Last Updated on December 22, 2020 by Oddmund Groette
A typical question among investors is: Is it possible to live off dividends? If yes, how much do I need to invest to live off dividends?
Yes, you can live off dividends, but it requires a huge capital base because of the zero interest rate policies. Furthermore, you should calculate a margin of safety and have other types of income.
Making a living is the basics of surviving in a world where nothing comes for free. Sources of income may differ from person to person but income is the final need. The properties that come from the concept of active income is the stability and surety that comes with the ordeal. But we all want that little source of passive income that brings some extra money, perhaps even enough income to retire early.
Dividend-paying stocks are definitely a presumably easy way of earning that little extra money. But are they enough? Can you imagine living your life with just that? An income that may or may not come? They are beneficial, yes. But are they enough?
Yes, it’s true there are those who have somehow outsmarted the world and made it possible to make a living out of dividend-paying stocks but it should always be considered that dividends are risky. There are many external factors that allow or disallow dividend distributions.
Let’s look at what a dividend is, why dividends are risky, and why you should always plan with a margin of safety:
Going back a decade, there was a notion called a FIRE movement that gained extreme popularity among the millennials. The concept revolved around early retirement. We have a set image and number to what constitutes retirement – an old man/woman, working their whole life and then retiring at the age of around 60 to 70. But millennials in the FIRE movement aimed for retirement by the age of 30-40.
FIRE stands for Financial Independence, Retire Early. The main aim of the movement was to save and invest extensively about 50-75% of your income and retire early to do what you want. Basically live a happy life where you do the things you want and love to do. The concept, however, is not about sitting ideal or sipping Hawaiian punch on the beach. It is about working limited to a part-time job and not stopping altogether. It’s about spending your time as you please! Dividends are what push positively towards the FIRE movement as a way into early retirement and scaling back to less work in the future.
It shouldn’t come as a surprise to anyone that in order to support a life you need a steady flow of money. In order to pay expenses, you need income. And to earn income, you need to work. That’s the basic line that defines a normal life. You work, you earn, you pay, repeat. But as a person saves and goes on expanding their fortunes, it’s okay to find an extra source of income. However, it’s almost impossible to replace your salary or compensation unless you really have a big nest egg.
Dividends in this very case are no income. By definition, it’s a capital distribution of your wealth from the company to a person as an individual. Moreover, it’s nowhere near being stable or guarantees the next one. By labeling dividends as income, many investors do themselves a disfavor. It’s a highly unstable “income” that could be cut or eliminated in a recession.
It’s not just dividends. Nothing, in reality, is a sure thing. A fixed salary isn’t even a fixed amount. There are always gonna be factors influencing any kind of monetary inflow. Treasuries are probably the only monetary entity that is even close to being a sure thing. But the basic rule applies- the bigger you risk, the more you get, so are the chances of loss.
The stock market has been in an ever so fluctuating state, giving trading and investing opportunities to millions, but at the same time generating problems in predicting future returns. Moreover, it is a common misconception for investors to compare dividends with a coupon. The difference is that in the case of coupons, companies are obligated to pay but with dividends, there is no such compulsion.
Dividends heavily depend on the company’s net profit and can’t possibly be taken for an income, especially when a company keeps a steady and regular record of dividend payments. However, there are factors like low growth, low inflation, low productivity, low rates that can contribute to failing prospects for future returns.
Any decision that affects the cash flow in your life should always be taken after heavily considering your living expenses. Calculating your monthly or annual expenses should be the first thing one should do before risking funds into any form of investments that reap potential returns.
Even in the FIRE movement, it was majorly about scaling back the expenses to further into early retirement and keeping minimal work in older age. Dividends are one of the primary incomes for some investors but mind you, it should not be the only one. So once you procure the average number for your living expenses then strategize according to your needs.
Having established your annual living expenses, it’s easier to establish the risks you need to take in order to fulfill your goals. The basic rule is again the same, the more capital you have to invest, the more potential returns you can expect in the form of dividends and capital appreciation when it comes to stocks. Dividend-stocks rely famously on the dividend yield. For instance, the current dividend yield of the S&P 500 is 1.62%. So in order to make 50,000 USD a year, you need 3.1 million USD. Mind you, by constructing a portfolio of stocks with a higher dividend yield than the S&P 500, you might take on higher risk.
Being the most obvious probably, but having a safety net is the most important aspect in both everyday lifestyle and expenses. Make it as your thumb rule to have more dividends and income than you actually need. Moreover, check the stocks you are planning to buy, there is no point in investing in risky stocks. Check the average history of a company by their earnings, profits, debts, and dividends before investing in their stocks. Moreover, do not go after high yields, why? Keep reading.
High yields do look great in numbers and yes are profitable for the temporary income from dividend stocks. But a surge in dividend yield could be a red flag. It reflects often directly on the company’s growth. Take EMD for instance, Western Asset Emerging Markets Debt Fund, which has a relatively high yield and has been a popular investment vehicle for dividend investors. But the share price of the fund hasn’t gone anywhere for over a decade. You had an “income” stream from the dividends, but negative capital appreciation and huge underperformance compared to the S&P 500.
Receiving dividends could be good and in many ways reflects well on the company. However, a high yield of paying dividends can reflect on the lost value of capital. Thus in the light of receiving higher dividends, dividend investors get distracted from capital gains. Always make sure you look at the potential total return when you analyze a stock and don’t fool yourself by your dividend bias:
Instead of focusing on the amount transferred from your investment account to your cash account, the goal should be an effective way to compound the money. Therefore, quite frequently investors forget in the course of dividend payments, the importance of capital earnings, growth, and multiples. It’s important to understand, a company that can compound your earnings is a lot more beneficial than a dividend payer. In the case of well-planned compounding, an investor can sell shares to create income.
Like dividend yield, the dividend payout ratio tells you a lot about the company. To live off the dividend you want to see dividend growth. Going with analyzing and keeping track of the payout ratio leaves lower chances of error when picking a stock to invest in. For instance, a high payout ratio of a company’s stock dividends is generally considered a matter of concern, especially if the ratio is above 70%.
The reason being a high payout ratio to be a tad concerning is that it reflects poorly on the company’s plans for its future growth and potential returns in the future. A smart investor strongly knows the value of compounding and increased profit that comes with an increase in capital value. A high payout ratio suggests that the company is lacking in retained earnings and pouring money on dividend payments. Although a lower payout ratio suggests lower-income through dividends, a 50% or less ratio is more feasible in the long run.
Moreover, a high payout ratio might indicate the dividend might be in jeopardy. Why? Because the dividend must in the long run be covered by earnings and cash flows.
There was a study performed back in 2017 by the name of Do Stocks Outperform Treasury Bills? by Hendrik Bessembinder. The study brought the fact that the top-performing, four percent of the listed companies were responsible for the net gain of almost the entire U.S stock market since 1926. As for the remaining stocks, they collectively matched the Treasury Bills.
In laymen’s terms, this means that out of the entire listed stocks, 96% of them would come back similar to the Treasure Bills during their listing. With such steep odds, it’s pretty easy to come to the conclusion why stock picking is not as easy as it may seem.
It is a hard fact that dividends are of unsure nature but they are dynamic. But it completely depends on the company’s profit. So if a company endures a loss, it may choose not to pay dividends reflecting negatively on your “income”. And it’s okay for the companies not to pay dividends in the case involving losses since they are not obligated to dividend distribution.
Saving in mutual funds and ETFs are highly beneficial if you plan to sell units when you are in need of capital. A fund reinvests the dividend it receives and puts it right back to work. If you want to invest yourself, go on to diversify when reinvesting. You can choose to purchase both actively and passively managed funds, and by doing so you most likely reduce the possibilities of picking the wrong stocks.
History indicates women have been better investors than men. They make fewer transactions, invest more in mutual funds than individual stocks, and follow their investments much less than men, thus minimizing behavioral mistakes. They are not trying to be smart. The conclusion is simple: work, save, invest, and “forget” about it. The simpler you make it, the more likely you get better returns. Don’t try to outsmart the market.
As much as working consistently brings productivity and a sense of achievement to many, it is also a basic long term survival hack. No matter how much-strategized investments you have with great returns, nothing is sure, not even life itself. So for any reason whatsoever, imagine running out of money at the age of 60 and not have worked for the previous 10 years. The source of any further income won’t come easy and there would be even fewer employers interested in hiring someone unemployed for the past decade. So keep working even if it’s part-time or at scaled back hours. Make sure you are always improving your skills.
Yes, you can live off dividends, but is it smart? To have passive “income”, you need a big nest egg, for most people several million USD. Thus, your main goal should be to compound the most effectively. You want to create a big nest egg, and to start investing in dividend stocks might not be the best option. You make yourself liable to picking the wrong stocks, and by picking stocks you are more likely to make behavioral mistakes. For most investors and savers the best option is to buy mutual funds and make sure you save regularly. Then “forget” about it. When you later need cash, you sell shares or units.
Make sure you read our other articles about dividend investing: