Many people consider passive index fund investing the gold standard of stock market investing. The main advantage of index funds is that you don’t have to pick individual stocks to achieve success.
The main disadvantage is that you will likely have to sell shares during retirement to generate enough income to survive. This means you will slowly dismantle your mountain of index fund capital gains. This scenario does not sound fun to me.
A powerful alternative to passive index fund investing is investing for dividends. Dividend investing allows you to collect stocks and funds that pay you income for every share you hold.
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Ideally, you simply turn off automatic reinvestment during retirement and use the dividend cash flow to pay for your expenses and lifestyle.
The two types of dividend investing. Dividend investing comes in two flavors: dividend growth and income investing. It’s vital that investors know the difference between the two before creating their retirement plan.
Everyone needs passive income during retirement, but it is up to us to ensure we create these passive income streams well before our last days of work.
The goal of dividend growth investing is to purchase shares in powerful companies that pay a portion of their profits to shareholders. Over time, the price of the shares will increase along with the amount of dividends they pay.
The goal of income investing is to create a high level of income compared to other types of investing. Income investors can use their cash flow today as well as tomorrow (retirement).
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An income investor may aim for a 9-10% yield on their income portfolio, which is much higher than index funds (1.5%) or dividend growth (3-4%). However, income investors typically sacrifice capital gains for current income.
An example of dividend growth investing. I want to give examples showing how powerful and different these two investing styles are over a lifetime.
Let’s give Josh $100,000 at age 25. (For this example, I will make up the numbers and rates.) Josh uses all of his money to purchase shares of McDonald’s (MCD), which currently yields 2.5%. From day one, Josh generates $2,500 in annual income.
Josh has held onto McDonald’s for 35 years while focusing on three numbers: share price appreciation, dividend growth rate, and dividend growth.
- Share price appreciation is simply how much the share price increases over the years.
- The dividend growth rate is the speed at which the company increases the dividend between years.
- Dividend growth is how much the dividend grows over the years.
After 35 years of holding McDonald’s without purchasing new shares, Josh now has $4 million. McDonald’s current dividend yield is still 2.5%, which would pay new investors $100,000 in annual income.
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However, Josh receives much more in dividends because of his yield on cost. Let’s say his yield on cost is 20%. Therefore, he may receive closer to $800,000 per year in dividends. That’s the true magic of dividend growth investing: high capital gains and high yield on cost.
The downside of dividend growth investing is that Josh had to reinvest all his cash flow back into the portfolio to achieve maximum effectiveness and cash flow. Josh went 35 years without using any of his dividends.
An example of income investing. On the other end of the cash flow spectrum is income investing. The goal here is to generate income that you can use today and tomorrow.
Why is it important to have “extra” cash flow today? As a retiree, parent, and homeowner, I can tell you that all sorts of things come up in life.
I recently bought an RV and had a whopping $1,200 registration fee. My son needed an allergy test to join the Air Force, which cost $1,000. All types of things come up in life that having more money can solve.
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Let’s give Josh the same $100,000 at age 25. He invests the entire pile of cash into the PIMCO Dynamic Fund (PDI), which yields 12% and generates $12,000 annually.
Josh does something different with his cash flow. He reinvests only 25% and uses 75% for cash flow. Over 35 years, Josh ends up with $300,000 in his account, which pays him $36,000 per year.
That doesn’t sound like a lot, but Josh received over $700,000 in dividends that he could use for anything he needed. I know the numbers don’t sound impressive compared to DGI, but Josh leads a much better lifestyle because of his income.
The magic of passive income. As you can see, if you can create a massive pile of cash and protect it, you can end up with a huge income stream.
However, most people will encounter bumps in the road that cause them to use their stocks to solve pressing emergencies.
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That’s why it’s a good idea to use both dividend growth and income investing as you start your journey. I use both to great effect.
I find that income investing brings me the most joy every month. It is simply amazing to get predictable, boring cash flow from closed-end funds, mortgage REITs, and preferred shares.
On the other hand, it is also exciting to read about dividend increases from McDonald’s (MCD), Walmart (WMT), Verizon (VZ), and Abbive (ABBV).
I find the best way to use both investing styles is to have separate brokerage accounts. I use Cash App and STASH for dividend growth investing and SoFi and Charles Schwab for income investing.
I combine both investing styles inside my Wells Fargo and M1 Finance brokerages. The moral of the story is that I focus on current and retirement income. You shouldn’t have one without the other.
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Planning for retirement. The best part of being an income investor is that you receive your income today, so you can start planning today.
For example, I receive $2,100 in dividends per month. I can see how far that money takes me today and start planning for tomorrow.
I may predict that I need $4,000 per month in dividends to hit my retirement goals. I can use a pension, social security, annuities, and roommates to close the gap in my cash flow.
As a dividend growth investor, you do not know exactly how much you will have when you retire, which can cause some stress.
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You can alleviate some of that stress by investing in Dividend ETFs like Charles Schwab High Dividend (SCHD), which collects the best dividend growth stocks in one fund.
I like to think of dividend growth investing as the icing on my investing cake. However, the foundation of my cash flow comes from income-investing products.
Conclusion. The person with the most passive cash flow wins. Life throws all kinds of silliness at you, especially when you least expect it—that’s why it is vital to focus on cash flow.
If I gave my son $100,000 on his 25th birthday, I would encourage him to invest $80,000 in income products and $20,000 in dividend growth.
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His income-investing portfolio could generate $800 per month, which he could use to save an emergency fund, invest in more income, or cover expenses as they arise.
As cool as it would be to invest $100,000 in DGI stocks and never touch them, I think the more reasonable thing is to account for “life happening.”
Again, I am a hardcore income investor—you may feel differently. That’s why we must have these conversations early and often.
We need passive income streams today. Dividend growth investing can be a dream come true if you can survive 35 years without touching your portfolio. The more common sense path is to generate much-needed cash flow via income investing. Good Luck!
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