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Passive Income Myth: Passive Income Dividend Investing

Passive income dividend investing involves much less time and risk than other passive income strategies.

Dividend investing may be one of the only true forms of passive income investing I’ve seen in more than 20 years as an investor.

I started my professional career as a commercial real estate agent and developer before getting started in income investing through rental real estate. As an investment analyst for the past decade, I’ve worked with investors in stocks, bonds and startup investing.

More recently, I’ve seen the income potential in blogging and online stores through the five websites I own.

Income dividend investing has them all beaten for truly passive income.

I still love the income I receive from rentals each month and my online assets keep growing every year…but none of them offer truly passive income potential.

Dividend stocks have historically beaten other groups in the stock market and the consistent cash return can be an excellent income source for people living off their investments. There are risks involved in passive income dividend investing though and getting started can be confusing with so much information available.

That’s why I created this guide, a step-by-step for passive income dividend investing, to help you understand how to pick the best dividend stocks for your investing goals.

Passive Income Dividend Investing Basics

Passive income is technically an income you receive on a regular basis that involves little or no effort on your part. You get paid every month, quarter or year but don’t participate in management or contribute work in the investment.

Despite all the promises you’ll find on the internet, very few investments offer absolutely passive income. Most passive income sources require some level of management or at least some regular analysis.

While income investing through dividend-paying stocks is the most popular among investors, there are other investments that offer good passive income potential including master limited partnerships (MLPs) and real estate investment trusts (REITs).

I’ll focus on dividend income investing here and leave MLPs and REITs for another post on income investments.

Running a business means regularly making the decision between investing profits back into the business for growth or cashing out some of those profits to the owners. For smaller companies, the opportunities for growth outweigh the short-term benefit of a cash return to owners.

As the company matures and growth opportunities become scarcer and the scale shifts to favor returning some of the cash to owners. When a company has issued shares, it returns that cash in the form of dividends to stock owners.

For most companies, dividends are paid every three months according to a fixed amount for every share you own. There are companies that pay dividends twice or once a year, or even twelve times a year but these are the exception rather than the rule.

Investing in these companies that pay regular dividends is the most popular passive income strategy among investors, especially those on a fixed income. Depending on how much you have invested in dividend-paying companies and how much the company pays per share, you can build a strong income without having to do much of anything.

For example, the SPDR S&P International Dividend ETF (DWX) pays 5.4% a year in dividends, paid quarterly. That means you would receive a payment of $1,350 every three months for a $100,000 investment in the fund.

Beyond the regular cash payment, investors earn a return from the stock appreciation in dividend investing as well.

  • Passive income investing is receiving regular cash flows without the headaches and hassle of managing your investment
  • Companies decide how much they are going to pay out in dividends each year
  • Dividends are usually paid every three months but may be paid monthly, semi-annually or once a year

How to Set up a Passive Income Dividend Strategy

Understanding some of the basic terminology will help us get started in setting up a passive income dividend investing strategy.

A stock’s dividend yield is just the annual dividend divided by the price of the shares. If the company pays a $1 dividend each quarter ($4 per year) and the stock price is $120 then the yield would be 3.3% ($4/$120 = 0.033).

The dividend yield is the cash return the stock is going to provide every year. It may increase or decrease slightly depending on movement in the share price but most companies try to maintain a consistent yield.

Be wary of dividend stocks with super high yields above 8% annually. Some companies like MLPs and REITs pay out higher yields to keep tax advantages but most companies pay a dividend yield between 1% and 4% a year.

If the company is paying out everything in dividends, it won’t be able to grow as quickly or at all. A very high dividend yield may also mean that the stock price has plunged but management has not yet cut the dividend payout to investors. This usually means a dividend cut is coming and the stock won’t offer such a high yield for very long.

The payout ratio is the percentage of a company’s profit or net income it pays out as dividends. If a company earns $20 per share over a year’s period and pays out $12 in dividends then the payout ratio is 60% ($12 divided by $20 = 0.60).

The payout ratio is important because it reflects how much the company is keeping back to reinvest in growth. A company that pays out nearly everything in dividends may not be able to grow the business, or the stock price. I generally limit my dividend investing search to companies that pay between 30% and 70% of their income as dividends. This ensures that management is serious about returning profits to shareholders but also wants to keep the business growing.

Dividend stocks in the S&P 500, the largest U.S.-based companies, pay an average dividend yield around 2% though it ranges from less than a percent to well into double-digit yields. Stocks with a yield below 2% probably will not be very attractive to a passive income dividend investor while stocks offering yields above 10% may not be able to support the payment. I would stick with stocks that pay between 3% and 6% on an annual basis.

There are more than 800 publicly listed companies that trade on the New York Stock Exchange, the Nasdaq and the American Stock Exchange that pay dividends. I have made a living as an investment analyst, telling people which are the best dividend stocks for your portfolio but the fact is that it isn’t really that difficult to pick good investments if you take a long-term view.

Finding good dividend stocks for your passive income strategy starts with a simple stock screener.

A simple stock screener tool will get you started with basic dividend fundamentals to search. I like starting with dividend stocks that yield over 3% with payments for at least five years. You can check dividend payments on Yahoo Finance by clicking on the Historical Prices link in the left-side menu.

Passive Income Dividend Research

From the initial list, I also look for companies that pay out between 30% and 70% of their income as dividends. The payout ratio is also available on Yahoo Finance by clicking Key Statistics and then scrolling down to the lower-right under Dividends & Splits.

Using just these two criteria is still going to leave you with a large list of potential dividend stocks in which to invest. I generally also limit my search by companies with a market capitalization, the value of all shares, of at least $5 billion to make sure I am looking at large companies with some financial power behind them.

I like to compare the price-to-earnings (PE) ratio and operating margin among stocks within each sector and industry. The PE ratio is just the stock’s price divided by the company’s net income over the last four quarters. It is a crude measure because management often uses several tactics to manipulate earnings but it is easily understood and can give a passable idea of value.

The operating margin is the earnings after operating expenses divided by sales, a good measure for how well management is running the company. The PE ratio and operating margin are relative measures, meaning they are only useful when compared against the stock’s historical average or against other stocks.

This brings us to one of the most important ideas in passive income dividend investing, more important than picking individual stocks with high dividends, you absolutely must pick stocks from different sectors and industries.

Every company in the stock market belongs to an industry which shares a relatively common product type. Google, Yahoo and Facebook are all website companies within the internet information providers industry. Industries that share common characteristics are grouped into sectors like technology, healthcare or energy.

Passive Income Investing

The reason this is important, especially when building your dividend investing portfolio, is that each sector reacts differently to the economy and other market forces. The utilities sector reacts negatively to higher interest rates because cash flows to public utilities are relatively fixed while higher interest rates are generally a good thing for stocks in the financials sector.

Calm down, you don’t really have to become an economist to figure out how each sector behaves or to build a passive income portfolio.

The key idea here is that you need to make sure you have a good mix of stocks from each sector. That way, when the economy or news headlines are playing havoc with a specific sector, you’ll have stocks in the other eight to keep your portfolio steady.

The nine sectors are: consumer staples, consumer goods, energy, technology, healthcare, utilities, materials, financials and industrials.

This is really where Motif Investing comes in with the ability to buy a group of stocks for one commission fee. Buying all the stocks in a portfolio individually means spending hundreds of dollars in fees each time you invest. Put all your investment in one stock and you set yourself up for all the risk in that one company. With Motif, you can diversify cheaply each time you invest by buying a group of stocks all at once.

Another critical idea is that when you’re comparing price-to-earnings ratios and other fundamentals like the operating margin, you have to do it among stocks in the same industry. Measures like value and profitability can vary widely by industry. Only choosing stocks with a certain PE ratio or profitability above a certain percent is likely going to leave you with a portfolio of stocks concentrated in a few industries or sectors. This kind of concentration is great if you’re lucky enough to pick a hot sector but not so great when that sector falls and your entire portfolio crashes with it.

It can be a lot to take in but you don’t have to be an expert overnight. A simple strategy of picking stocks from a few criteria and from each of the sectors, holding them for at least five to ten years is generally best. Resist the urge to “buy-low and sell-high” or to listen to brokers with a hot tip.

Still not sure about how to pick dividend stocks? Check out this post on dividend investing strategies through investing themes to help pick groups of stocks rather than individual companies.

  • Dividend yield is the dividend amount divided by the current stock price. While the dividend amount does not change often, the yield will rise and fall along with the stock price.
  • Payout ratio is the percentage of the company’s profits it pays out as a dividend. Look for dividend stocks that pay out between 30% and 70% for good income but that keep a little back for growth.
  • Be wary of dividend stocks that pay yields above 8% because the payout might not be sustainable.
  • Make sure you invest in dividend stocks across all nine sectors to diversify your risk. Compare measures like price-to-earnings and operating margin across dividend stocks within the same sector and industry.

Passive Income Dividend Investing Tips

Just a few more tips here for choosing individual dividend stocks before we get to some ways to make your passive income plan easier and how to avoid some of the risks. The points here are general investing ideas that will help you get the most out of your portfolio, stock market basics that will help you reach your investing goals.

  • Make sure you hold at least 20 or 30 stocks in your portfolio and no one stock should account for more than 5% of the total value. That way, even a total loss in one stock will not devastate your investments.
  • Don’t forget dividend stocks of foreign companies for international diversification.
  • Putting all your money in stocks leaves you at risk of another market crash, no matter how diversified you are in different sectors. A well-rounded portfolio includes fixed income, real estate investments and other strategies.

Dividend Income Investing in Funds

Trying to pick individual dividend stocks can be confusing for investors and you have to make sure to invest across different sectors to diversify your portfolio. A solution to this is investing your money broadly in exchange traded funds.

Exchange Traded Funds (ETFs) offer a great way to diversify your portfolio with one purchase and are one step further into passive income territory. A fund manager invests in individual dividend stocks that meet the fund’s criteria, usually to mimic an investing strategy or a specific group of stocks.

Most ETFs invest in hundreds or even thousands of stocks, giving you instant diversification in all the companies but with just a single commission for buying the fund. You don’t even have to watch the fundamentals for each company because the fund manager will do it for you, buying or selling stocks that fit the fund’s criteria.

ETFs are like mutual funds but trade like stocks and are usually much cheaper. For passive income dividend investing, check out these three ETFs:

  • iShares International Select Dividend (NYSE: IDV) provides exposure to 103 companies in non-U.S. developed markets and pays a 4.9% dividend yield
  • iShares Emerging Markets Dividend (NYSE: DVYE) provides exposure to 102 companies in emerging markets and pays a 4.1% dividend yield
  • Vanguard High Dividend Yield (NYSE: VYM) holds stock in 435 U.S.-based companies and pays a 2.9% dividend yield

Returns to a Passive Income Dividend Investing Strategy

With bonds paying next to nothing on historically low interest rates, dividends have become the next best thing for income investors looking for stability and safety. While you’ll find newer companies that pay dividends, most are relatively large and mature corporations with less volatility that the average stock.

The chart shows how much of the return on stocks has historically been from dividends versus price return.

Passive Income Dividend Returns on Market

Dividends have historically accounted for about a third of the total return on stocks and sometimes as much as half of the return when the market tumbles. The change is mostly due to the volatility in the return on price appreciation against the stability in dividends. While price appreciation amounted to a bigger slice of the market return in the 90s, many investors didn’t have a chance to book those returns before the internet bubble sent prices crashing.

The lesson is that even when stock prices are soaring, don’t neglect a strong passive income dividend investing strategy in your portfolio. If those stock prices crash lower, you’ll be happy you stuck with dividend investing.

Check out the two reasons why I don’t worry about a stock market crash and stress-free investing.

Not only is dividend investing an important part of the overall return to stocks but dividend-paying companies have historically beaten other stocks on return.

Over the four decades to 2012, dividend-paying stocks that regularly increased their dividends returned 9.5% on an annual basis compared to a return of just 1.6% for stocks of companies that paid no dividends. Even companies that did not increase their dividend payment offered a 7.2% annual return over the period.

Dividend Stocks Returns

There’s a good reason why dividend stocks tend to outperform other stocks. Paying out a regular dividend requires cash management and spending discipline, something that a lot of corporate management lacks. The need to consistently pay and even increase the dividend means that management needs to be more selective of the projects it wants to support.

The favorite disclaimer in the stock market is that, “past performance is no indication of future returns.” That means you can’t look at past returns and expect to get the same thing in the future. That will always be true but dividend investing has consistently proven a strong strategy over other stocks and I’d bet that trend continues.

Over a long period of investing in dividend stocks, you should see between 2% and 4% annual return from dividends along with about 4% or 5% return on the share price. A cash return of 4% is likely not going to be enough to cover all your expenses if you are living off dividends as a source of passive income but it’s a return for which you really didn’t have to do much to earn.

Younger investors will want to reinvest their dividend payments to buy more shares, building the portfolio and potential income for the future. Older investors may need to gradually sell some of their shares to supplement dividend payments and cover living expenses.

Dividend Income Investing versus Bonds

Fixed income bond investments are a popular source of passive income as well and benefit from safety in payments. Bond investors get paid out before stocks and the investments offer a fixed payment over the life of the bond.

Dividend investments carry two distinct advantages over bonds.

  • Rising interest rates drive down the prices of bonds since their coupon rate is fixed but generally denote a healthy economy, a fact that helps push stock prices higher. This means that dividend stocks do well when interest rates increase while bond investments may not do as well.
  • Inflation will also decrease the value of a bond since payments are fixed. Dividend stocks offer a better hedge against inflation than bonds since companies can pass some of the higher costs through to customers.

Risks to a Passive Income Dividend Investing Strategy

The biggest risk to a passive income dividend strategy is that the company will cut its dividend payment or will not have the cash flow to grow the dividend. A dividend that doesn’t grow over the years will not help you much against the constant loss of inflation and lower purchasing power.

passive income dividend investing stocksWith the drop in oil prices at the end of 2014, many energy companies rushed to protect cash flow and cut their dividends but payments in other sectors like healthcare remained stable. Holding a diversified group of dividend stocks, across different sectors will help avoid problems related to larger economic issues.

Choosing stocks of companies with advantages in size and scale also helps avoid problems with dividend growth. It’s not to say that giants like General Electric cannot fall on hard times but the company is less likely to run out of cash than companies that don’t benefit from worldwide scale and billions in cash reserves.

Another risk to your passive income dividend investing strategy is the difference between qualified and non-qualified dividends. The distinction isn’t well known among investors but can save you a ton of money at tax time.

Qualified dividends are taxed at a lower rate, and may be tax free for investors in lower income brackets. Non-qualified dividends are taxed at your personal income rate which can eat into nearly half the return for high-income investors.

To make sure your dividends are ‘qualified’ you need to hold the shares for at least 61 days within the 121-day period around the date when the dividend was declared by the company. This usually isn’t a problem for most investors but you’ll want to take note if you buy and sell your dividend stocks frequently.

True Passive Potential: Passive Income Dividend Investing

Dividend investing is one of the few truly passive income strategies I’ve seen in two decades of investing. Unlike blogging and online stores, income investing will begin to cash flow almost immediately as companies pay out their regular dividends and distributions. Unlike real estate investing, income investing takes relatively little ongoing work to maintain a stream of income.

Start-up costs to an income investing strategy are the principal drawback compared to other strategies. A cash yield of 5% is considered good for a diversified mix of dividend stocks, MLPs and REITs but would still only provide an annual income of $5,000 on a $100,000 portfolio.

That is prohibitively high for some people and much higher than the amount you might put down on real estate or the upfront costs to start a blog. The upside to passive income dividend investing is that there are no ongoing costs other than regular deposits to your account to grow the portfolio.

The time commitment required for a passive income dividend investing strategy is very low compared to other passive income strategies. You can spend hours analyzing dividend stocks and other investments but it really isn’t necessary. An annual check on the business fundamentals for each investment is more than enough and some investors may not even choose to do that.

Income momentum is strong for passive income investing because your dividends and distributions can be reinvested into the investments until income is needed to pay expenses. Do this for a couple of decades and the income you earn from prior dividends can be substantial.

Besides reinvested payments, companies generally try to grow their payments as business improves which can boost your dividends significantly over the years.

Continuity is also an advantage of income investing. As long as the companies you choose do not go bust or you do not sell out of the investment, you should continue to see regular payments throughout the year.

The scale below presents my passive income potential for income dividend investing. Each of four factors is scaled in reverse with 1 being the worst or the most unfavorable to a true passive income investment. Since startup costs are relatively high for income investing, it receives a 3 on the scale, not quite as unfavorable as bond investing since some leverage is available.

Time commitment is low for income investing with a (8) or the lowest next to investing in fixed income bonds. Income momentum and continuity are also very good for income investors and helps to make it the most passive income strategy overall.

Passive Income Potential Income Investing

Overall, passive income dividend investing is a good source of passive income and a critical part of your investment portfolio. Even if you don’t need the current cash payments from an income portfolio to pay expenses, the regular cash yield can be reinvested to grow the portfolio and secure a stronger income in the future. While income growth may not be as high as business-related strategies like blogging or real estate, the risk and time commitment required is much lower.

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Comments

  1. Thank you for such an insightful article! I am currently a college student with very little money to my name and I work a part time job during the school semesters. I am interested in developing a passive income portfolio to grow what cash I have as well as to gain experience in financial management. From what I understand from reading this article as well as my research on the internet, I would need a decent sum of money in order to receive a decent payout from dividends in the stock market. As of right now I’m looking for the best way to invest around $500. I was wondering what method you would recommend for someone starting small in order to invest that $500 effectively and generate passive income? Thanks!

    • Hi Jaron,
      If you’re looking for immediate passive income, I’d say your best bet is through peer loans on Lending Club. Peer lending pays higher returns than bonds but generates more cash than stocks. Make sure you reinvest the investment part of your monthly income even if you are spending the interest part, otherwise you will have spent down the investment once the loan is paid off. A better strategy would be to reinvest all the monthly payments to grow the portfolio. Even a 10% annual return on $500 isn’t going to amount to much but grow it over ten years and you’ll have a nice stream of income.

      Check out these Lending Club investing strategies for different types of investors for more detail.

  2. Wasn’t lending club investigated for fraud (or was that another P2P site?), issues I have with P2P are:
    1) I hear taxes are a bloody nightmare to put together.
    2) Your money is tied up and not liquid
    3) You are taxed at your standard rate, no capital gain tax like dividends.

    • Thanks for the note Alan,
      1) P2P is taxed as income, the same as with non-qualified dividends. The peer lending site will issue a tax statement each year just like any investment account. It all goes on one line so isn’t difficult.
      2) Most peer loans are only for three- or five-years. I see the difficulty of selling your investment as a good thing because it keeps investors from poor investing behavior like panic selling that costs them so much money. If you’re investing for the long-term, 3-to-5 years isn’t long at all.
      3) The best way to invest in p2p and dividend stocks is in a retirement account, that way you don’t pay taxes on the annual income. Hold growth stocks in a regular investing account and all income-producing investments in an IRA or SEP.

      Lending Club was investigated but it was only a small group of management that was involved and they have left the company. They changed the date on some loans that were sold to an investment bank to qualify for resell. It didn’t affect the loans any but was a breach of confidence. The new CEO has put in place new rules so it won’t happen again.

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