4 Reasons Why Successful Investors Choose Dividend Investing

The following is a guest post from Mike, MBA and author of The Dividend Guy Blog where he writes about dividend investing. He is also the author of the book Dividend Growth: Freedom Through Passive Income US Edition.

“You can make a lot of money from the stock market.”

I’m sure you’ve heard something similar to this in your lifetime. You probably got all excited, opened a brokerage account and started investing. You were already thinking about the nice house you will build from your investing profits or the vacation to Hawaii that would be paid for by selling a few good stocks. This was until you received your first statement showing that you were losing 10% of your cash. Your dreams faded away and you then realized that making money off the stock market is not that simple. So… can you really make money from the stock market?

I’ve been investing for several years and meet with investors regularly as part of my work. The most successful investors I have met over the past 10 years all have their own investing strategies and their little trading secrets. But they share one thing in common: their love for dividends. After reading another guest post on FMF called “Dividend Investing is Not the Perfect Solution for Yield”, I wanted to share with you the reasons why successful investors choose dividend investing to build their core portfolio.

How About Making Double Digit Returns with Your Investment?

Would you believe me if I told you buying Coca-Cola (KO) will lead to a double digit return year after year? This is the case of several dividend paying stocks as they use the power of dividend growth to reward their investors. Let’s take a look at the KO example and you’ll understand. Let’s start with the KO dividend graph over the past 10 years (dividend payout is adjusted considering 2:1 split in August 2012). (Click image to enlarge.)

Since 1971 Coca-Cola has increased its dividend yield at an annualized rate of almost 10%. This means you double your dividend yield every 7 years or so. Back in 2003, the stock was trading around $22.00 (price value adjusted with the 2:1 split in 2012). The dividend yield back then was about 2%. Today, KO is now paying a quarterly dividend of $0.255 or $1.02 per year compared to a $0.11 per quarter back in 2002. The $1 dividend currently paid on an original investment of $22 per share represents a 4.64% yield.

If you had bought 1000 shares of KO back in 2003, you would have paid $22,000.

The share is now trading around $37.00.

Your investment is now worth $37,000. That’s a 68% investment return.

In the meantime, you have also received a total of $7,220 in dividends (or 32.81% total dividend return).

So in 10 years, you would have made a total profit of $22,220 on an investment of $22,000. That’s a 101% investment return for an average (not annualized) return per year of 10.1%.

The interesting part is that a third of your return is coming from the dividend. On top of that, you are now holding an investment paying a 4.64% dividend yield based on your cost of purchase. In another 10 years, chances are that you will be showing a 10% dividend yield if you keep holding this stock.

The Best Sign of a Solid Business Model

Besides the power of dividend growth, the fact of paying a steady dividend is a great sign of a solid business model for investors. When you find a company that has been paying a dividend for the past 10, 20 or even 50 years, you have a great indication (while not being a certitude) that the company business model is sustainable.

Since dividends are paid from after tax revenues, the company must ensure that it constantly generates a higher profit per share (followed with the Earning Per Share ratio) to be able to increase its dividend accordingly. A long dividend increase history shows you a responsible management team and a business model being based on solid assumptions.

As an investor, you can also easily follow what the company is doing with its profits as a part of them are returned back to you. It ensures that they don’t “waste” their money on irrelevant projects. By looking at the Dividend Aristocrats or Dividend Champion lists, you find solid and sustainable businesses that will continue to be in business for several years to come.

The Best Protection against Yourself

Do you remember how you went through 2008? What happened when you saw your stock portfolio drop by 30%? Did you panic? I can tell a big part of you did since everyone was selling on the market to go back into cash and bonds. Then you woke-up in 2013 and found that most of your losses had been recovered… but this is all on paper since you sold your stocks in 2008 and you will never see this money again.

Dividend stocks are usually less affected by major drops in the stock market. For example, I pulled-out five dividend growth stocks and compared them with the S&P 500 from Jan 1st 2007 to Dec 31st 2009:

• Chevron (CVX): +6.92%
• Procter & Gamble (PG): -2.29%
• Coca-Cola (KO): +22.71%
• Johnson & Johnson (JNJ): -1.21%
• McDonald’s (MCD): +40.24%
• S&P 500: -21.57%

(Click image to enlarge.)

This is a great example to show you that if you had held a dividend portfolio in 2008, you would have probably lost money but a lot less than by holding the S&P 500 index for example. During a stock market crisis dividend stocks usually:

#1 Continue to pay their dividend which reduces your loss

#2 Hold more investors on board which avoids massive stock value losses

#3 Prove their business models are among the most solid on the market

Think About Retiring With a Smile

In my opinion, I think the two major challenges we will face regarding retirement planning in the future is inflation combined with an aging population. Back in the 60s, we didn’t expect to live past 70 or so. Today, we retire around 60-65 and expect to live at least to 85. This means that you need a lot more money on the side to keep up with your lifestyle.

The problem is that once we retire, we don’t want to take risks anymore. We usually turn to CDs and bonds. Now that those investments don't even cover inflation, how can you expect to live 15 years longer with a portfolio that loses purchasing power each year?

By choosing stocks growing their dividend payout faster than the rate of inflation year after year, you can build a solid portfolio and live from your dividend payouts almost indefinitely. Your lifestyle won’t be affected by inflation since your dividends will increase every year to cover the rate of inflation.

Dividend Investing is the Way

On top of these 4 reasons why dividend investors are sucessful, I personally favor dividend investing for 3 other reasons:

#1 Dividend Investing is Easy to Understand – A prestigious financial background is not required if you follow simple and time-tested investing principles.

#2 Dividend Investing is Perfect for Lazy People – Not much time is required once you learn the basic principles of how to select your stocks.

#3 Dividend Investing, if done right, equals Receiving Money Monthly! – Dividend payouts are regular.
 
It’s obvious that simply buying dividend stocks is not enough to guarantee a good investment return from your portfolio, but I truly believe that this is the right place to start if you want to make money from the stock market.

Disclaimer: I own shares of KO, JNJ & CVX

Comments

[My Financial Independence Journey]

I abandoned index funds for my taxable accounts and moved towards dividend growth investing about two and a half years ago. Overall, my experience has been very positive. My capital appreciation matches that of the S&P500 index and my dividend payouts exceed those of the index.

The downside being that dividend growth investing takes a bit of work. You do have to be committed to doing some research on stocks and there is a bit of a learning curve. I don't think that these are substantial hurdles, but if thy aren't things that you're willing to commit to, stick with index funds.

[Mike @ The Dividend Guy Blog]

@My Financial Independence Journey,

I started dividend investing around the same time as you, but I did it for a different reason. I used to seek growth through undervalued stocks and penny stocks. While I was successful at first, this strategy required a lot of time. I find dividend investing less time consuming. It's more work to pick a stock but chances are that you will be holding the same position for years.

@iPhone App,

cash flow is easily generated from a dividend portfolio though as you simply have to manage your payouts to receive money each month. You are right, the dividend payout ratio is one of the most important metric to follow as you want to make sure that the dividend is sustainable.

[Oliver @ Christian Money Blog]

I'm not a dividend guy but you've done a nice job of explaining the basics of dividend investing. The one thing you maybe didn't highlight is the increased time it would take to manage a portfolio of individual dividend stocks compared to a purely passive index approach.

I do see that you previously spent more time with a former investing strategy, so maybe that is why you didn't consider the time comparison to a purely passive approach.

Thanks for an informative post!

[Mike Collins]

Thanks for the great article! I’ve become a big fan of dividend-paying stocks for pretty much the same reasons you mention above. Companies like Coca Cola that have been increasing their dividend for 50 years are a safe bet to continue that policy for the foreseeable future. They also tend to be a bit less volatile and often come with a moat to protect their market share. I only recently started buying individual dividend stocks (I’m still a believer in index funds too) but the goal is to create a stable stream of income that I can rely on without having to worry about selling shares.

[Paul]

The mathematician inside me is screaming. The article cites an example of gaining 101% in 10 years, and then says that is an average return per year of 10.1%. Ha. That totally ignores the effect of compounding. The real average return per year is 7.23%.

[Apex]

To piggy back on top of what Paul said, the citation of the dividend yield based on the money invested 10 years ago of 4.64% and then saying that in 10 years the yield could be over 10% is the same problem. This is about a 9% annualized increase in the dividend. So if you continue with that same 9% every year what do the numbers look like if you keep reporting things based on your initial investment. After 20 years the yield is 11%, after 30 years the yield is 27%, after 40 years the yield is 63%, after 50 years the dividend yield is 149%, after 100 years the dividend yield on the original investment is 11 thousand percent.

To show what happens when you report average yields rather than compounded yields. In this example if the stock returned the same annualized yield every year for 20 years the average yield would be 15%, for 30 years the average yield would be 24%, for 100 years the average yield would be 1,075%. But yet the compounded annualized yield would be the same 7.23%

Does it make any sense to report yields and returns like this? No it does not. It misleads people into believing the numbers are better than they are. This works because the time frames used here are only a decade so the increases in returns are small enough that the returns seem just pretty good rather than excessive. But when you take this means of reporting returns out into long time periods the large mathematical mistake becomes apparent.

Please do not report returns like this. Your intro says you are an MBA so you know this is not a valid way to report returns. The article and your argument has merit. Why detract from that by using misleading statistics to embellish the point?

[Mike @ The Dividend Guy Blog]

@ Paul and Apex,

I've mentioned in the article that I've used average return and not annualized. However, you are right that it's more important to publish the annualized return than average. I should have reported it differently. Sorry about that!

[Joan]

Thanks for explaining this. I am definitely going to check into dividend investing. I always learn good info from you!

[Matt]

Dividend paying stocks are great and signing up to a companies Dividend Reinvestment Plan (DRIP) is a great way to reinvest those dividends into the stock usually at minimal to no cost.

Most dividend paying stocks have DRIPS.

[Jane Savers @ The Money Puzzle]

I automatically reinvest my dividends and I have been investing in individual stocks for almost a year now.

I don't know why more people aren't interested in dividends and why everyone is in to high fee mutual funds.

If I can begin to learn this stuff then anyone can. I had considered buying Coke before Christmas but I ended up with some more shares of a good Canadian bank.

[Old Limey]

I guess I'm the lone exception in this discourse on the merits of buying stocks with above average dividends.
I retired in 9/1992 at the age of 58 and by 12/28/92 had consolidated all of our investments at Fidelity where they have been ever since.

Period 12/28/92 - 3/10/2000 ..... My Ann=38.51% ...... VFINX Ann=19.78%
1993 was a great year to be in emerging market mutual funds then when the the dot.com bubble started taking over the place to be was aggressive growth mutual funds until they peaked in March 2000.

Period 3/10/2000 - 12/1/2008 ..... My Ann = +6.64% ...... VFINX Ann = -4.41%
This was a period to focus on capital preservation and to avoid stockmarket volatility. I went in and out of Junk bond mutual funds most of the time.

Period 12/1/2008 - 1/18/2013 ..... My Ann = +5.06% ..... VFINX Ann = +18.08%
By this time I was at the age where I wanted to be in the slow lane so I moved into laddered muni bonds in our taxable account and laddered corporate bonds and CDs in our IRAs.

Total period 12/28/92 - 1/18/2013 ..... My Ann = +16.81% ..... VFINX Ann = 8.29%
Total gain 12/28/92 - 1/18/2013 ..... My Gain = +2153.29% ..... VFINX Gain = 393.49%

During this 20+ year period I have never owned any individual stocks, I have never had a losing year and outgained Vanguard's S&P500 index fund by a factor of almost 5.5. However I am the first to agree that periods like January 1993 - March 2000 are very rare, though most investors did not get out when the Nasdaq crashed in March 2000.

[Shawn James]

Definitely, Dividend Investing is the best investing in stock market. I also prefer it and due to this I invested in Coca-Cola (KO). However, I did not get more dividend because I have few share of it. I am familiar with four dividend growth stocks that you picked to compare but Chevron (CVX) is new for me.

[Sean]

What's your opinion of "Dividend Achiever" etfs like PEY and PFM?

[Matt]

How does this compare with a low-cost fund that focuses on Dividend appreciation (i.e. Vanguard Dividend Appreciation Index Fund Investor Shares (VDAIX))?

[Brett @ wstreetstocks]

Dividend investing is the way to go. It as cool as day trading, but you will win in the long run. Great advice, thanks for sharing this information!

[Kirk Kinder]

Great article. Numerous studies show dividends comprise about 60% of the stock market's returns over long periods. I like the ETF products based on the Dividend Aristrocrats - companies that have raised dividends for 25 years in a row or longer. Wisdom Tree also has several ETFs based on dividends.

Of course, you can certainly buy individual stocks, but this requires more work and adds an extra layer of risk to buying a diversified ETF or index fund.

[Old Limey]

@Matt
VDAIX may sound pretty good when you look at its goals but in the short period from 10/9/07 to 3/9/09 it still had a loss of 46.69%. On the other hand it provides far more diversification than holding a handful of stocks, and as we all know even the best of companies can come up with a big earnings miss which will send it down like a rock even though it may be paying a decent dividend. Stocks can also cut their dividends if they have a poor earnings report which will also send their price down. Unlike owning bonds, in the case of stocks and mutual funds you have no such thing as getting your money back at some future date.

In the years when I was using stockmarket mutual funds(1993-2007) I liked to do my best to avoid the bad periods and there are many indicators that can do that. My software could generate and plot the (New Highs - New Lows) and (Up Volume - Down Volume) summation indexes for both the NYSE and the NASDAQ, all four indicators gave very clear sell signals by the end of 2007 and would have avoided the big decline of 2008. By the 3rd. week of July 2009, all four indicators were giving buy signals.

In my own case after getting out of the stockmarket when I did I was also at the age, and in the financial position, where unlike stocks, I found muni amd corporate bonds more to my liking since they pay dividends twice/year, have very low volatility, have tax advantages and are not bought for capital gains. They also give you your money back when they mature - qualities that are very appealing when you start getting into your seventies and no longer have the stomach for gambling.

[richard]

If you are a long term investor and want stability with your returns than do market research and track the stocks who is in your portfolio that way you can minimize risk frequency.