3 Brutal Income Investing Truths!

Summary

• We need to take a moment to look at 3 brutal truths, so you have a clearer perspective.
• Income investing will revolutionize your retirement portfolio, but there will be many skeptics.
• Every journey with great rewards has truths you must understand as you travel it.
• Looking for a portfolio of ideas like this one? Members of High Dividend Opportunities get exclusive access to our model portfolio. Learn More »

Gerardo Carnero/iStock via Getty Images

Co-produced with Treading Softly

Have you ever had news to share and wanted to find a way to soften its hard-hitting nature? I'm not talking about spin-doctoring it to make bad news into good news, but I'm talking about the desire to ease the potential damage from a hard-hitting truth out of concern or love for another.

Sometimes our family or friends will encourage us to "tell it straight", meaning no softening, no dilution, no spin, just the hard truths. I enjoy getting the truth straight out, letting the impact take its toll. Although I often am tempted to soften the blows for my children, I resist the urge to do so. All truth without love can be brutal. All love without truth is substanceless.

So today, I want to shoot it to you straight with some brutal truths about income investing. Today we need to look at stark reality, so we know what we are doing with a clear mindedness that often we do not naturally possess.

Brutal Truth #1: You Will Face A Dividend Cut

The biggest flaw we have when it comes to income investing is thinking we will magically avoid all dividend cuts. Some investors believe this will be the case by only buying "blue chip" companies, "dividend aristocrats", "dividend champions", "SWANs", or another fancy name someone slaps onto dividend stocks. Sadly, many investors get blindsided and taken off guard.

When Kraft Heinz (KHC) cut its dividend, many were caught off guard. After all, it was a company that Warren Buffett held (and still holds) and, until 2019, had a history of raising its dividend annually.

The Great Financial Crisis helped reveal how fragile the dividend aristocrats list was. It looked heavily different, as 40% of the 2008 members were cut from the list within five years following the market crash. No matter how long of a history a company has of dividend raises, no company is immune from a cut.

The simple truth is this: You will face a dividend cut.

It's not if you will but when, and when it happens, you need to be prepared to decide what to do. Some companies cut their dividend due to financial duress like KHC. Others like Lumen Technologies (LUMN) cut their dividend because the CEO and Board of Directors do not feel they're getting enough credit from the market for their high yield. Some might cut as part of restructuring the company for a stronger future like Antero Midstream (AM).

You must stay on top of your portfolio and remain informed on the financial health and outlook of the companies you invest in for income. No matter how old or established, any company can cut its dividend in a time of need. CEOs are the ultimate salesmen or saleswomen for their company, so don't blindly take their word on the matter. Do your own due diligence and determine if the dividend cut might be a positive for the company.

Brutal Truth #2: Dividend Growth Lags High Yield For Income Generation

This one I know will ruffle a few feathers. I often get asked, "Why not just buy a growing dividend instead of a high yield?" This is often asked with the implicit assumption that a growing dividend is innately "safer".

There are two issues at hand here:

1. A growing dividend often has a low yield.
2. Dividend growth expectations are not guaranteed to occur.

If we have a 5% yield growing at 5% annually, how long does it take it to match a 9% yield that's unchanging?:

- Source: Author

It would take 13 years for the income to be comparable. And that is just to start receiving the same income on an annual basis. Since the high yield was paying higher all along, that is a lot of income to catch up on.

The dividend growth strategy would generate $88,530 of income vs. $117,000 from the high-yield strategy. By focusing on dividend growth, this investor loses out on over $28k worth of income over 13 years. According to the U.S. census bureau, the average retirement is only 18 years.

How long does that take for dividend growth to catch up? An additional ten years!

- Source: Author

This rough model fails to account for the time value of money. Cash right now is far more valuable than cash in 10-20 years. It also assumes no reinvestment, dividend cuts, or changes in dividend growth. For a dividend growth stock, the failure to increase the dividend can be every bit as damaging as a dividend cut since investors are including expected dividend growth into their valuations.

The brutal truth is that while "delayed gratification" is often better for investing, delaying income is not your friend if you don't live to see it. A bird in the hand is worth two in the bush. Get your income now and enjoy it.

It often seems like dividend growth is promoted by those who expect this mythical benefit from growing dividends. Yet, they forget the first brutal truth, that any dividend can be cut at any time. So just because it was growing for years, often at a plodding rate, it doesn't stop it from being cut. KHC grew the dividend right up until they cut it. Dividends aren't guaranteed until they are deposited into your brokerage account.

Brutal Truth #3: Friends Will Be Skeptical

If you had teens in the '90s, you might remember they loved a song by Greenday called "Boulevard of Broken Dreams" one refrain from that song was:

I walk this empty street

On the Boulevard of Broken Dreams

Where the city sleeps

And I'm the only one, and I walk alone "

While it wasn't and isn't my jam, income investing can often feel like a lonely battle for individual investors. The news cycle focuses on the big wins more often than the big losses of day traders and meme stocks. It can create the sense that you are "missing out" if you aren't up 80% in the past month. Big names like to ignore dividend investing or, out of hand, reject high yields as "dangerous" and "overly risky". We see it in our comment section. Income investing is often maligned and pushed to the side by others.

If you tell a friend you're getting 8% yields from a great company - they may scoff at you. I frequently get one of two responses:

1. The capital gains are so small. I'm up X% in TNBT (TheNextBigThing), it's going to be worth trillions!
2. OMG, 8% is SOOOOO risky! I'm buying LYDA (LowYieldingDividendAristocrat), it is yielding 1.5% with 10% annual dividend growth!

One of the things I stress with the Income Method is focusing on the income. Share prices are volatile, and they change every single day. While your friends are panicking about COVID, Delta, Omicron, the next financial crisis, the next big bust, and how 50% of their retirement is wiped out in the next bear market, you won't panic.

Why? Because you've spent your time growing your income a dividend at a time. Your dividends come in several times a month, providing you cash to buy the market crashes, pay your bills, and a cushion besides. Whether the market is up or down, there are places you can go to grow your dividends and keep your head while those about you are losing theirs.

- Source: Shutterstock

Conclusion

Today, we looked at three brutal truths about income investing. We often talk about the positive aspects - there are so many! Today, we wanted to shed some light on less covered aspects.

Income investing can and will revolutionize your retirement, it will make it easier to afford your daily life and new experiences, reduce financial stressors and unlock so much potential from your portfolio.

Yet you need to be aware that you will face a dividend cut at some point in your investing career, so don't bank all your success on never having one.

You shouldn't forego strong income now hoping that dividend growth will continue indefinitely. The "Dividend Aristocrats" index only holds 64 names. It is very hard and rare for a company to sustain dividend growth for 25+ years. Unfortunately, that is the type of time frame that many "dividend growth" investors rely on for their picks to grow.

You will also face many skeptics who doubt your methods while hoping to hit it rich on a single stock pick.

Retirement is a time to kick back and relax while enjoying the fruit of your labors. We must also have a clear and unhindered understanding of our journey in the market. Complete understanding allows enjoying our retirement thoroughly!

Analyst’s Disclosure: I/we have a beneficial long position in the shares of AM either through stock ownership, options, or other derivatives. 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.

Treading Softly, Beyond Saving, PendragonY, and Preferred Stock Trader all are supporting contributors for High Dividend Opportunities. Any recommendation posted in this article is not indefinite. We closely monitor all of our positions. We issue Buy and Sell alerts on our recommendations, which are exclusive to our members.

Comments

[jtbjr58]

Rida, I am constantly reminded of what a good writer you are. I appreciate the depth. And your reference to "Boulevard of Broken Dreams" just killed me. Funny, but apropos.

[63C-Vette]

Nice to see Aristocrats put in their place. With so many of them yielding a puny <2% yield (and even <1% for some), regardless of growth rate, they are the most over-hyped investment theme; a certain identifier for newbie, unsophisticated investors.

[Rida Morwa]

@63C-Vette I'm glad you enjoyed that

[atatekin]

Thank you for the great article. It feels good to have own thoughts confirmed by someone else you respect.

My solution is to divide up my portfolio as follows: 70% Dividend Stocks, 25% Growth Stocks and 5% Speculative Stocks

[PendragonY]

@atatekin

Great if that works for you.

[2Reb]

In 2021 my investment income increased 6.88%. The government's CPI index, as of the end of November, increased 6.8%. So I am just holding my own. No runs, no hits, no errors.

Should I worry about this? Let me just say I am concerned. I am inclined to buy the Fed's explanation that the factors driving these price increases are temporary. But if they are wrong, we could be in trouble. It is hard to get inflation back in control once it gets out of control.

[User 138453]

@2Reb Inflation isn't yet anything to be worried about. And even if the Fed raises rates by a full percentage point or two we would still be at historically low interest rates. We are spoiled by the low interest and inflation rates we have experienced for decades. All this gnashing of teeth and hand-wringing is motivated by unjustified pessimism and perma-bears.

We should all read Morgan Housel's excellent essay, The Seduction of Pessimism:

www.collaborativefund.com/...

[Donggle]

@2Reb depends if you are in the accumulation mode or retired maintain mode. The market made 20% plus. You need to get part of that action!

[PendragonY]

@2Reb

You do need to be a bit worried. Look at your holdings and make adjustments to hold more of companies that have pricing power or otherwise do well in inflationary times. New money and dividends you aren't spending should also be used to buy more shares of such invetments.

[richwhb]

Thank you Rida for another great and informative article. I hear exactly the “ 3 Brutal Truths “ from my friends and colleagues.
Does HDO recommend covered calls in your service? I have been thinking about a membership for the past 6 months.

[PendragonY]

@richwhb

As part of the basic service, we do not have recommendations on covered calls, but several of us do use covered calls, and we do have a channel on the service chat where we cover and discuss covered calls (and cash-secured puts as well).

[GJ25958976]

One other method of generating additional cash flow is covered calls. Not all of HDO recommended positions have call options as a choice, but some do, and I have about 35% of my holdings in non HDO positions. Periodically I do get called out, with a capital gain, but most times I just get to keep the premium. NO tax consequences in a IRA.

[PendragonY]

@GJ25958976

I too use covered calls (and cash-secured puts) to enhance cash flow.

[I, Investor]

Happy New Year, Rida!
I am also mainly an income investor with growth as a secondary objective. My portfolio is heavy in REITs, utilities and financials. Generally, my monthly increases (YoY) are 10 to 20%. The income method works and I sleep better at night!
Hope your 2022 is healthy and happy!

[Sam_12]

Happy New Year, Rida. I enjoy reading your commentary. You have a good team. When I read the commentary, I always see them contributing, which helps make the commentary informative. Re: High Yield, I need it because I am at the stage of RMDs from my IRA. 2022 is my first year taking a RMD, and I will cover my RMD with dividend income. It will get more challenging each year as my life expectancy actuarially decreases and the percentage drawdown increases. Obviously, my goal is to maintain my IRA value as much as I can so that my wife or descendants will receive it. My overall dividend rate is above 4%, but that won't be sufficient in 2023. I'm counting on some appreciation in 2022 to allow for that. I'm overweight in Real Estate, Energy and Financials for 2022. There are a half dozen authors on SA who are required reading, and you are one. Thank you.

[Rida Morwa]

@Sam_12 You are very welcome! Thank you for your readership and kindness

[PendragonY]

@Sam_12

Thanks for the nice compliment. Sounds like you have a good plan in place.

[witrakw]

@PendragonY you mentioned before that your portfolio has beaten SCHD. Any timeframe and numbers on that yet? Thanks

[me66]

Excellent article ! It is especially good to see the graph of high yield vs. dividend growth, I knew growth took time to catch up, I did not appreciate how long the lag was ! I invest for total return, I have a few dividend growth stocks but I have focused on high yield the last 2 years. I built a large position in EPD and I opened a position in PDI in my Roth this week.

[Rida Morwa]

@me66 You are very welcome!

[Sklyazo]

“Income Method is focusing on the income. ”. Total return investor is also focusing on income. Price fluctuations can work for you when you are reinvesting your dividends and capital from rebalancing. As your total balance increases, your future income does as well.

$100K in 60% $SPY and 40% $TLT is worth $230K while $PDI is worth only $88K and $ETJ is worth $102K.

The above did not reinvest dividends because you said the money you receive today is worth more.

The high yield CEFs had three times the drawdown than my lazy portfolio.

I prefer to have more money period. The higher balance would allow me to withdraw a smaller percentage and still produce good income so I won’t have to stress the portfolio and never run out of money. 8% yield on 88K is less money than 4% withdrawal on $230K. So why bother.

$88K vs $232K. I think the choice is obviously clear.

[PendragonY]

@Sklyazo

If you say so. SInce you gave no dates for this performance, it is hard to check.

[milesgib]

@Sklyazo If you're investing that $100K over a given period of time, it seems obviously common sense to reinvest the dividends. You weren't drawing money in the 60/40 SPY/TLT combo, right?

[Sklyazo]

@milesgib in my original comment "The above did not reinvest dividends because you said the money you receive today is worth more." Thus, the author did not see it as "obviously common sense to reinvest the dividends"

The test period is January 2013- December 2021 because PDI started in June 2012.

I also ran a test going back to 2008 reinvesting dividends and then withdrawing annually 8% adjusting for inflation with a staring balance of $500,000 using $ETJ and the 60/40 lazy portfolio.

The withdrawal started at $40,000 and in 2021 it was $52,933.

ETJ failed because the balance reached zero: It could not support withdrawals at 8% but the lazy portfolio not only was able to withstand inflation adjusted 8% withdrawals the ending balance was higher than my starting balance; $503,175.

I started with $500,000: pulled tons of money out of my portfolio, end of 2021 I still have 100% of my portfolio.

Lastly, I rant the same experiment by withdrawing only 4% adjusted for inflation to see if I would keep some of the high yield and reinvest the difference to "grow" my income.

Well, not surprising to me but my lazy portfolio thrived: the balance grew from $500,000 to $1,231,687 while providing me ever growing income starting at $20,000 and ending at $26,467.

ETJ value was only $594,000 while providing me the same income.

Imagine how my total return portfolio allowed me to withdraw ever increasing income during a highly volatile investing period and still grow my total value; in fact, more than doubling the size of my net worth. During this period ETJ had only 60% of positive periods while SPY had 67%, which confirms serious volatility.

$1,231,687 vs $594,058 while allowing me to extract the same income for each portfolio.

The choice clear a pie to me: total return and a diversified portfolio.

[Bathman]

More people called in sick thank to covid-19 and omicron breakthrough infection, so I forecast some company will cut dividend. Some scientists said, omicron should hit the peak, but it is unlikely and because breakthrough infection.

www.bostonherald.com/...

More restaurant close early due to staff shortage.
www.businessinsider.com/...

[ButscherDoug]

@Bathman I'm really tired of hearing breakthrough infection. In other words the vaccine is worthless..

[Bathman]

@ButscherDoug Yeah, we might have to wear "Vaccine Covid-19 Patch Monitor" for the rest of the life. Just like wearing diabetes patch monitor.

[PendragonY]

@ButscherDoug

The vaccine is hardly worthless. It just doesn't provide 100% protection.

[Doug2000]

Good article

[PendragonY]

@Doug2000

Thank you. Glad you like it.

[Rondayvous]

Example 1: I bought LRCX a few years back @ $75/share it paid $.30/share it is now over $700/share and pays $1.50/share quarterly dividend which is an 8% yield on my original investment. That took a little over 5 years. If I now sold half of my position and bought growth stocks with 1.5%-3% yields my yield on my original investment would be over 10%. Ten percent that is on what will likely be a growing base and income.

Example 2: When the stock market crashed with covid in the spring of 2020 I bought BGS @ around $14/share. It yields about 14% on my original investment. When the stock surged during the GameStop fiasco I sold over half of it and reinvested across three different industries for about the same effective yield.

My point is to demonstrate that capital appreciation is not inconsequential to income. You just have to have a time horizon of more than a few years. I retired last year. I figure I'll be needing money for at least the next 20 to 25 years. That being the case I have enough cash and cash equivalents to get me through about 2 years, the rest is invested for long-term growth and income.

The problem with high yield is that it rarely has any growth. If you extrapolate that out over 20 years even if you start out at 8% what provided you with a comfortable income now won't go very far later on in life.

Example 3. I bought an ETF VOOG (S&P 500) in 2012 for around $61/share, it is $291 now. Who knows what it will be 10 years from now when I convert it into income-producing investments. If you do the math, even if DRIP your high yield (many of whom have capital shrinkage over time) back into the stock you won't get the same income that the S&P 500 conversion later in life will give you.

Of course, I could be missing the point. This thread may be for a bunch of 80-year-old investors.

My portfolio

[Robert in Vancouver]

@Rondayvous Very good comments. But high dividend ETF's and REIT's can also go up in value, and many do. I have some that have tripled or more in the last 10 years and some raised their dividends too. So it's the best of both worlds. And I don't have to try to buy low and sell high over and over (nobody makes money doing that in the long run). I just wait for a drop, buy low, then hold. By the way, I'm 70.

[Mr.Sceptic]

@Rondayvous Old guys know a lot.

[Donggle]

@Robert in Vancouver The market has forever to recover, humans not so much!

[mmouse527]

Completely ignoring capital appreciation of the stock price. Total return will often be much bigger with dividend growth stocks

[PendragonY]

@mmouse527

Unless you sell shares, the price has little meaning. We aim to cover our expenses in retirement with dividends alone so that we are not forced to sell shares.

[sme20]

@mmouse527 For the life of me, I can't understand why income investors bash the total return concept. Half of the premise is dividends/distributions, the other half of the equation assures you that you are not just getting your own investment back when you cash that distribution check. Man, what's wrong with that? You have it right 100%

[User 138453]

@sme20 I'm a dividend income investor and I don't bash the total return concept. But I agree with PendragonY about not focusing on that when I want to rely on a fairly reliable dividend income stream. My emphasis in on the income stream and not harvesting capital gains but I am not adverse to harvesting those gains when it seems appropriate to me to sell all or some of a company's shares, such as when the valuation is much higher than my estimate of fair value or the original thesis of the investment is no longer valid.

[BMW7]

Good insight Rida. I owned a small position in Altera Infrastructure cumulative preferred stock . . Brookfield Partners acquired the company and immediately eliminated the preferred dividends . Cutting the dividends to zero with no guidance . Stock lost 70% of its value and the yield is now at 50%. I was surprised to learn that this happens more often that investors realize . any thoughts on cumulative preferred stock cuts ?

[PendragonY]

@BMW7

It is always a good thing to evaluate a company and its preferred when it is taken private. You can make a lot of money when that happens. Sometimes you get the gold mine and sometimes you just get the shaft.

[Rida Morwa]

@BMW7 Brookfield has a history of taking a preferred private and cutting its dividend. They can let it accrue and eventually put the Company into bankruptcy to shaft preferred holders. This wasn't their first time and likely will not be their last

[PendragonY]

@Rida Morwa

Yeah, that history is why we changed our opinion on one preferred that we once liked a lot. It took a while, but Brookfield did eventually eliminate the dividend on that issue.

[jackrussels]

Rida, Appreciate your articles and suggestions. Have been shifting to income since retiring 5 years ago. In my case there is no reason to swing for the center field fence. Carry about 12% in a TIPS mutual fund so I can ride out a sustained market decline. Bulk of my portfolio is still in index funds since diversity is important to me. But, income is also important to me at this life phase so all new acquisitions are focused on income. Your columns have been most helpful in this regard. Thank you for sharing your insights.

[leephx]

You've been kind enough to answer some of my questions before. Here's a new one. Using a real world example: I bought MO fairly recently, at $43. So right now it is up about 14%. That's better than the 9 to 10% yield I was hoping to get over the course of the year. I did buy at $43 hoping to get some price appreciation. Now, if it holds this current valuation or goes higher over the course of the year, then I made over 20% on my investment, in one year--pretty good, by my standards. But what if the price is going to backslide sometime over the next year? At what point am I better off selling the stock and looking to put those dollars to work again, maybe in some other decent dividend-paying but undervalued (in my opinion) gem? I have had this dilemma so many times, and I am never quite sure of the best answer. Sell and take the double digit profits after holding for a couple of months or hold and hope the price stays high and I collect the dividends? Any thoughts on the matter? Tax issues, for the moment, are moot. I have some losses to offset, and some of these holdings are in IRAs. Appreciate any and all responses!

[BobW333]

@leephx
I think you'll be disappointed asking people to predict the future...
But I empathize, being in the same boat with other stocks and having the same question.
Personally, I'd be tempted to take some gains and lock in profits if the price went to $57, the 3-year high. But as long as the dividends keep coming, I wouldn't mind holding it either.

[Donggle]

@leephx you hit on another dirty little secret. Dividend Income only is unworkable in the long run since you cannot take risk off the table without cutting your income. Those with the big capital gains also give you the highest YOC you cannot replace until another market crash.

[Rondayvous]

@leephx IMO if the stock price appreciation on a low growth stock rises enough to lower the yield on value to less than you can get from an equal risk/lower risk investment then you sell and reinvest in another stock. Otherwise, you sit tight and get paid to wait.

[Vandooman]

Number 4. When interest rates rise your stock price goes down.

[User 138453]

@Vandooman Maybe initially on a very short-term basis, like yesterday on news that rates will rise, but for the long-term stocks actually appreciate with rising rates so long as the rates do not rise a lot and abruptly. Read this:

awealthofcommonsense.com/...

[garkster]

@Vandooman That's ridiculous. Plot TLT and BND vs. PRU and MSFT over the last 12 months. I purposely picked a financial and a tech, since the common 'wisdom' is that they behave so differently in a rising rate environment.

On an NAV basis TLT is -7.05% and BND is -2.51%.
On a TR basis PRU is +51.28% and MSFT is +46.41%.

Or you could use 6 months -- the numbers are different, but the comparative results rhyme.

[2Reb]

@garkster I own them all, although not in equal proportions. I discovered long ago that it is not a good idea to put all of my money in my strongest convictions. Some have pointed out that I am occasionally wrong. Can you imagine that?

[dimage54]

Nice to see an article from you that isn’t just about a recommended stock idea. Well written!

[PendragonY]

@dimage54

Glad you liked it.

[Rida Morwa]

@dimage54 I'm glad you enjoyed it

[DividendVet]

Brutal Truth #4: you will need to study continuously and put your studies in practice in the market and make mistakes! Learn from your mistakes and other people. Market takes from unknowledgeable investors and gives it to the knowledgable ones. “The more you learn, the more you earn!”

[Donggle]

@DividendVet your financial education will cost you about 10% of your retirement networth!

[atatekin]

@Donggle Sounds about right at least in my case....