Dividend investing is one of the best ways to create a completely passive income stream. With dividend stocks, you invest once and earn forever!
Passive income, the type of income that you earn even while sleeping, is something desired by many. It can be used to either build your wealth by reinvesting, or help cover your regular monthly expenses. Dividends really do fit the bill as the best passive income source, since the income is sustainable, grows much faster than inflation, requires little to no maintenance, and can potentially be tax-advantaged. It may take time to get a sizeable amount of dividend income, but luckily time is on your side!
To build a dividend-paying portfolio, you’re going to need a brokerage account
If you don’t already have one, you’re going to need to open a self-directed brokerage account to buy dividend-paying stocks.
A brokerage account is different than a bank account. It allows you to buy and sell securities on the stock market. When looking for a brokerage account, you want to find the lowest trading fees out there. After all, you don’t want fees to eat into your dividend income!
Questrade is an online discount brokerage, that only charges $5 to $7 per stock trade. You only need $1,000 to open an account, and they offer both registered and unregistered accounts.
Once you’ve opened and funded your brokerage account, you’re ready to get started.
The World of Dividend Investing
Dividends, like many financial topics, are simple at the surface but complex underneath. At the surface, dividends are paid to distribute a company’s earnings to its shareholders. Being a shareholder of a dividend-paying company entitles you to a share of the profits! A good dividend policy is beneficial to both the shareholder and the corporation, but we’ll discuss more of that later.
There are many people who choose to invest in strong, dividend paying companies as the core of their portfolio. This strategy is often referred to as dividend growth investing. The growth in the title refers to the growth of dividend payments over time. The average annual dividend increase for S&P 500 companies is 6% (dating back to 1990). It is not unheard of for individual companies to have an average annual dividend increase of 10% or more!
When is the last time you got a 10% raise?
Dividend Investing 101
If you’re not too sure about what dividends are, then this part is for you! As I mentioned earlier, dividends are a way for companies to share its success with its shareholders. They are a portion of the earnings that are paid out to you, the shareholder. You can receive dividends in the form of cash or as more shares, but we’ll get more into that after.
What are all these dividend dates?
A company will declare a dividend of X dollars. The date they do so is called the declaration date, however, that date is not too important. There are however two very important dates when looking at the dividend:
- Ex-Dividend Date – you must own the stock before this date in order to receive the dividend!
- Payment Date – the day the money actually is paid out to shareholders.
You may also read about the Record Date when looking at stocks. This is technically the day you need to be a shareholder “on record” in order to be entitled to the dividend. It is always two business days after the ex-dividend date; this is because trades often take that many days to settle. This date has less meaning to an investor than the ex-dividend date, although it’s good to know at least what the record date is. You should pay more attention to the ex-dividend date instead!
How do I compare stocks for dividend investing?
There are a few different metrics used to look at dividends and figure out how good they are. Luckily, they all involve simple math!
The dividend yield is a percentage showing how much the annual dividend is compared to the share price. Higher is better; it means you get more passive income out of your investment. Just to give you an idea, the average dividend yield of the TSX Composite was 3.45% in 2018. That means you earned $3.45 in dividend income for every $100 invested.
A second important metric is the dividend payout ratio which is the paid dividends divided by the total earnings . Quite simply: does the company make enough profit to cover the dividends they promised you?
Companies with low payout ratios (say 50% or less) are more conservative with their dividend. They have more than double the money required to pay the dividend they promised! Companies with larger payout ratios are taking on more risk, but as a result, offer larger dividends and higher yields. It is up to you to determine the level of risk that is right for you.
Finally, you should look at the dividend growth rate. Companies like to raise their dividends over time, and this metric measures the rate in which they do so! The more your dividend payment grows, the more your passive income grows. If you recall what I said earlier on, the average annual dividend growth is about 6% for the famous S&P 500 stock index.
Remember, you are building a six-figure stock portfolio, which may be full of various funds or individual stocks. Don’t only look at the dividend! It is just a small part of the big picture here, and you have to look at the stocks and the company as a whole.
To reinvest, or not to reinvest?
Remember when I said there are two options when it comes to taking your payment? You now have to consider that. Luckily for you, it is quite an easy choice given you know what your investment objectives are.
The simple thing to do is take the dividend in cash form. You now have cold hard cash that you can do whatever you want with. If you want passive income to withdraw from your trading account and spend, this is the way to go. However, given your age, this might not be the wisest choice! You’ll want to take advantage of the magic of compounding.
Reinvesting your dividends will allow your shares to compound into more shares. Companies and brokerages actually make it really easy to do this, using something called a DRIP. The Dividend Re-Investment Plan (DRIP for short) automatically converts your dividend payment into shares without charging a commission; plus you sometimes get a discount of 2-3%.
You can enroll in the DRIP program by consulting your stockbroker. Just so you know, not every stock has a DRIP sadly; it is a decision the company’s management must make.
Dividend Growth Investing: A Case Study
Let’s go over a made-up situation to show you how powerful dividend growth investing can be.
The Dividend Growth Investor
Let’s pretend you bought $10,000 worth of Chevron shares on the New York Stock Exchange* at the beginning of 1999. Here is what you would have at the time:
- 243 shares of Chevron worth $41.03 each
- $296.46 in passive income over the next 12 months ($1.22 per share annualized)
- 2.96% dividend yield ($296.46 / $10,000)
*Note, the example had to be on the U.S. exchange since all these awesome financial calculators online only support U.S. tickers!
Fast forward 20 years. Your $10,000 investment is worth $53,762.49. Here is what you have exactly:
- 485 shares of Chevron worth $110.69 each
- $2,308.60 in passive income over the next 12 months ($4.76 per share annualized and split adjusted)
- 4.29% dividend yield ($2308.60 / $53,762.49)
- 23.1% yield on investment ($2,308.60 annual return on the original $10,000 investment)
Let’s take this in. After 20 years, you made more than 5x your initial investment mostly due to capital gains. But, your passive income stream grew even more, multiplying itself by over 7x the initial income amount! This passive income growth was due to two things: dividend pay raises and dividend reinvestments.
How to Start Chasing Dividend Income
Are you ready to get started? Here is the three steps you can take to put your newfound knowledge into action.
1) Pick a type of account
You first need to take the type of account into consideration. Dividends are taxable in Canada meaning you could benefit from keeping them in registered accounts (like a TFSA or RRSP). Deciding where to put your investments can be confusing, which is where this post on portfolio building can help. Here’s a small blurb from this article that is most relevant:
For those that don’t want to speculate excessively, this is a simple division of assets:
- TFSA: Canadian stocks & ETFs (to avoid foreign withholding tax)
- RRSP: Canadian, American, and International stocks & ETFs (because you pay less foreign withholding tax and likely have more contribution room)
- Unregistered Accounts: Canadian, American, and International stocks & ETFs, and any margin trading activities (to pay minimum taxes on dividends and manage riskier investments so you can claim capital losses if an investment goes badly)
Generally speaking, the tax rate on dividends is lower than “regular” income. There are many exceptions and rules, most notably regarding U.S. stocks. It is difficult to come up with a one-size-fits-all answer, and it’s best to consult a pro especially as your portfolio grows larger.
2) Choose a stockbroker
Of course, the broker needs to offer the type of account you wanted from step 1. You also definitely want a broker that offers a DRIP when pursuing dividends. Questrade has got you covered in this regard! It is a great low-cost broker for self-directed investors, and they have robo advisors as well. They also support registered accounts like TFSAs and RRSPs.
3) Decide between stocks and ETFs (or choose both!)
Traditional dividend growth investing involves picking individual stocks using some or all of the metrics we discussed earlier. However, it doesn’t need to be just stocks anymore now that ETFs have gone mainstream. Check out How to Invest with ETFs.
There are some index-tracking ETFs that focus on dividend income and have relatively low fees. As I write this, there are 18 ETFs in Canada that focus on dividend income and have management expenses under 1.0%.
While the ETFs do charge a fee that bites into returns, it is a low maintenance strategy. You do not have to look at individual companies, their payout ratios, and stuff like that. One thing you should look at with ETFs is the distribution you earn and the yield it gives you.
4) Keep on contributing and investing
The process doesn’t stop once you make your initial deposit and purchase your first stocks. The case we looked at above focused on a one-time investment and tracked it over 20 years. In reality, you will be (hopefully) making regular deposits, slowly picking up more dividend stocks and ETFs! Your passive income stream will grow at an even faster pace this way.
Summing it All Up
Hopefully, now you see the true power of dividend growth investing: the ability to create a stream of passive income that multiplies itself. Ideally, you would use a DRIP when possible for most of your working life to accelerate growth. Later in life, you could then take the cash to supplement or even fully substitute your income. This won’t happen overnight, but luckily time is on your side!