While there are lots of ways to earn passive income (writing a book, selling a product online, affiliate marketing, real estate, etc.), we prefer dividends for three reasons:
- They’re the most passive we can think of.
- The benefits of DRIP (or equivalent) investing.
- Their preferential tax treatment.
Let’s talk a little about each of these. First, they’re truly passive. Other than a little work a couple of times a year to choose a stock to buy, you shouldn’t be spending any time managing or worrying about your portfolio. We’re buying companies that are stable and we’re in the market for the long term, which means at least five years. Take a look at what the S&P 100 index has done since 1982.
Notice a trend? Sure, there are periods when the index drops significantly (that’s called a correction), but the recovery follows soon after. Check out the Dow Jones Industrial Average over a similar period.
Same trend! Pick nearly any 5 year period you like and you’d have made money. In other words, if you’re in the market for the long term rather than trying to get in and out at the best times (we call that timing the market) you really can’t lose. Basically, don’t worry about it. Buy a good company and hold it – forever.
Second, the advantages of DRIP investing. A DRIP (dividend reinvestment plan) allows you to use the dividends you receive to purchase additional shares in the company with no trade fee. If you don’t need the cash from the dividends this is a great idea because those additional shares are also eligible to earn dividends in the future. The compound growth that occurs is a powerful way to grow your portfolio. Sometimes, your broker will even offer a discount on shares purchased in a DRIP. These plans are automatic so, again, completely passive. Let’s look at an example. Imagine you have 100 shares of ACME Widgets that are trading for $40 per share and pay a quarterly dividend of $0.50 (5%). In the first quarter, you would be paid a dividend of $50. In a DRIP, $40 of that dividend would be used to buy an additional share and the remaining $10 would be collected in cash. In the next quarter, you’d own 101 shares so you would be paid a dividend of $50.50. Again, you would buy another share in the DRIP and receive the difference in cash. At the end of the fourth quarter, you would own 104 shares and have $43 in cash. If we imagine the stock price was still $40, your effective rate of return for the year would be 5.1%.
Third, preferential tax treatment. Dividends are paid out of the after-tax profits of the company (i.e., they’ve already paid tax on them) so it wouldn’t be fair for the shareholder to also pay full tax. In Canada, dividends are grossed-up and qualify for a tax credit to “credit” you for the tax already paid by the company. In the U.S. dividends are taxed at a considerably lower rate than regular income. In a later post we’ll describe the preferential treatment of dividends in detail.
So there you have it. The reasons we love dividends. We think you should too!