A Different Dividend Income Perspective

Photo by Alexander Mils on Unsplash

Standard Dividend Approach

A typical approach to dividend investing may look something like this.

You find great dividend growing stocks that pay adequate yields and have histories of increasing dividend payments. Over the span of years, perhaps decades, you build positions in several such stocks. Meanwhile you watch the market value and the annual dividend income of your portfolio grow, taking full advantage of compounding. You may even use an online calculator to project how long it will take for you to reach certain milestones and ultimately the necessary dividend income that will allow you to become financially free.

This buy-and-hold style of dividend investing is probably the most common path followed by dividend investors. You’ll likely hit a few bumps along the way, like dividend cuts or mergers that will force you to make unwanted changes to your overall strategy. But with some luck, hard work and a great deal of patience the results of this style of investing can be excellent.

If you’re a dividend investor, this path, or a variation of this path is likely the strategy you follow. But have you considered whether this is the optimal strategy for you.

The late Charlie Munger shared a tremendous amount of his knowledge with the world. The one piece of advice from him that resonated with me more recently was his strategy for solving problems. Mr. Munger liked to invert his problems, look at them backwards to gain a different perspective. The example he referenced frequently was his job as a meteorologist in the Army during World War 2.

If you’d like to hear him explain it, check out this video:

This is a great piece of advice that can come in handy for many of life’s problems. Let me show you how it can be beneficial in a dividend income investing strategy.

Inverted Perspective

The approach to dividend investing I laid out earlier is primarily forward looking. The same can be said of most financial calculators that help you determine how long it will take to reach your income goals. What if we invert this problem and think about it backwards, can that give us a different perspective on our strategy?

Let me lay this out in a hypothetical example using real numbers and investment products.

I’ll start by laying out some basic parameters.

Our starting portfolio value is $1,000.

We can contribute $1,000 to this portfolio each month.

And to keep our goal simple, let’s aim for replacing our contribution, generating $1,000 of monthly dividend income or $12,000 per year.

Using a basic online calculator from market beat we can estimate that it would take us approximately 14 years to reach this goal by just investing into SCHD. I estimated a 3.5% starting yield, a 7% dividend growth rate, a 7% rate of capital appreciation and reinvesting all dividends along the way.

Some of us will find this extremely motivational while others will find it less than appealing, everyone has their perspective.

This is the “forward” way to look at the problem, our goal of generating $12,000 in annual dividend income.

Let’s now take a look at it backwards.

How can I generate $12,000 in annual dividend income?

If SCHD is our preferred investment vehicle of choice and we assume it can pay a relatively similar yield in the future as it does now, the math is quite simple.

$12,000 / 3.5% (yield) = $342,858

Before I continue, ask yourself, has this changed your perspective already?

If not, consider this. Our problem of figuring out how long it will take our stream of invested capital into SCHD to generate our desired ($12,000) annual dividend income can now be viewed as how can we turn our stream of invested capital into roughly $342,858. This is the amount of capital we would need to invest into SCHD to generate $12,000 in dividends.

Perhaps there are better alternatives than investing into SCHD that could help us reach our goal faster.

Between 2012 and 2023, SCHD had a time weighted rate of return of 12.74%, slightly faster than the return assumption used in the calculator earlier. However, during the same time period, Visa had a time weighted rate of return of 22.28%. Meanwhile, Nvidia grew at a staggering rate of 52.30%.

Neither of these two stocks would help us hit our desired dividend goal during this 12 year period. SCHD would bring us the closest and another year or two would be enough to hit our milestone. But this only holds true if we take a “forward” looking view at the problem.

Remember, the inverted way to look at our problem simply required us to build enough capital (roughly $342,858) that we could invest into SCHD to achieve our goal.

In the 12 year example in the screenshot above, Visa would help us hit this goal in the 12th year, while Nvidia would help us exceed that goal by a wide margin.

Even if we factor in the burden of capital gains taxes, we would be better off investing in Visa and Nvidia than SCHD.

Using the data from the chart above.

Selling our stake in Visa at the end of 2023, we would realize a capital gains tax of approximately $42,000 leaving us with about $380,000 that we could invest into SCHD.

This would generate about $13,566 in dividend income if it were invested into SCHD, using the 3.57% dividend yield in 2023 from the image above.

The $286,986 balance shown for SCHD would only generate $10,245 in dividend income, using the same yield. Leaving us short of our goal.

The after-tax balance left from the Nvidia investment would give us about $5,589,000, that would generate nearly $200,000 in annual dividend income if it were invested into SCHD at the end of 2023.

Matter of fact, the Nvidia position would allow us to exceed our dividend goal by the end of 2017, based on the data in the image.

Different Perspective

My analysis and example aren’t geared towards diverting dividend investors to become growth investors. I merely wanted to show you how Mr. Mungers trick of inverting problems can help you find alternative solutions.

There are no guarantees in investing, which is why we all have to decide which path is optimal for us.

What resonates with me is investing in high quality companies, buying them at a fair price and generating an attractive rate of return. My goal is to grow my capital.

I also like dividends, but my dividend goals are long-term goals, years into the future. Therefore, conceptually, it makes perfect sense for me not to base my investing decisions on current dividend yields. Having a different perspective on how I can possibly reach my goals gives me more levers to pull when constructing my portfolio and does not limit me to solely invest in companies that fall into arbitrary yield thresholds.