Do you know what to do with your 401K when you quit a job? I sure as hell didn’t. I let it just sit there for two years, not really knowing what to do. Luckily, last year my sister was dating a financial advisor and I was able to reap the rewards of his short lasted presence in my family’s life.
His advice was to roll over my 401K into a Charles Schwab account and build out a portfolio that was based on high yield dividend ETFs. The strategy made so much sense to me, within a month I’d have passive cash flow that I could re-invest as I pleased. I built out my portfolio exactly as he showed me and the three of us started celebrating “dividend day” at the end of each month.
Full disclosure, this dude is kind of an assshole and happily, he’s no longer around. That means that I’m on my own in figuring out my long-term investment strategy and I’m questioning the wisdom of putting my entire future into a dividend strategy. I’ve started doing some extensive research and wanted to share it here so we can all answer the question – WTF is a dividend? And more importantly, do I want them?
Definition of a Dividend
If you google this here’s what you’ll get: a sum of money paid regularly (typically quarterly) by a company to its shareholders out of its profits (or reserves).
What that means in real words is that a company gives you cash for owning their stock. Kind of cool right?
Not every company pays dividends, those that do are generally large established companies. Coca-cola, for example, is often recommended as a dividend stock. A company’s board (majority shareholders) is who decides if the company should pay dividends or reinvest the money in the company. Smaller companies need that money to be reinvested in their own strategy so are less likely to pay dividends.
The goal for dividend-paying companies is to maximize shareholder wealth. They may have saturated their markets and feel that growing the total value of their stocks is a slower game than just paying people to invest in them. It’s also a way for the company to signal to the market that they are financially healthy.
Despite dividends being a signal for financial health as well cash in pockets of investors, there is a multitude of reasons to not include them in your portfolio.
Arguments Against Investing in Dividend Returns
Dividend investing is controversial for younger investors. They’re seen as conservative, safe and low growth. Plus the types of companies that pay dividends, utilities, for example, are seen as generally boring compared to more exciting options, like Tesla or Etsy, that are seen as high growth investments.
Personally, my high dividend investment portfolio has done well. I rolled over a total of $95K and now am up to $124K in just over a year. The total market growth for 2020 was just over 18% so that means I beat the market – something that is every investor’s dream.
That being said, if you’re looking at dividend investing, there are some things to be wary of:
- If a company is paying out high dividends, that’s money they’re not investing back into their growth. You could have a high dividend yield while the overall value of the stock tanks.
- There are a lot of voices in the financial analyst world that say dividends are irrelevant, that the cash you get paid out could just as well come in the form of increased value to the overall stock.
- Dividends are not guaranteed. The board decides, generally on a quarterly basis, if they will pay out their profits to shareholders. Even the most consistent dividend-paying companies can decide at any time that paying out to shareholders is not the right financial strategy for them that quarter. Disney, for example, turned off the dividend spigot in 2020. Totally understandable in the midst of a pandemic, but a disruption nonetheless to investors who had set strategy against that income.
Arguments for Investing in Dividend Returns
The main reason to invest in dividends is passive income. When you invest in growth stocks, the only way to access your cash is to sell the stock. With dividends, that’s not the case. You can choose to not reinvest dividends when they are paid out and then you have liquid cash that you can use as you see fit. Do note, that dividends are taxed as regular income. If you take this money out of your account you’ll need to pay income taxes on it.
If the desire was to live off of dividends alone, you would need a pretty sizeable balance. I have $120K in my retirement portfolio with 80% of it in high dividend yield funds right now. That generates about $600/month for me in passive income. Because the account is a 401K I don’t pull it out. I use those payouts to buy bonds and broad market funds.
Read more about bonds and broad market funds in my blog about two-fund portfolios
How to Choose Dividend Investments
There are a number of ways to build an investment strategy around high yield dividends, but for the most part, you’ll probably be looking at individual stocks vs. exchange-traded funds (ETFs) or mutual funds.
I’m not a proponent of investing in individual stocks. Single stocks carry a significant amount of risk due to their general volatility. The less money you are investing the more risk you assume because it becomes difficult to diversify your portfolio. For that reason, I focus on ETFs and mutual funds.
By buying funds you are instantly diversified to the extent that the fund is diversified. A fund can include thousands of different stocks and that keeps your money safer than relying on a single company’s strategy.
Things to look for in a fund:
- Dividend yield. This is the value of the dividend relative to the total value of the stocks in the fund. Generally you want to look for 2%-6%. Remember that the dividends you’re paid represent money that’s not being invested into company growth. You don’t want to sacrifice your investment just for the cash
- Expense ratio. Below 0.5% is recommended but always look for lower. Whatever you pay for the fund to be managed is money coming out of your pocket. For comparison’s sake, my broad market fund through Charles Schwab has a 0.03% expense ratio
- Historical returns. There’s no way to predict how any fund or stock will perform. If that was possible we’d all be flying into space on penis rockets. Historical returns are your best way to get a sense of how the fund is managed.
- Stocks included in the fund. Funds can be built out of any variety of stocks. Generally, larger companies are going to be safer investments and more likely to pay out dividends each quarter.
Like any investment strategy, there are endless opinions on the value of investing in dividends. Do your research and decide if building out a dividend-based portfolio is right for you.
Please note, I am not a financial advisor. I’m just someone who likes learning about money and sharing those learnings forwards. Everything included here is strictly for educational purposes.[/et_pb_text][/et_pb_column][/et_pb_row][/et_pb_section]