The answer is definitely yes. Long-term dividend stocks using a dividend reinvestment program (DRIP) can be a fantastic strategy for someone who is young. I did not find this question too surprising, though once I am done answering it you will realize that basic math has already told us that dividend stocks are for the young as well as the slightly older.
Strategies for Retirement, For the Not Yet Retired
The reason that dividend stocks are considered the bastion of the old is because it is always talking about retirement, which people in their 20s rarely think about. Strategies for retirement are not always for just approaching retirement. A dividend strategy can be coupled with a growth strategy for the young as well.
All of your wealth should not be in growth stocks. If you like risks, and can monitor your investments effectively this might be 25% of your wealth. If you really want to get up into your elbows you might try 50% before moving to 25% at the age of 30, and 15% at 35. The rest of your portfolio should be devoted to safer investments.
Dividend Reinvestment Plan Explained
Dividend Reinvestment Plans, or DRIPs, allow you to take the dividends you receive from a company and reinvest them into the stock of the company. Basically if you get $1000 of dividends, you will buy $1000 worth of shares. Sometimes that amounts to fractional shares, which I have seen. I am not sure if certain plans or brokerages just round down to the nearest whole share and give the change to you.
DRIPs are fantastic for younger people, especially in a tax-deferred account. Even with DRIPs you need to pay taxes on the dividends received but you have not gotten any actual cash. You need to pay out of pocket for the taxes. In a tax-deferred account you can just set up the investment and forget about it.
Why DRIPs?
DRIPs should really only be used for extremely long-term stocks that you would like to own more of. If you think you could take the dividend money and invest it better than don’t use the DRIP. Also, companies that have high yields are usually exploiting some favorable environment, but in the long-term those companies might have shrinking yields along with serious capital depreciation.
For example the mortgage based REITs offer large yields, but the spread between short-term and long-term debt has been falling so it has been harder for them to make money and maintain high dividends. You are probably better off going with bigger companies that offer dividends. There are quite a few, just make sure that they are companies that won’t become irrelevant in a short period of time. These are sometimes called forever stocks. The long-term strategy is a powerful one if you choose correctly. Aiming for a high and resilient yield makes the strategy far more effective.
Compounding
I should do something devoted to compounding, but most people know what it is. Compounding is a very powerful way to increase total returns. You roll back any gains into the original investment. If you generate 10%, then you roll 10% back into the investment. If you start with $100 you get $10, but then you have $110 with 10% returns on that. Next time you get $11 giving you $121 total. Next, time you receive $12.1. Notice how the amount does not just increase lockstep. It is not $1 each time, but the total amount of the gains go up as well.
I know I am not explaining it in a really clear way. It is hard to explain math in text. The point is that the first time your absolute gains grow by $1 then by $1.10. This should be clear as 10% of the gains is what the increase is. I hate explaining math. It is just important to understanding the potential of the strategy.
A 10% return is great, but this is an ongoing return of 10% on a base that increases by 10% in each cycle. When people think percentages they tend to think stagnant. For people who are always in finance or just people who are rigorous about math they will mention whether a return is compounding or not. However, a lot of people think a 10% return on $100 every year would just be $10 a year. If you say compounding a few of them will realize that it grows, but few will realize that the return line curves upward at an increasing slope. If you show them the chart then they realize the magnitude. Some people won’t even know what compounding is.
DRIPs are compounding. If you get $1 per share, then when you get the dividend you are buying more shares. Next time you get another $1 but now you are getting it on more shares. Each time you can buy more and more shares if the price is exactly the same. The great thing about DRIPs in a strong company is that fundamental strength with technical weakness is meaningless.
It would be awful to own a great company and see it go down, because some other company had accounting fraud. Panic is contagious. Even if the stock price gets depressed the dividend might be maintained. Also, management and the board tend to be shareholders as well. They will either increase the dividend or do a share buyback in order to return more value to shareholders. A DRIP investor should prefer the hiked dividend.
Consider this, if a stock loses 50% of its value due to 2008, but is still making a ton of money, you can buy way more shares when the dividend is issued. You can buy twice as many as you could have before the decline. When the stock goes back to where it was as things improve, you have way more shares. Just remember dividends are fixed but the yield percentage is not. Increasing prices means the yield percentage drops.
So with each dividend payment you get more and more shares which increases your dividend check even if the dividend stays the same. If the dividend hikes it will magnify your benefit. Assume a company aims to keep a 6-7% annual yield, what would it be in 20 years? If you take a $1000 investment with a consistent 7% yield for 20 years you will have over $4000 at the end of it. If the share price rises, and the yield is maintained though dividend increases, then you will have way more than $4000. That sounds like you should get started young.
Adjusting the Strategy
Another effective variation on this, which requires a more active investor, is to establish a yield cut-off. Some dividend stocks never move. However, there might be times that they rise really fast. A yield cut off is some minimal percentage after which you will sell off your position. You sell the position after the next dividend check, like the week after. This is as long as the yield is below what you have.
If I am creating a dividend portfolio utilizing DRIPs and I only go for yields that are 7% and above, then I could set my cut-off at 7%. You might consider 5% or 6% to be more flexible since price fluctuations do occur. Yields can fall because of dividend cuts, but more often it is because the price of the stock increases.
In that scenario you sell your position with your original investment and all reinvested dividends with the capital gains. Then you can by another 7% or more yielding stock. With the capital gains from the last investment you can buy even more of this new stock that yields 7%. This adds another layer of compounding to the strategy, though this one is not at a regular interval. On a chart it would appear as random jumps in value.
Sticking to the Strategy
Choosing the right stocks is the key with this, but you can quickly build a list of candidates. Also, with the cut-off you will revisit the stock you sold. One day the dividend might go up or the price might fall and it could have a great yield again. Remember you are selling because you drew a line in the sand. The company might still be amazing, but the yield is just not there for you.
If the yield ever improves you can always retake a position, and this time you will have more money to put to it for the right yield. Even if the price goes up it is still a 7% yield. Since it is a percentage yield provides a great way to cross compare stocks. A stock that yields 7% will yield 7% on a $1000 investment whether it costs $10 or $100.
You could always move it to a different part of your portfolio. Your entire portfolio does not need to be about yields, but you need to allocate an equivalent amount of money back into your dividend portfolio. So you should treat your different “strategy” portfolios as different people.
“Conservative portfolio” can’t have stock Z from the dividend portfolio without paying for it. That way you can keep the funds segregated. The whole point of compounding is ever increasing value through reinvestment of income so do not detract from that. Keep the goal in mind and adhere to the strategy.
Nothing will work like it’s supposed to if you play it fast and loose. Not to say you cannot make money playing it fast and loose with a lot of luck and brilliance. Most people adhere to a strategy and a set of rules, even if they are of their own design through experience.
Mix in Covered Calls
Dividend stocks, especially those with high yields tend not to move too fast. Once you understand more about how a stock moves you can write covered calls to increase the income and then buy more shares. Calls for dividend stocks tend to get lower premiums, because the price drops when the stock goes ex-div.
If you have been following a dividend stock and you see that it does not really move and is not in a business that could see major developments that could move the stock. Some tech stocks offer nice dividends now, though I do not think they reach 7%, and they might develop something or win a big contract that send the stock high.
Check out a company like Seaspan (SSW) that offers a fairly nice dividend, and has been fairly flat. Even these companies see a huge rise once money flows in. There is a lot of cheap money out there right now (Early 2013). The reason all of this is important is because a covered call strategy is not a great way to go if real capital appreciation is a possibility. I discussed it above that it might just be good to sell when the price rises and yields fall and then buy something else.
This only comes into play if you have covered calls that are too close to the current price. If you nail it and the stock only crosses the strike by like five cents, the premium will probably make you more money. This is especially true if you are writing contracts regularly. It is a tradeoff between the risk of missing upside and earning extra regular income. If a stock doesn’t move for a year writing covered calls through that whole year might be great. It is just that in the current 2013 market stocks can make huge moves in like 3 weeks after doing nothing for a very long time.
The strategy is sound but depends on the implementation. How far do you choose your strikes? Then consider the stock itself, and how long it is expected to be flat. There is a trade off to using covered calls, but you might come out ahead for certain stocks.
Conclusion
This strategy is most effective over long periods of time. I would say that compounding really takes about 10 years to really kick off. One final way to enhance the strategy that is not really an investment method is to add additional money monthly or yearly to the portfolio. So not only is it growing, but you are adding money to increase the base even faster. The strategy sounds easy, but it is not. Choosing the right stocks and adhering to your own rules is very hard.
The one great thing about an income strategy even with reinvestment is that an event like 2008 is softened. You are fully invested in stocks so you are not immune, but dividends even ones that are reinvested have an edge over pure capital appreciation. With capital appreciation alone you can move from gains to losses with a 2008 event. At least with dividend reinvestment you own more shares and this will lower your losses.
Not all companies were destroyed in 2008. Some still managed to make profits, or return to profits quickly. They also maintained their dividends, which means that you could buy a ton more shares. Banks were the ones that removed their dividends, but they did have some nice yields in the past. Nothing is completely immune to something as drastic as the credit crisis.
I think a dividend strategy is great if you are looking to stick with it though. You might have some recessions in the mean time, but compounding will make your portfolio very robust. Try it for 30 years and you could have a great retirement portfolio.
Note: Not sure if all dividend stocks can use DRIP. The ones I have listed here might not. this is a lesson not specific stock picks.
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