Can You Rely On Dividends For Income?
A lot of people are working in retirement these days, but everyone has to stop working at some point. Not having to commute, dress up, or deal with office politics anymore is an appealing prospect for sure, but not having a steady stream of income is a source of concern for many.
There’s real value in knowing where your money will come from. Hence the appeal of income investing – building a portfolio focused on creating a long-term steady stream of income.
Sounds like a good idea, right? But income investing presents a few problems.
We’ve talked about why income investing doesn’t work before (relying on dividends for income is a scary prospect in a bear market). Today I want to look at an example of what happens when your portfolio shoots off income.
Let’s say we own two stocks: ABC and XYZ. Both stocks trade for $20 and we own 100 shares of each. So that’s $2,000 invested in each company.
Hypothetical data. For Illustration purposes only.
Now let’s say XYZ decides to issue a $1-per-share dividend. Naturally, they have to pay for that dividend, so their assets (and stock price) drop $1 per share, but the shareholders (that’s us) don’t care too much because we now have $1 per share in cash.
So our total portfolio now looks like this:
Hypothetical data. For Illustration purposes only. Assumes no non-dividend related price movements.
Now that we have the cash, we can do whatever we want with it. We could reinvest it right back into the company by buying more shares, we could rebalance our portfolio, or we could buy that pair of shoes we saw the other day that we liked so much.
But at the end of the day, we’re still looking at the same amount of money we had before the dividend was paid out. In other words, no value was created or destroyed, we just moved it from one pocket to the other. This was actually one of the key insights that got Franco Modigliani his Nobel Prize back in the ’80s – that the structure of capital is irrelevant.
The big thing to notice here is that the company doesn’t really need to send you your money. You can always create your own “dividend” by selling shares.
There are two major benefits to the latter method:
- You have complete control over when you get paid.
- You have complete control over how much you get paid.
When you rely on dividends, the company’s board of directors decides when you get your money and how much you get.
One of the main reason people find dividends so appealing is that they don’t have to sell their stocks – their “principal” remains untouched. That’s true, but dividends aren’t free money. Just like XYZ’s share price dropped when they paid us $100, a stock’s value will always drop when it transfers cash from itself to its owners.
You should care about meeting your spending goals, not how you get your money out of your portfolio. There’s a lot that you need to manage with your portfolio: the amount of risk in your portfolio, your level of diversification, your asset location, your expenses, and all sorts of other things. The amount of income your portfolio puts out is not one of them.