Provided that you are willing to have a diverse selection of dividend-paying stocks (more than 10 with no more than 20% of your money in any individual company or any sector) and you are willing to pay attention to it so you don’t end up holding a company as it falls down the Enron drain, this strategy can work. It’s often discussed in investing books as “dividend investing” and can work very well for you, not only as a retirement plan, but as a way to build steady income.
- Spend way less than you earn. Pay yourself first. You’ll need the investments to return substantially more each year than you would spend.
- Keep a year’s worth of living expenses in cash, savings account, and CDs. This isn’t just an emergency fund, but it helps you get through the ups and downs of your other investments. If they don’t return as well as you’d like for a quarter or two, things aren’t disastrous – you still have a lot of breathing room.
- Roll the excess back into your investments. Whenever you start to build up way more than a year’s worth of savings, roll it into more investments. Keep pretty careful track of your spending and so you have a strong estimate of the year to come. If the amount in cash and CDs gets over fifteen months’ worth of living expenses or so, cut it down to twelve months’ worth and put that difference into your investments. And what are they?
- Put all of the rest of your money in stocks which pay a good dividend. Buy stocks in companies you believe in over the long haul that pay good dividends. So how does that work? Let’s take a look at AT&T (Google Finance). As of this writing, a share of AT&T is at 24.83 and has a dividend of 0.40. What that means is that every three months, for each share of AT&T that a person holds, AT&T pays that person $0.40. So, let’s say that over time, you bought 1,000 shares of AT&T – at today’s market prices, that would have cost you just short of $25,000. This means that every three months this year, AT&T is directly going to pay you $400. Over the course of a year, that would have added up to $1,600. And if that dividend holds, over ten years, the investment would pay out $16,000. Obviously, the board of directors of a company can choose to raise or lower a company’s dividends. That’s why you should choose to buy only stable companies that have a long history of paying good dividends.
- Choose your stocks wisely.
- Don’t just go by which stock has the highest dividend yield, which is the annual dividend divided by the current stock price. That may be caused by a low stock price, which could be the result of the company having problems, compared to the historical dividends.
- A company with a history of paying a consistently growing dividend is best, next is a company that pays a consistent but steady dividend, and next is a consistent but flat dividend. Be wary of a company that has had to cut its dividend–that doesn’t mean you should avoid it completely, just look closely.
- Look at the dividend coverage ratio. Take the 12-month operation cashflow per share and divide it by the last 12-month dividend (or expected annual dividend). A company with a ratio of 1.0 or better is generally “safe”.
- Go for companies that have a lower debt load than the industry average or its peers, because that offers the flexibility to borrow if needed to support operations and the dividend.
- For the most part, you don’t need to worry about the stock price. All you care about is the dividend – as long as it stays reasonable, it doesn’t matter how much or how little the stock can sell for. You intend to hold it for a very, very long time. In fact, you should hope for low prices on many stocks, just as you would hope for low prices on beef if you intend to buy beef and not a cattleman yourself. You can buy more dividend-earning stocks given the low market, and get more shares for your dollar.
- An added bonus is that dividends are generally taxed at a lower rate than other interest income.