Last Updated on April 26, 2022 by Rational thinking
An additional source of income is what motivates the need to start investing in dividend stocks. Many dream of making a living by receiving dividends, and the good news is that it’s possible. Anyone can make money on dividend stocks if they have a rational plan. This article looks at how to make money on dividend stocks.
In order to make money on dividend stocks, you need to start saving early and reinvest the dividends received. Furthermore, you also need to be a bit lucky when you start saving: you need good real returns (after inflation) to successfully make money on dividend stocks.
Moreover, there are many studies conducted based on an exponential amount of data that proves the significance of a consistent savings rate, robust investment returns, and a good timeline/horizon on accumulating a great amount of wealth in the long haul. Additionally, you need to be a bit lucky with the sequence of returns, something that is described in this article about dollar cost averaging vs. lump sum investing.
A lack in the vision for long-term goals and benefits from dividend stocks is generally noticed in young investors, who are just starting out. And when such investors look into the dividend yield of companies like the S&P 500 which is currently at 1.62%, they disregard it as too low or not enough to make them more money.
But take it as a thumb rule that dividend yield does not tell enough about a company to make an investment decision.
Regardless of a low yield, investing in dividend stocks is a proven method of growing into accumulating more money. It is important for every investor to understand that there is nothing like a set of guidelines that dictates a way into becoming rich through dividend stocks. There are many factors influencing the volatility that comes with building an investment portfolio with dividend stocks.
Factors influencing dividend stock investing
There are typically five factors behind successful dividend stock investing. The factors mentioned below play a significant part in influencing the long-term returns of an investment.
The savings rate is your baseline
By definition, the savings rate is expressed as a ratio or percentage that accounts for the amount of money kept aside in the form of a safety net meant to be used after retirement.
In technical terms, savings come from a point of choice where a person reduces their current expenditure in terms of favoring future consumption. So by increasing your savings rate, you are simply delaying the time preference for spending money.
In order to save you need to delay gratification, something which many finds hard:
The money saved and accumulated can be put to better use or invested in order to reap higher returns in the future. There are investments like mutual funds, bonds, stocks, etc that can be used to further invest for great returns.
However, there are many economic factors like market conditions along with an individual’s character traits that can heavily influence the savings rate.
The time horizon- the longer you save, the better
The total amount of time that an investor decides to hold onto a security, a mutual fund, or a portfolio is known as the time horizon.
In technical terms, it is also known as the investment horizon. A very good example is to consider a young investor who has barely started investing has the ability to expand his time horizon to decades, but then again it would be an individualistic trait.
Some argue the biggest asset of Warren Buffett is not his investment skills, but his patience and long-term mindset. He has made around 99% of his wealth after he turned 50, and 97% after he turned 65. How is this possible?
The answer is compounding. In the bond market, this is called the interest on the interest. As you reinvest the earnings/profits, you have a bigger investment amount every year. Thus, we can argue the return starts “snowballing”.
The chart below illustrates the compounding effect:
The chart shows how 10 000 grows to 506 000 after 50 years with an 8% annual return. The value after 25 years is around 70 000, while it grows to 506 000 during the last 25 years. Quite a difference time can make!
As a matter of fact, if you can get a decent return on your investment the time spent in the market is the most crucial factor in wealth creation, not the return itself.
Let’s assume you manage to get a 12% annual return on your initial 10 000 investment. How long does it take to get the same 506 000 as you managed to get after 50 years with an 8% return?
The answer is 35 years. However, a 12% annual return is above the stock market’s return, and you need to be a very skilled investor to increase the return from 8 to 12%.
The lesson learned is that you should start saving as soon as possible. The earlier you start, the better. You will need to save a huge part of your income if you delay saving until you reach 40 years of age.
Your investment returns are important
More commonly known as financial returns, they are defined as the earnings gained or lost over a certain amount of time on investment. Financial return can also be defined as the change in the value of the currency that has been invested for a significant amount of time.
It’s important to distinguish between average returns (arithmetic returns) and compounded returns (geometric returns – CAGR): arithmetic vs geometric returns. This is important because of the sequence of the returns.
This is best illustrated with an example. Let’s assume you have the following sequence of annual returns:
10 -2 5 25 -15 30
This sequence has an average gain of 8.83%. However, the CAGR is slightly lower at 7.7%.
If you started with 10 000 in year 0, you have 15 634 after six years with this sequence of returns. This means your smoothed returns are lower than the arithmetic average returns.
The tax rate
If you invest in dividend stocks you obviously receive dividends. Even though the dividends are a distribution of already taxed profits, most countries treat it as taxable income.
Thus, the same income is taxed twice. No matter how illogical this is, it’s a fact of life that must be dealt with.
The reason why dividend stocks have outperformed non-payers is that the dividends are reinvested at the same time when it is paid out.
If your stock is trading at 100, and you have 100 shares and the company pays 3 dollars in dividend, your receive 300 dollars in dividends that you must reinvest into the same stock (or in practice, you can invest in any other stock – it’s up to you).
However, if your investment account is in a taxable position, you might have less to reinvest, or perhaps more taxes to pay (DRIP is done without a deduction for taxes). If your tax rate is 25%, you can only reinvest 225 dollars.
Taxes are a real headwind over many years. Read this article to see the difference:
Make sure you invest via a tax-deferred account. This is crucial for dividend investors, more so than investors investing in mutual funds (where the dividend is reinvested tax-free internally in the fund).
The last factor influencing your returns is the change in the valuation multiple over our holding period. This is also important in terms of dividend investing, but of less importance as time passes.
Over really long periods of time, let’s say 25 years, the valuation multiples are of less importance.
Let’s make an example:
If your stock earns 4 dollars a year and trades at 25 times earnings, you pay 100 per share today. If earnings grow 7% annually for 25 years, the earnings are 20.3 after 25 years. Assuming a PE of 25, the share price is 507.
However, if the earnings multiple has dropped to 18, the share price is 365. The CAGR drops from 7 to 5.3%.
If we assume 30 years, the CAGR drops to 5.6%, slightly less. The longer you stay in the market, the less important is the earnings multiple contraction/expansion.
However, it matters if you reinvest your dividends at a P/E of 10 or 20. The higher the valuations, the more you pay for each unit of earnings.
Most investors are wrong in always wanting their holdings to rise in value. If you are a net buyer in the future, you don’t want to pay more for the earnings. You want to pay as little as possible. The only time you want a high earnings multiple is when you sell.
Likewise, a dividend is paid out from the equity/book value, and most likely reinvested at a multiple to the book value. As Warren Buffett says: you take a beating by doing so. For an explanation, read this article:
Making money on dividend stocks
Now for the main question, how to actually make money off dividend stocks. As long as you understand the significance of the above five factors, it will be relatively easy for you to figure that out.
Considering a steady dividend yield and an average income, adjusting the savings to a higher percentage with a lower time horizon can reap an average amount of returns.
The shocking part is in a similar scenario in terms of similar income and consistent dividend yield but with a lower than average percentage of savings rate and an extended time horizon, the timeline really compensates for the lack in the savings ratio.
In the same trail, with an increased rate in savings as well as time horizon, it becomes easy to interpret the heavy nest egg of returns an investor can accumulate for his total returns.
How to make money on dividend stocks – conclusion
To conclude, making money for a relaxed future is obviously a dream of many. In order to do that, you foremost need to understand the importance of time, but also the savings rate, returns, your tax rate, and the valuations you pay for your earnings. And, as mentioned, you need to be a bit lucky with the sequence of returns.
In order to create a strong portfolio, it is also important to keep in mind the risks that come with investing in dividend stocks and how to minimize them. The more knowledge you have, the more power you hold for dealing with risk factors that at times you cannot control.
If you want to read more about the pros and cons of dividend investing, please check out this link:
And one last piece of advice in the end:
Don’t stop working altogether. We belong to an ever-changing world, so even if you have a great source of passive income, it is always beneficial to keep working even if it’s part-time. How to make money on dividend stocks require that you make money to invest.