One of the most common
and effective ways of generating passive income is by investing in high
dividend paying stocks. 'High' is a relative number, one has to compare with
the government bonds or other coupon paying bonds. However, investing in stocks
has another distinct advantage and that is the upside potential. In financial
terms, this is called capital gains. Let's say there is a stock of XYZ Company
trading in the market at $100 today. The holder of the stock receives a regular
dividend of $4 every year. In addition to this, a stock can gain in value (and
also reduce in value). In the scenario where the stock price rises and become
$110, there is a 10% gain called 'capital gain' in addition to the 4% dividend
yield. However, this capital gain is unrealized till we sell the stock and is
thus less significant for our purpose.
We want to invest in
such stocks which we can hold on for very long periods of time where with time,
dividends are at least regular and keep increasing at a reasonable rate. So, we
don't want to sell the stock at $110 also, we just want to hold it and keep
achieving this 'passive income' in the form of dividends from the stock.
Now as we grow old, our
risk appetite changes based on our portfolio needs. If we could grow a
portfolio which is giving us regular income without having to sell it, that
would be the ideal case to have. However, the stock market experiences regular
crashes and can take away a lot of value from the stocks. And if we are forced
to sell the stocks in such times, we will be selling them at a loss. Ideally,
we should keep reducing our dependence on stocks and invest more and more in
less risky assets such as bonds as we grow old.
Not all high dividend
yield stocks are good. Understanding
this is of particular importance. The fact that a stock ABC trading at $50
today and still giving $4 of dividend doesn't mean that it's a good stock. It
may be that recently the market has been shorting the stock aggressively in
light of some bad news regarding the firm. This bad news can be of such a
nature that can affect the future dividend payments and thus affect the stock's
attractiveness for us. Hence, it is important to look and understand the
financial statements of the stocks before investing in them. We have to
especially look at the ability of the firm to be able to pay future dividends
and interest payments. It definitely helps to look at the revenue streams of
the firm and see if they are going to be affected in the future or if they are
probably going to stay steady.
How much dividend yield
is good?
A good comparison is
with the government bonds that are trading in the market. If investing in the
government yields can give good coupons comparable to the stock dividend, it
might make more sense to consider investing in them as they are risk free.
However, in early stages of life we want to get exposure to stock price
appreciation and thus invest in stocks. Personally I think anything above 4% is
good given that the company is a good strong brand with steady cash flows to
support these payments in addition to reinvesting something back in the
business to make it grow.
How to invest?
The best way to invest
would be to regularly invest equal amounts of money on a stock (also known as
SIP or systematic investment plan). This means when the stock price comes down
you are buying more units of the stock and when it goes up you are buying
lesser number of units. For our case as we are looking for dividend yields, we
may even want to put more conditions like not buying a stock if the price goes
so high that the effective dividend yield falls below 4%. For example, we have
a stock that is trading at $50 and gives a dividend of $4. Now we keep buying
shares worth $1000 each month, till the stock price rises above $100 at which
point we stop as the effective dividend yield then falls below 4%.
How many stocks to hold?
Being from the financial
industry, I know people who have million dollar portfolios. But what I have
found in the most successful investors is their ability to invest in few good
stocks. Nobody undermines the power of diversification. However,
diversification works so much better when done across asset classes. And
instead of investing in 40 stocks in the name of diversification and thus
picking up some bad names, successful investors pick 10-15 solid company stocks
and keep investing money in them regularly.
How long to hold the
stocks?
Holding only 10-15
stocks in the portfolio doesn't at all mean that you need to hold them forever.
In fact what one should do is review the portfolio after every earnings report
(once every quarter) and look at the financials of the company. If the things
that made the stock good once don’t hold any good there is no reason to hold on
to the stock in hope. Hope is not the way to invest. Investing should always be
backed by solid analysis for it to work. There is always some other better
stock out there in the market. Go look for it. The other point to sell might be
when the yields fall too low. Remember that we stopped investing when yields
fell below 4%. However, we can have another rule that we sell when the yields
fall below 1.5% or 2%, thus capturing the capital gains for the stock. We need
to make sure that a substantial dividend increment is not expected before
selling, as that might be the reason for stock price to appreciate so much.
Over time, the portfolio
should grow large giving good regular dividends. We have to then also think
about putting these dividends to good use. If we are already earning a regular
salary from our job and don't need these dividends for 'paying the bills', then
just regularly invest them somewhere else, or even back into more dividend
paying stocks if the valuations are good.
Always back you
investments with solid analysis and see your portfolio grow!
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