Dividend investing is a great way to create a passive income while also positioning an investment portfolio for long term capital growth. That may sound like a contradiction in terms, but there’s good evidence to show that it works.
Companies that pay dividends and are also growing will generally see their share prices reflect that growth over the medium term. If, in addition, some or all of the dividend income is reinvested, the effect of compounding will increase the overall return of the portfolio. Academic studies have shown that apart from the last couple of decades (affected by a number of factors, including low interest rates and quantitative easing), dividend yields have accounted for a very significant portion of investors’ total returns.
Watch out for dividend traps
Of course, picking the right stocks is important in ensuring that the portfolio’s objectives are achieved. “Dividend traps” abound – companies which pay a high yield, but are facing challenging business conditions and may see their dividends fall in future. Many retailers right now appear to be paying great yields, but their businesses are under pressure from Amazon. Companies which pay only very low yields, on the other hand, will have to grow very fast to be profitable investments.
The ‘sweet spot’ is from the S&P 500 average to about three times the average – that is, from 2.5% to about 6.5% right now. Above that level, there’s probably a good reason why the company has such a high yield, and you’re running a higher risk investing.
Of course you run a capital risk investing in any share – prices can rise and fall, and if the stock market gets the jitters, even the best of stocks can tank.
Use REITs to improve returns
One sector that might give you a little diversification is REITs (and real estate funds that invest in REITs). Although REITs are traded like stocks, their price performance isn’t correlated with the stock market. They also pay good dividends – the average yield is 3.5%, a good deal higher than the S&P 500, and many pay more than that.
The key to REITs’ high yields is a high payout ratio; 90% of rental income has to be paid out to investors as dividends. Buying a REIT is very like buying a property portfolio and getting rental income. Additionally, the REIT has a special status which means it doesn’t pay tax, so you get 90% of the rent, not 90% of rent-less-tax.
Besides, REITs are backed by real estate assets, unlike many trading companies which have very limited asset backing. True, REITs can borrow, and some over-leveraged REITs have had problems in the past. There’s also one potential problem linked to the high payout ratio. REITs that want to expand by buying new properties don’t have retained profits to fund a purchase, so they may need to issue shares. Watch out for REITs that have a track record of numerous share issues and poor payouts.
Any dividend investor should have a good mix of REITs in an income producing portfolio. As much as 30% exposure to REITs can help improve yields and diversify the portfolio in order to reduce overall risk. And while there’s a little sector specific education required, REITs trade like any other stock, and most are highly liquid.