Can you Make a Living off Dividends?

Most financial planners argue that a person in retirement should withdraw four percent of his portfolio each year, and this will be by a combination of income from bonds and capital from stocks. This rule is designed to provide longevity to income, providing regular ‘income’ to the retiree. However, with yields from treasury bonds now at a little over 1.5%, many investors are looking for other ways to create income in retirement.

Investing in high quality, high dividend yield stocks can produce a good income stream. A stock that pays a dividend of, say, 7%, and that has a long record of increasing that dividend, will produce an income on an initial investment of $100,000 of $7,000. And this income should grow over time if the company continues with its dividend policy.

However, with careful planning early on, it may be possible to create a fund that will pay an income sufficient for all living expenses.

Building a dividend portfolio for retirement

Investing to create a portfolio for retirement requires a different approach to the traditional. Conventional wisdom states that the first aim of investing toward retirement should be for growth early on. As retirement approaches, this higher risk strategy should gradually be turned into one for stability and finally to produce income (and this income is usually recommended to be from “safer” bonds).

However, investing in dividend paying stocks early on, and then reinvesting those dividends paid, can be a valuable strategy, with the by-product that when the time to retire arrives you will know all there is to know about dividend investing (and make better income investing decisions accordingly).

As with all types of investing and investing strategies, there are rules that will help you achieve your goal of living off your dividends:

1)      Invest in stocks that have a history of growing their dividends. Companies that grow their dividends year on year tend to continue to do so. Investors expect it, and management want to protect the good name of their company in the market.

2)      Look for dividends that grow by more than inflation. This will help protect you against the effects of inflation, and preserve the spending power of your money

3)      Invest regular and often. By doing so, you will take advantage of dollar cost averaging, buying shares when the market falls as well as when it rises.

4)      Reinvest your dividends. Dividend reinvestment is the key to seeing your investment grow exponentially. You will receive dividends on the stock you buy with the dividends received, and over time your fund value will grow way above the average of an investor who does not do likewise.

5)      Diversify your portfolio. As with any other stock portfolio, diversification is important. Whilst high yield stocks tend to be less volatile than growth stocks, they will still be subject to market forces and outside influences that management cannot control. Seek to diversify your holdings across business sectors.

6)      Monitor your portfolio. With a long term strategy, and given that you will have conducted proper research before buying your dividend stocks, this does not need to be a daily process. But at least once-a-year you should take stock of your portfolio and alter accordingly. Perhaps one of your dividend stocks has stopped performing, or its yield has fallen below an acceptable level. Adjustment of the weights and make-up of your portfolio is a necessary process to keep you on track for your ultimate goal.

An example of dividend growth

If you invest $100,000 to create a portfolio that yields 4%, with a 6% dividend growth rate, and reinvest the dividends for 20 years, the dividend amount you will receive per year when you decide to withdraw dividends in year 20 will be $24,289. Without the dividend reinvestment, the dividend payment would be just $9077.

Clearly, combining dividend reinvestment, with high yielding stocks that offer a good rate of dividend growth pays more than dividends!

For those that are already retired

The effect of reinvesting dividend payments, and benefiting from the exponential growth that compounding produces, is great if you are investing for the long term toward retirement or other time when you require income from your investments. But what if you are already retired and looking to boost your income?

Here, yield is the most important factor. High yielding stocks such as REITS will help to pay those bills that are falling into your post box. However, the rate of dividend growth tends to be low on such stocks.

So, investing in stocks that have a good record of dividend growth may help toward beating the effect of inflation, but some current yield may have to be sacrificed to benefit from such future dividend growth.

Planning for the time you need to take income will allow better investment decisions and be cheaper over the longer term. Investing regular and often will help to negate the peaks and troughs of the market, and reinvesting dividends will help to power the value of the dividends in your portfolio to a level that may just pay for your lifestyle in retirement.

However, portfolio management will be needed, even if not on the level of that of an actively managed portfolio.

Making sure your investments are working toward your goal throughout the life of investment will help you to reach your goals and ensure your dividend income grows at a faster rate than inflation. If you have already retired, it is not too late to benefit from investing for dividends: decide whether you want to address your costs now by investing in high income stocks, or to create a rising level of dividends by investing in stocks that have a high dividend growth rate.

Remember though, making plans early may help you beat the four percent rule without the need to touch your capital.

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