This header image may be confusing to most of you when talking about dividends, but by the end of this article it will all make sense, I promise.
Today we will be rounding out our article series on the Yield Shield. So far, we’ve discussed three pillars of the yield shield, which are:
Today we will be discussing the 4th and final pillar of the Yield Shield: High-Dividend Stocks.
What is a Dividend?
To give some background, as a company grows and makes money, they can basically choose to do two things with their profits. They can either reinvest it back into the company or distribute it to shareholders as dividends.
Reinvesting in the company can take many forms. They can buy equipment like computers or tractors, they can expand by buying more land or hiring more employees, or they can pay down debt. All of these activities make the company more valuable and, in one way or another, their stock price will rise over time to reflect this higher value. All other things being equal, a company that owns a bunch of tractors is more valuable than a company that doesn’t, right? This type of return is classified as a capital gain for investors.
The other thing they can do with their money is simply to distribute it out as a dividend. The board of directors decides how much money they want to distribute, then they take that number and divide it by the number of outstanding shares, and this becomes the per-share distribution. If a company wanted to distribute $1M, and there were 4M outstanding shares, each shareholder would get $0.25 per share.
Why would they do this? A bunch of reasons actually, but they all boil down to the situation where the company doesn’t have a great opportunity to reinvest in something that will rapidly grow the business. Remember that typically the directors of a company are also major stockholders, and generally it’s not that advantageous from a tax perspective for corporations to invest in the stock market themselves, so if they can’t find an opportunity to get an ROI of at least 6-7% inside the corporation, it makes more sense to pay it out as a dividend so they can invest it themselves.
The Dividend Yield
Every stock index has a dividend yield. This is because the index is made up of hundreds of different companies. Some of these companies pay dividends, and when they do the fund manager collects all these dividend payments and divide them equally among the ETF shareholders. As a result, even though you generally own stocks for long-term capital appreciation, you still get-advantaged dividend income from it!
As of the time of this writing, here are the dividend yields of some major stock indexes.
Generally, US stocks like to reinvest their income rather than pay them out as dividends and go for capital gains, so the US index’s dividend yield is notoriously low. Canada and EAFE is generally better, around 2.75%.
Which now brings me to the meat of this article: high-dividend stocks.
In the index, smaller companies like high-growth tech start-ups will generally want to throw whatever profit they manage to get into expanding and grabbing more market share. They typically don’t pay any dividends at all.
On the opposite end of the spectrum are bigger, more established companies operating in saturated markets where they’re already the market leader. Think Coca-Cola, or Johnson & Johnson. They’ve already cornered their respective fields, so there really isn’t a whole lot more room to grow. So for these companies, it makes sense to distribute their income as dividends rather than just have it sitting in cash doing nothing.
These are the companies we want to focus on if we want to increase our dividend yield.
Fortunately, there are ETFs that invest in just these companies. These funds basically just yoink the biggest, most established, and highest-yielding companies out of the index and invest only in those. Here are a few of the funds that do this, and the difference you get in dividend yields.
|High-Dividend ETF Name
|Vanguard High Dividend Yield ETF
|iShares Canadian Select Dividend Index ETF
|iShares International Select Dividend ETF
And again, to be clear, I am not recommending any of these funds. These are just examples I pulled out of iShares and Vanguard. Do your own research!
Note that just like every other pillar of the Yield Shield, you do give up something for the higher yield. Not only do you have to pay a higher MER, but you also give up some long-term capital gains as well. This is because larger, more established companies tend not to gain as much year-over-year as smaller, high-growth companies. Also, they’re literally giving away their profits as dividends instead of reinvesting it, so of course you’d expect capital gains to be lower.
If we were to bring up a chart of one of the High-Dividend ETFs vs. the underlying index, it would look like this.
Conveniently, this move also has the added bonus of reducing portfolio volatility. This is because bigger, established companies that tend to pay high dividends also tend to be swing less in price than the overall market. In fancy Wall Street terminology, we would say these ETFS have a Beta lower than 1, meaning it’s overall less volatile than the overall market.
So again, we don’t want to completely replace our equity exposure with high-dividend stocks. This would fundamentally shift our investing strategy away from indexing and we don’t want that. What we want to do is pivot part of our equity holdings into a high-dividend stock ETF. Of my domestic equity holdings, I’ve pivoted 25% of it into REITs, and another 25% of it into high-dividend stocks.
So again, to be clear, building a Yield Shield should only be done as a temporary departure from a balanced index portfolio to hedge the first few years of retirement from sequence-of-return risk. As we wrote about here (How We Plan to Change Our Equity Allocation in Retirement), I’m intending to slowly lower my Yield Shield as my portfolio grows in size and return back to my normal low-cost index fund strategy.
OK, But What About That Header Image?
That header image is of a Chinese hongbao, or red packet. On birthdays, Chinese New Year’s or other special occasions it’s a tradition for our parents and grandparents to distribute lucky money (as if there’s any other kind) to their children in the form of red packets, or hongbaos.
A year ago during one of the many many tense conversations FIRECracker had with her dad demanding when she’d come home, get a job, and become a normal respectable Chinese girl again, she tried to explain the idea of the 4% rule, then passive income, then geographic arbitrage. Maybe these ideas didn’t translate well into Chinese, but the explanations failed miserably, one by one.
Only when she explained the idea of dividends did her dad finally get it. “Oh! Fenhong!”
Fenhong in Mandarin translates to “distribute red.” As in to distribute red packets.
Only then did the culture gap truly get bridged. To a Chinese person, the idea of investing in the stock market sounds an awful lot like gambling. But owning a company that distributes money to shareholders every quarter sounds kind of like a kindly old parent or grandparent distributing hongbaos, or red packet money.
So that’s what dividend stocks did for us. Not only did it boost our Yield Shield, lowered our volatility, but it made FIRECracker’s parents understand what the bloody Hell we were doing with our lives for the first time ever.
Questions? Comments? Chinese proverbs? Let us hear it in the comments!
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