Those of you who have not read my previous article on this topic, which also happened to be my first article on Seeking Alpha, you can read it here . When we hear the words "Passive Income", most people think of income during retirement or when one gets close to their retirement years. Thus, it does not appeal to young people much. However, they are the ones who should pay most attention as time is on their side. If you are 30 or even 40 years old, this is the time to think of generating passive income because it will provide dual benefits; passive income can be re-invested to grow and compound over time. At the same time, in few short years you will have a stream of income that can meet some of your basic expenses if you were to ever need, and it can provide a sense of financial security in a big way.
I don't intend to convey the impression that stock dividends are only for young people, folks in any age-group can take advantage from a well thought out portfolio. But if you are young, it is even more important to understand the meaning of investing for the long-term in dividend paying stocks. The way most of the employer sponsored 401K's are structured, they offer limited choices of funds to invest, sometimes with lot of fees. Some companies do offer a choice to their employees to invest in individual securities/stocks in a "brokerage linked" type of account, but most companies don't offer such a choice. So it is very important to invest outside of your 401K. It is best to invest just as much in 401K that is necessary to get the employer's matching funds, so as not to leave the free money on the table. Beyond that one should invest in individual dividend paying stocks in IRA's (traditional and roth) and then in taxable accounts.
Dividend Stocks Investment strategy:
I want to demonstrate the value of investing in dividend stocks and power of compounding. In Part-I of this article [LINK], I had provided an example of dividend growth for a single stock; in real life you will rather want to create a portfolio with at least 20 stocks. For the sake of today's example, we will consider a fictitious investor, "Joe", who is 50 years old. Let's go back twenty years to year 1994 and assume that as a young person, Joe decided to invest in twenty dividend paying individual stocks, to re-invest all dividends and to not sell anything for twenty years (unless something drastic changed with a particular company). Joe also decided on the following criteria to make the stock selection:
- Select companies that have paid dividends for at least 15 years, preferably 20 years (as of Jan 1994).
- They must have increased the dividend in the previous 10 years
- They must have a market cap of five billion or more
- Not to pick more than two companies from the same industry/segment
- Pick at least one company from each industry segment, if possible.
- The company's products or services were well known, in other words, it had a wide moat.
As of January 1994, our young investor Joe had already saved up $40,000, so he decided that he would invest $2,000 in each of the 20 stocks that he was going to select based on the above strategy. He also decided to invest $500 in each company on the 1st of January every year for the next 20 years from future savings, so as to take advantage of dollar-cost averaging. So, the total investment contribution over 20 years would be $40000+20*(20*500) = $240,000. After 20 years, in 2014, Joe is not so young anymore, but his portfolio is rock-solid and he is already a millionaire. Total value of his conservative portfolio spread across 20 companies as of Jan'2014 is over $1.1 million, generating approx $30,000 in annual dividends, providing in excess of 12% yield on cost.
Based on the above criteria, in our example, Joe picked up the following stocks on 1st of January 1994 to invest $2,000 in each of them, followed by $500 investment in each of them on first trading day of January each year until 2014.
Below is the table that I have created showing the progress of Joe's portfolio over 20 years, showing the individual positions, their current value, yearly dividend generated, etc. To keep the calculations simpler, it was assumed that the dividends were collected through the calendar year and invested back in the original stock on first trading day of the following year.
If the same amounts were invested in a S&P 500 index fund like SPY starting 1994, the likely returns as of January 2014 would be something like shown below:
Our sample portfolio generated nearly 13% annualized return compared to a 7.9% return if the same amount was invested in a S&P 500 index fund at the same time intervals. Total value of our portfolio at the end of 20 years stood at over $1.1 million compared to $625,000 for S&P 500 (including dividends). In other words, the sample portfolio outperformed S&P 500 by 70% over 20 years. These 20 well known large cap conservative stocks were randomly picked, based on a set of simple criteria. It did not matter which specific companies you chose, as long as they met our basic criteria, the returns would have been similar. From 1994 to 2014, the stock market went through a wild ride a few times, and had many boom and bust cycles. You will also notice that some stocks did a little better than others and some others like Coca Cola barely matched S&P 500 returns, but that is the function of diversification. Overall the portfolio performed very well. Theoretically, it is definitely possible that a growth oriented portfolio could have fared much better, but it does not work out that way for most investors, due to a host of reasons, ranging from picking wrong or risky companies, lack of confidence in the investment decision, panicking and selling at the wrong time, etc. The above portfolio example only tries to demonstrate that you could invest in safe dividend paying companies, sleep well at night and still achieve market beating results. However, there are a couple of ingredients that are essential for an investor who wants to match such a performance; in my opinion they are "patience" and "determination" to stick to the plan.
Full disclaimer: Some of the calculations in the stock portfolio illustration may be approximate and are presented for information purpose only and in no way it should be construed as financial advice. Every effort has been made to correctly reflect the "split and dividend" data/information used in the calculations, however the author does not claim for 100% accuracy.
Disclosure: I am long ADM, ABT, MCD, WAG, MO, XOM, JNJ, PG, CLX, KO, SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.