy shares, but I’m thinking people should have more discussions about what investments could look like in the future.

  28. Consider learning much more about any stock before you buy. A good place to start is Value Line, which is in lots of libraries and has vast amounts of great information, though the format is very dense and will take some time to become acclimated with.

    Make sure you understand anything you’re investing in and that it intuitively makes sense to you (think of the dotcom boom and companies selling heavy and cheap dog food with free shipping and no profit margins – did this ever make sense?).

    I also strongly suggest that with individual securities people implement an automatic “market sell” order at a designated price right when they buy. This keeps you from holding and buying more and more and more shares in an effort to lower your average purchase price. Sometimes this works out if the stock bounces back, but when it doesn’t* it can devastate your returns. You can also buy a whole new position if you’ve sold but want the stock again.

    *Worldcom, Enron, AIG and Citigroup are great examples of “good” companies that lost most or all of their value.

  29. I also recommend Benjamin Graham’s _The Intelligent Investor_. It’s especially fun to read the later edition where he evaluates predictions he made in the earlier edition. Then get a stock chart out and see what happened to his later predictions. Yes, they were obviously in a stock bubble at the time. A stock bubble that lasted 20 years. You just never really know what’s going to happen.

    My only answer to that is to diversify. Get various kinds of stocks. Bonds. Pay off your house. Stock up on canned goods. Learn skills that save you money (cooking, hair cutting, whatever sounds fun). Learn skills that earn you money. I wish I had more ideas.

  30. Trent,
    You are confusing Dividend Yield with Dividend Rate in your example featuring Warren Buffet. The dividend rate is expected to rise, but the yield is actually a function of the stock price.

    @#10 Jason – Frugal Dad.
    I’m glad you’ve taken some of my ideas and started using them! Great discussion we had on your site about this topic. Best of luck!

  31. I really think it’s risky to invest in individual stocks if you lack the knowledge to make some sense of the company’s financial statements. This may be even more important if the stock is being purchased primarily for its dividend yield.

    I do invest in individual stocks and have quite a few high-dividend yield stocks that I’ve acquired over the past few years using the stock-screener my brokerage offers, but being able to read the financial statements led me to rule out quite a number of seemingly attractive stocks whose financial statements revealed looming problems (shrinking profit margins, rising inventories and receivables or current liabilities, cash flow problems, asset values heavily weighted with commercial real estate or intangible assets resulting from poor acquisitions, etc.).

    It’s important also to understand at least some of the risks the company and its industry and sector face, such as currency exchange risks, political risks, limited supplier risks, pricing pressures, and many more.

    I enjoy studying these things, rarely get caught up in the herd mentality, and proceed very cautiously with considerable diversification and still make huge mistakes (remember WAMU, anyone? At least I bailed well before the end) or suffer bad luck (NW Airlines purchased right before 9/11).

    If studying this stuff is not fun for you, or you can’t take a wipe-out occasionally and still sleep at night, it’s really best not to get into it. With college economics, accounting and tax law classes, years of experience professionally analyzing business reports and financial statements, and 25 years of investing, I’m still not sure I should be doing it.

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