The Yield Shield: Dividend Stocks

Wanderer
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Wanderer

The Wanderer retired from his engineering job at a major Silicon Valley semiconductor company at the age of 33. He now travels the world, seeking out knowledge from other wealthy people, so that he can teach people how to become Financially Independent themselves.
Wanderer
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Image by Jpquidores @ Wikipedia

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:

  1. Preferred Shares
  2. Real Estate Investment Trusts
  3. Corporate Bonds

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.

Region Index Yield
USA 1.80%
Canada 2.90%
EAFE 2.75%

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%.

High-Dividend Stocks

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.

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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43 thoughts on “The Yield Shield: Dividend Stocks”

  1. How so the final pillar? Won’t you talk about CEFs and CDs ? C’mon M&R you can do better than this.
    Good topic btw.

    1. No. CEFs are just another mutual-fund-like investment structure that I don’t use, and are typically actively managed which is why I avoid them.

      As for CDs (or the Canadian equivalent, GICs), at no point in my investing career has it ever made sense to hold CDs when I can get the same yield from a HISA without locking my money in for 5+ years.

  2. I retire this Friday at 54yo and my wife will work until the end of the year then we will both FIRE. So I’m doing a ton of reading on prepping the portfolio to guard against sequence of return risk. Your articles have been very timely. Thanks!!!

  3. I have found these yield shield posts very helpful. I think others, who are more pro real estate, use cash flow from rental properties to do the same thing.

    1. Yeah, except with real estate you have to live in a place where you can pick up rental properties for the right price to replicate their cash flow. With this, anyone can do it.

  4. I love the red envelope metaphor! And it’s also like the best gift giving tradition in mankind: who doesn’t love a crisp bill?

    We are pure indexers (using Bernstein’s Simpleton’s/aka No Brainer portfolio) so we have no explicit dividend strategy. But it’ll certainly be the first money we spend in that stage of our our FI journey: if we’re going to pay taxes, we might as well spend it first!

    1. Bernstein’s portfolio is a little more aggressive than ours but what I never liked about these one-size-fits-all portfolios is that they don’t account for your changing life situation/income needs.

  5. A nicely written post on dividend stock basics Wanderer!

    I’d never heard of dividends described as ‘red packet’ money before, but I guess that’s as decent an analogy as any!

    I don’t think you specifically stated it anywhere, but most readers are going to be curious about dividend growth rates in the High Dividend ETF’s versus the a Standard index fund. (It’s not where you start that matters afterall, it’s where you end up)

    Last time I checked, the numbers were quite similar.

    1. Looking at dividend growth rates is more appropriate for people doing pure dividend investing for the long term, and for them I’d suggest a dividend aristocrats ETF rather than a high-dividend ETF. You’re a dividend investor, right? What approach do you use?

      Also, you’re Japanese right? Do you guys have something similar to red packets?

  6. Oh man. I haven’t seen one of those since my mom took me to a parade in DC’s Chinatown back in… must’ve been 1986. You know how a familiar old smell will yank you back in time? That just happened! Suddenly I’m a first grader surrounded by huge darting dragon head puppets and spent firecracker tubes. Anybody got any 山楂餅?

    Thanks for the nostalgia!

  7. That story at the end was cute. I was reading this with my spouse in the room and when at got to the part at the end I started laughing and read the part of the red envelope to him. It reminded him of this episode of The Office when they have a budget surplus and one of the accountants has to explain to the office manager how the budget surplus works. The office manager doesn’t understand so he says “explain it to me like I’m 5 years old” and the accountant has to explain it using a lemonade stand analogy.

  8. Nice that you talked about dividend ETFs. I was afraid that you were going to take “high-dividend stocks” down into risky business and possibly even stock picking (which would be counter to just about everything you guys write about!)

    But by sticking with normal, reasonable ETFs, you can actually reduce risk overall (at the typical trade-off of capital gains for income, of course.)

  9. Great story and excellent metaphor! My yobo is Korean born. There is an old custom in Korea, used for newlyweds, new home buyers, etc, of giving laundry soap. The concept is that a little soap generates a huge amount of bubbles (prosperity). When I’m monkeying with our portfolio (rebalancing, reinvesting a laddered CD, etc), she might ask what I’m doing. I simply tell her that, “I’m checking the laundry soap.” Now, how am I gonna get me some Fenhong?!

  10. I always learn so much from your posts. I feel like you guys are so young to know this much (and be able to condense it down into a very readable post). Way more than most people at typical retirement age, but I guess then, that is pretty much the point.

  11. What would be your thoughts about the tax implications of having a big part of your portfolio in high dividend stocks?

    Capital gains you can control (i.e. you can harvest them and offset loses), but dividends go straight to your taxable income, correct? What is your advice to minimize those tax implications?

    1. Dividends are taxed very favourably for both US and Canadian investors. The two of us could earn about $70k between the two of us in dividends and pay an effective 0% tax rate. For Americans it’s even better.

      1. As always, great post that was well written and informative.

        Not sure if you all are looking for more post ideas but it would be interesting to see an analysis of how you all plan to achieve a 0% tax rate given your portfolio.

        If not that, do you happen to know any good sources to read up on how to achieve 0% tax rate given various portfolios?

        Keep producing great work!

  12. Hey guys, a question not related to dividend yields so sorry to through everyone off focus. But should I consider my Company’s 401k contributions into my savings rate? Or is that cheating?

    1. Ultimately that’s up to you. I count my employer’s match in my savings rate since its cash flowing into my accounts. Despite the jokes, there are no ‘retirement police’ that are going to throw you in jail if you do or don’t count it. Count it however it makes sense to you to count.

    1. There is no such thing as a Dividend Growth REIT, so I guess I’m against it?

      Dividend Growth Investing is a whole other ballgame. It involves buying individual stocks that have a track record of growing dividends and then holding them. I don’t like it myself. I prefer to use dividends to build my Yield Shield but on top of an underlying strategy of indexing.

  13. I am Asian and I have educated my parents in dividend investing.

    They have been quite successful at it and our family (myself, my spouse and child) gets hongpao at lots of occasions from my parents’ dividend payments!

  14. Could you elaborate on the 70k dividend income tax free please wanderer? Do the same rules apply wherever you are in Canada? thanks for the great help

  15. Damn, can totally relate to the last part of this article. Just had an intense argument with my mom yesterday because she insisted me using my savings to buy a house as an investment, and wouldn’t listen to me when I tried to explain financial independence to her. No, Mom, just NO!

    1. Do we have the same Mom? Mine said “so what? You don’t even have a house” when I told her I was FI. I’m also a failure because of my flat nose bridge.

      Ahhh Asian parenting. So many good stories…

  16. REIT is down quite a bit recently. The yield is looking better and better, but the price might continue to drop for a while.
    I like the yield shield strategy. Less volatility and a bit more cash at the beginning of retirement is a good thing.

  17. Dividends are pretty awesome. That’s why my nickname is Lady Dividend. There is another Dividend class called the aristocrats which people may want to research. These companies have not only paid but increased their dividends without interruption for 25 years.

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