When people begin their journey into dividend investing, they frequently mistakenly focus on what they can earn today.
For example, a $100,000 portfolio invested in a diversified portfolio of dividend stocks with a yield of 3% will earn $3,000 per year. Dividend investors see this immediate income as the goal, and often stretch to find higher yielding stocks to boost their current income. What they fail to understand is their long term income goals are often at odds of their current income needs.
Remember: the dividend that is paid today will grow over time.
The S&P 500 dividend has grown on average 6.01% per year since 1989. If you exclude 2009 – a once in a lifetime financial crisis – during which the dividend on the S&P 500 fell by over 21%, the average annual growth rate is 6.89%.
The long term growth of dividends is the key consideration for dividend growth investors. If your time horizon to retirement is 20 years, you’re investing today for the dividend you expect to receive then. Because higher dividend yields often come with lower growth rates, it can be counterproductive to your future income to focus on generating income today.
Below I provide 3 hypothetical examples of portfolios generating 2%, 3% and 4% current dividend yield growing at 10%, 7% and 4% respectively. The growth rates differ because companies that pay out less in dividends generally can use capital for better purposes (i.e. growth). (Of course, this relationship is better represented by the dividend payout ratio, but for argument’s sake most companies with lower dividend yields tend to have lower dividend payout ratios.) The faster the company grows, the faster it is able to grow dividends. I then carry these assumptions forward over 20 years to see what income is generated at retirement.
As you can see, the lower current dividend/higher growth rate combo wins over the alternatives. In 20 years, this portfolio (assuming no additional investments) would earn $12,232. That’s 12.23% yield on original cost of $100,000. In reality, most people would be re-investing dividends along the way, growing the capital base on which more dividends are earned. But I’ll stick to a super-simple example.
The 3% portfolio ended up earning $10,850 per year in 20 years and the 4% portfolio $8,427. The 2% portfolio provides 30% greater income in 20 years! Why? Because it came with higher growth rates.
While today it might feel like a 2% yield is pointless for a dividend growth investor, over the long run that portfolio could potentially generate much greater annual income.
I look at dividend investing like I’m paying for something I will get in the future. When you invest for dividends, you’re really gaining a lower-cost entry point for the dividend that you expect to receive some time in the future. The longer your time horizon, the greater that dividend will be.
The thing is, to generate tomorrow’s income you need to invest today. Because the price for that income rises all the time. If the portfolio yield remains a constant 2%, the portfolio generating $12,232 in 20 years will then cost over $1.1 million.