There comes a time in every investor’s life when they think about creating an income machine that operates on autopilot. Creating a stream of passive income that can support your family’s lifestyle forever is a fairly common dream.
Thankfully, the global economy is designed to offer this dream to savvy investors. Capitalism allows investors to live off of capital. But the returns an average investors can expect depend on where the capital is allocated.
Money could be left under a mattress, where it generates no income at all. It could be left in a fixed savings account at the bank, where it can earn historically low interest. Bonds offer low returns while derivative trading is remarkably risky. Commodities are generally unpredictable.
What the average investor is left with is a choice between two assets, one of which is more popular than the other. Real estate and stocks are generally considered to offer a healthy balance between risk and reward. Most investors prefer real estate since there’s a general belief that property prices will eventually go up. The mortgage rates offered on real estate investments is at historical lows, while rents are an easy and predictable source of income. Stocks, meanwhile, can offer much better returns so long as the investor can handle a certain level of market volatility. Stocks are, admittedly, more complicated than real estate investments. But they’ve historically compensated investors for the added risks and complexities.
The Need for Financial Independence
If creating a passive income source sounds like too much work, you may be wondering if financial independence is worth it.
Most people assume passive income is meant for pensioners who live off the income. Younger investors would never pay attention to such investments because they’re too busy trying to create wealth instead.
But there’s an important argument to be made for income-seeking. Income is a steady flow of cash that offers consistent freedom. In other words, you can do what you want with the regular cash thrown into your lap. Whether you decide to add the income to your growing wealth or spend it all on living the life you always dreamed of having is up to you.
If you’re close to retirement, of course, finding ways to keep paying yourself is crucial. Creating a nest egg is a sort of right-of-passage in our society. But not everyone wants to wait till they’re old. Some prefer working on their passion and not having to worry about money. Some want to create a stream of income that sustains them while they go out and take bigger risks with the leftover cash. If you want to travel the world or quit the rat race, creating passive income is pretty much essential.
Is it Possible?
If your grandparents or parents are retired, you already know living off of wealth is difficult but doable. The government tries to make things easier by offering tax-efficient wrappers for your retirement fund – ROTH IRAs and 401Ks. You might even know someone who inherited a fortune and now lives off of the income from trust funds.
The question isn’t whether you can live off wealth, it’s whether you can create a sustainable source of it. Creating a portfolio that’s long-term and stable is easier said than done. Retiring early seems almost like a dream. But it is possible.
Mark Cuban retired when he sold his computer consulting firm at age 31. He eventually plunged back into business and turned his millions into billions. But you don’t need to start a multi-million dollar company to retire early. Blogger Mr. Money Mustache is a great example of a regular guy creating a passive income fund. His trick is pretty simple – save a lot, spend very little and invest wisely.
But wise investments are hard to come by.
A Wise Investment
Most people don’t start investing to become rich. They’re just trying to save up enough to live on. Perhaps through the end of their retirement.
We’ve already seen that a portfolio that promises financial independence needs to be stable and yield a high return. That puts commodity investing, bank savings accounts, bonds and high-growth stocks off the table.
What’s left is either real estate or dividend-paying stocks.
The most common investment is property. A recent survey by Bankrate.com showed that 1 in 4 Americans thought real estate was the best investment. The reason for this is simple – real estate is tangible. Property is something you can see and touch. You can repair it quickly and flip it for a great return. You can visit it, maintain it and lease it out for years.
The problem with real estate is that mortgages aren’t available to everyone. Banks has tightened the purse after the financial crisis and there’s no sign things will get better. There’s also a lot of money spent in upkeep with a house. Repairs and general maintenance costs a fair amount and can reduce the returns on property. Not to mention the taxes and insurance that come along with a property. The market is really illiquid and when it comes time to sell, you may have to wait months and look around for willing buyers to exit the market.
Perhaps looking for tenants is the biggest task of them all. There could be months where your house is vacant. Managing this vacancy period requires you to either put up with lower annual yields or spend a lot of time looking for long-term tenants. That vacancy rate chews into the overall yield on real estate. The average yield on residential property in the US was a mere 3.9%. That’s before fees, maintenance and taxes.
Nobel prize winning economist Robert Schiller already demonstrated why buying a house was a ‘consumption’ rather than a good investment. It turns out real estate simply isn’t going to offer the best returns on capital.
A better option would be dividend paying stocks.
The Power of Dividends
Dividends are fascinating. They’ve been closely inspected and obsessed over since the very first dividend paycheck was paid out by the Dutch East India Company.
Some of your friends may still be fascinated to learn that they can buy a piece of a company and share in the profits. It is easier now than ever before. Buying a company’s stock is just a click away. You don’t even need to be at home and in some cases you don’t even need to pay commissions for it.
Compared to investing in real estate, high dividend stocks are much easier to hold. They don’t need to be maintained, leased out or repaired. You don’t even need to pay taxes if you don’t sell them.
And the yield is better. As of 2016, the S&P 500 yields 2.11%. 84% of the companies in this index now pay a dividend. That’s up from just 75% in 2006. Telecoms giant AT&T yield the highest on the index, with payments close to 5%. Compare that to the 3% yield you can expect on real estate and you’ll start to see why savvy investors prefer holding dividend stocks.
The advantage with high dividend stocks is the efficiency. You get a regular source of income from a stable company and you can choose to either spend the money or reinvest it for better compound growth. A few decades back you’d receive a paycheck in the mail and have physical stock certificates to take care of. Now, you click a button and the stock dividends are paid directly into your bank account.
It’s simple and streamlined. But simple and streamlined isn’t everything when you rely on your investments to pay the bills. An income seekers objective is to get the highest yield. Do dividends beat real estate on that front?
Dividends Vs. Real Estate: Performance Wars
Maybe you know a relative or a friend’s Dad who is a successful real estate investor . Overtime the rents he collected allowed him to buy another house. By the time he retired, he probably had multi-million dollar properties spread across the country.
That, in a nutshell, is the dream of every property investor. “They don’t make land anymore,” is a common adage. Intuitively, it makes sense that land prices will always appreciate. The population is constantly growing, people’s incomes keep expanding and the number of prime locations is in short supply.
But has this philosophy paid off in the real world? The only way to know for sure is to look back at the past hundred years and see if you could make more money through high dividend stocks or real estate investments.
Here’s a look at the performance of the S&P 500 versus real estate over the past four decades:
Those charts compare house prices to returns from the S&P 500 since 1975. The reason the charts start in 1975, is because S&P 500 data is more reliable since then. The stock market, it would seem, has outperformed the real estate market by a fair margin.
This doesn’t include dividends reinvested, however. The index would have returned a much higher percentage had every dividend been reinvested back into the stock market. In fact, since 1928, the dividends paid by individual companies has account for over half of the S&P 500’s performance.
That’s a tremendous margin. But the higher returns, higher liquidity, and ease of investment are not the only factors that support this investment. There’s one key reason why you should pick dividends over rents – effort.
If you think about it, real estate is never really a passive investment. Yes, you can buy property once and rent it out over many decades. Sometimes you can even buy properties on the other side of the world and never visit it. After the ‘08 real estate bubble burst, many foreigners started buying property in the United States and handing them over to management companies to take care of. The problem with this strategy is the way it eats into the return on the investment. Property needs to be maintained and someone needs to be responsible for finding tenants. If you plan to do this yourself, it’s not a passive investment anymore. If you hire a management company, your returns are cut substantially.
An obvious advantage with real estate is the access to leverage. It’s easy to sign up for a mortgage and increase the return on investment with property. The loan-to-value ratio in the United States for investment properties is usually 50% to 70%. There is no doubt borrowing money to invest in property is likely to boost returns, but these returns cannot be compared to the unlevered returns of the stock market. You can, theoretically, borrow money to invest in high dividend stocks as well, in which case the dividend stocks will still beat real estate. The only problem is that it’s much harder to get leverage for a high dividend stock portfolio than for a rental property.
Overall, dividends are powerful compounding machines that can create a lot of wealth if you pick the best high dividend stocks. To harness this power, savvy investors take the time to create a dividend portfolio from scratch.
Building a Dividend Portfolio
The obvious risk with dividends is the volatility of stocks. Stock prices fluctuate a lot and that sort of volatility is hard to stomach for regular investors. It’s one of the biggest reasons why people prefer real estate over high dividend stocks.
But careful planning and a portfolio approach can reduce this risk substantially. Buying a basket of high dividend stocks will diversify your holdings and reduce volatility.
The key to success is having a well-designed strategy. To create a dividend portfolio you will need to do your research and pass every stock through multiple filters to make sure they are healthy and sustainable.
Finding a mix of good quality, high dividend stocks is time consuming, but the results speak for themselves. Many investors like to start off picking stocks in the S&P 500. Nearly 85% of the companies pay a dividend. Many of these companies pay a dividend that’s lower than the average return on the index.
You can invest directly in the S&P 500 and gain exposure to 500 companies and a dividend yield of close to 2%. But some investors prefer picking a narrow basket of stocks with a higher payout. The top dividend paying stocks yield more than the US treasury bonds and the average dividend yield of the index. These are called high yielders, and they include stocks like AT&T, Verizon, and Seagate Technology. Most high yielders offer at least twice the yield of the S&P 500.
But simply picking the highest yielding stocks isn’t an effective strategy long-term. Dividends can be cut or suspended by companies when they can no longer afford to pay them. Which is why it makes sense to look under the hood and check to see if the dividend is sustainable long-term.
This is why some investors prefer picking stocks from a curated index of good-quality dividend payers. The Dividend Aristocrats Index, published by the S&P Dow Jones company, is a collection of high dividend stocks that have paid dividends consistently for a period of time. Companies included on the list have either grown or sustained their dividend for many years. These Aristocrats include blue chip stocks like Archer Daniel Midlands co, Pepsico, Chevron, and Procter & Gamble.
Starting with an index is easier. Picking a dividend aristocrat offers a certain degree of safety, since the companies have a good reputation for investor paybacks. The dividends are healthy and growing and expected to do so for the foreseeable future. So, picking a narrow bunch of stocks from the list is more straightforward than simply picking from the 500 companies on the S&P index.
There are a number of factors that could help you narrow down a list of high dividend stocks to a handful of gems. Start with either an index or a list of high yielding stocks that have performed well over the past few years. Then take the time to study management. Managers with a focus on shareholder return are more likely to sustain a dividend policy over the long term. Beyond this, take the time to review the free cash flows for the companies you pick. Free cash flow is the root of all dividends and if the company is unable to create enough of cash over a certain period, dividends will surely be under threat.
Finally, compare the dividends to the risk-free rate of return. The US treasury yield is often a proxy for the risk-free rate of return. Pick the 10-year or 30-years US treasury bonds and compare the annual returns with the stock’s dividend yields. As we go on the Federal Reserve might increase the interest rates and this will have a negative impact on the spread between dividend yields and fixed-income returns. This ‘interest rate risk’ is perhaps the biggest risk to high dividend stock portfolios.
But these risks are manageable and if you follow a disciplined stock investment strategy, you should be able to create a stable passive income portfolio.
Financial freedom is sought after by everyone, but people go about seeking it in different ways. Investing in real estate is usually the most popular option, but returns on property have not lagged behind the returns on the stock market. With dividends reinvested, a solid high dividend stock portfolio is likely to give incredible returns over the long term. If high dividend stocks are well picked, the portfolio is stable, efficient and yields a higher return than rents or bonds.
Combining the effortlessness of stock investing with the healthy returns of dividends is the best way to secure financial freedom.