How to Make Money While You Sleep: Making money while you sleep is the gold standard of financial success. While there are several ways to achieve this, none is more passive than investing in dividend-paying stocks.
Even though many investors see dividends as a sign of stodgy, slow-growing companies, they can be surprisingly powerful drivers of overall portfolio growth.
Let’s take a look at the compounding power of dividends and why they have the ability to supercharge your portfolio over time.
Why Dividend Investing Is King
While not as exciting as investing in high-growth startups, buying shares in legacy companies with stable dividends is a proven way to build wealth over the long run. This is largely due to the power of dividend reinvestment, which allows investors to accumulate more shares and create a snowball of dividend payouts that amplify overall returns.
Every time a dividend is reinvested, it is used to purchase more shares in the same company or fund. The shares that are purchased then produce their own dividends, which are reinvested into further shares. This ongoing compounding effect is what makes dividend investing a truly passive way to make large amounts of income.
Another advantage of dividend investing is that it puts the focus on established, profitable businesses with steady free cash flows. While high-growth companies can produce good returns for investors who get in early, they can be a trap for those who arrive too late.
If a stock is priced too high and the company fails to continue growing at an astronomical rate, investors can see lackluster returns on their capital. Most reliable dividend-paying stocks are blue-chip companies that can afford to distribute cash to their shareholders rather than invest heavily in further growth.
There’s also a notable advantage to a dividend strategy when it comes time to retire. Allowing dividends to be reinvested could allow your portfolio to reach a considerable size. When you’re ready to retire, you can begin taking the dividends from your accumulated shares as cash payouts, providing you with a steady source of retirement income.
Most regular dividends are tax-free up to $41,675 for a single filer or $83,350 for a couple filing jointly. As a result, drawing dividends from your portfolio is a good way to generate substantial income in retirement without incurring income or capital gains taxes.
Finally, stocks that pay stable dividends can be good hedges against economic downturns. Many top dividend producers are recession-proof businesses that sell consumer staples, essential materials or other products that remain in demand in all market conditions. At times when share prices stagnate or drop, dividends can bolster returns or mitigate losses.
Does Dividend Reinvestment Outperform Over Time?
While it may sound like a small advantage, dividend reinvestment can allow your portfolio to generate substantially higher returns over long periods of time. A constant cycle of buying shares with payouts that then generate payouts of their own can create a massively powerful compounding effect that outruns even very successful high-growth stocks.
An excellent example of this power can be found in the disparity between IBM and Standard Oil described in Wharton finance professor Jeremy Siegel’s 2005 book The Future for Investors. In examing the returns on dividend-yielding stocks and successful high-growth companies, Siegel found that an investment in Standard Oil made in 1950 would have beaten out the same investment in IBM, assuming all dividends were reinvested. Between 1950 and 2003, Standard Oil delivered a CAGR of 14.42 percent, compared to 13.83 percent for IBM.
A similar dynamic can be seen in the overall returns of the S&P 500 index. This index is well-known for returning a historical average of 10-11 percent annually, making it one of the benchmark investments for wealth creation in America.
However, this return only holds if dividends are reinvested. Without this reinvestment, the long-term average return of the S&P 500 comes down to just 6.57 percent.
Dividend Yield vs. Dividend Growth Investing
When investing for dividend income, there are two primary approaches. The first is simple dividend yield investing, in which stocks that pay the highest yields at the moment are preferred. This approach allows you to create an immediate income stream from your portfolio.
The second approach is known as dividend growth investing. In this strategy, investors target stocks that are expected to raise their dividends year after year. Over time, dividend growth investing allows you to earn progressively larger returns on your initial investment.
Suppose, for instance, you bought a stock priced at $100 that yielded 2.5 percent. Now, let’s say that dividend grows by an average of 4 percent annually for 10 years. At the end of that period, the annual payout would be 3.7 percent of the initial $100 investment.
As dividend payouts continue to increase, the yield on the original investment will rise in tandem. At 20 years, the yield on your original cost will have grown to 5.5 percent, and at 30 years it will be 8.1 percent. Keep in mind that this annual return is before any potential growth in share price is taken into account.
For long-term investors, dividend growth investing is usually the better approach. With this strategy, you can create an income stream that will grow larger with every passing year. When combined with dividend reinvestment and allowed to work over enough time, this growth-oriented approach can become an extremely powerful generator of passive income.
How to Select High-quality Dividend Stocks
As with any other investment, it’s important to carefully vet dividend-paying stocks before adding them to your portfolio. Fortunately, there’s a list of extremely reliable companies known as the dividend aristocrats that are relatively safe bets for dividend investors. These companies are S&P 500 constituents that have raised their dividends for a minimum of 25 consecutive years. One step above the dividend aristocrats are the dividend kings, a small group of companies that have increased their dividends for a minimum of 50 years.
Investing in dividend aristocrats or kings is a relatively simple and safe way to buy reliable yields on your capital. You can also consider high-yield funds. These funds typically invest in several dividend aristocrats and other high-yield stocks, providing a decent degree of diversification for investors who don’t want to select individual stocks.
The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.