What if I told you there was a magical machine that could create money. Every year, on a specific day, this machine will spit out $1. Once you buy it, there is literally nothing you have to do. You stick it in a closet and forget about it and BOOM, once a year your dollar pops out. The machine doesn’t need any maintenance. You don’t have to plug it in. It doesn’t break. It just spits out dollars every year.
It gets better. Every year, the machine gets just a little bit more efficient and actually INCREASES the amount of money it can create. So the first year you get $1.00 even, but the next year you get $1.03. The next you get $1.07 and by year four it’s up to $1.12!
The machine allows you to either take your money and spend it, or automatically buy a little more of the machine so it can make even more money. Over time the machine grows and grows and spits out more and more money!
If you ever get tired of having the machine, you are free to sell it. This only takes a few clicks of a computer mouse. There are millions of people out there who will bid on the chance to take the machine off your hands.
The machine will go up and down in value over time, but the general trend is up. Hold onto the machine and keep buying more of it with the money it produces over a long period of time and you can have quite a contraption that can feed you in your retirement!
Sounds like a dream right? A machine like this can’t exist or be this easy. The reality is that this thing is out there and you can buy one (or a million of them) today!
Question: How much would you be willing to pay for a machine that could make $1 every year, grow in value and increase the amount of money it makes most years?
Well, if you invest in stocks, mutual funds or ETF’s that pay a dividend, you are in essence buying such a machine. The MARKET determines how much the machine costs at any given time. Sometimes it’s a great value, sometimes not so much. The dividend is the money that is produced by the machine and paid out yearly (or quarterly, depending on the fund).
What Is a Dividend?
A dividend is a payment to shareholders of a stock, mutual fund or ETF that comes from a portion of the profits of a company. Dividends are not guaranteed and may be reduced or eliminated at any time by a company. There is also the option to either take the dividend in cash, or reinvest the dividend into additional shares in the company (buying more of the machine).
Generally speaking, ordinary dividends which are paid out by big companies and funds are taxed as ordinary income. So Uncle Sam will want a slice of the pie the same way he would tax your paycheck. Just make sure you are prepared for that at tax time.
What Companies Pay Out Dividends?
Lots of companies out there pay a dividend. Probably the best known dividend stocks are large, established companies that pride themselves on consistency and steady growth. Coca-Cola (KO), McDonalds (MCD), Proctor & Gamble (PG), General Electric (GE) and AT&T (T) all pay a dividend. They all are well known brands that produce products and services that millions of people use daily.
Let’s use Coca-Cola as an example. A share of KO costs $57.23 as of today. It is projected to pay a $1.68 annual dividend this year, distributed quarterly. Basically, ever 3 months a share of KO will pay you $0.42. Over time, the company has a history of increasing its dividend (however this is NEVER guaranteed).
Believe it or not, there is even a list of companies in the S&P 500 that has increased their dividend every single year for 25 years or more! These are called the “Dividend Aristocrats.” KO is one of the Dividend Aristocrats. It has increased its dividend ever year for the last 59 consecutive years!
The Dividend Aristocrats give a lot of investors a warm and fuzzy feeling. They are often industry leaders with a proven track record. These companies may also tend to be less volatile than the broader market.
The cool thing is you don’t need to buy individual stocks to get a dividend payout. Even index funds that contain dividend paying stocks will pay a dividend!
For example, I am invested in the Vanguard S&P 500 Index (VFIAX). A share of VFIAX costs $413.04 as of today. Over the past 4 quarters it has paid dividends as follows: $1.31 on Sept 28, 2020, $1.38 on December 21, 2020, $1.26 on March 25, 2021 and $1.33 on June 28, 2021. Not bad!
Since I am in the growth/accumulation phase on my journey to financial independence, I do not take any of the dividends I receive. Instead, I choose to reinvest them into buying more shares of the funds I own. This helps me continue to build wealth for when I will need an income stream in the future.
What Companies Don’t Pay Out Dividends?
Not all companies pay dividends. Does that mean you shouldn’t buy those companies? Not necessarily.
A big reason why a company may not pay a dividend is because they prefer to reinvest the profits back into the company to fuel more growth. This is very common with the high growth stocks found in the tech industry. Companies like Amazon (AMZN), Google (GOOG), Facebook (FB), Netflix (NFLX) and Tesla (TSLA) do not pay a dividend.
When you invest in non-dividend stocks like the tech stocks mentioned above, you are hoping to grow your wealth through the appreciation of the stock price as the company grows. For investors in the growth/accumulation phase of their FIRE journey, the potential for this growth can be very attractive.
I invest less than 5% of my net worth into individual stocks. None of them are dividend stocks. I am currently holding Google, Facebook, Peloton (PTON) and Duolingo (DUOL). I don’t plan to go past 5% of my portfolio in individual stocks because of the risks.
Why Invest in Dividend Producing Stocks?
One of the biggest reasons you may want to invest in dividend stocks or funds is to get a steady stream of income. When you are retired and are not working anymore, having streams of income that are predictable and likely to rise over time with inflation are very valuable. Also, if you can live off the dividends of your portfolio only, it means you don’t need to sell stocks when you need income. This will likely result in an ever increasing portfolio over time. What better way to earn a living than to sit back and watch your magic money machine provide for you!
The biggest thing is you really need a lot of capital to generate enough dividends to live off of. For instance if I wanted to generate $50K a year in dividend income from VFIAX, I would need 9,470 shares! At $413.04 a share, that works out to a cool $3.9M!! Of course there are other funds that will produce higher dividends with less of an investment, but you get the point.
Dividend stocks and funds can be a great supplement to other income streams in retirement. Dividends coupled with money from rental properties, sales of growth stocks, side hustles and in time Social Security payments can combine for a very comfortable and stable retirement.
I would currently say that I am not a dividend investor. Right now, I am focused on growing my portfolio and net worth, saving money and planning for early retirement. However, I am learning all I can about dividends because they are a very attractive tool for producing income in retirement! I may be relying on a magic money machine of my own when I reach FIRE!
What are your thoughts? Do you invest in dividend stocks or mutual funds? Do you have recommendations on funds that pay a healthy dividend historically?