ET - Are Dividend Stocks The Best Choice For A Passive Income Investing Strategy?

2023-04-25 10:00:00 ET

Summary

• Passive income investing is a popular - and smart - way to approach saving for retirement.
• We discuss whether or not dividend stocks are the best choice for building passive income.
• We also share some of the most important - and often missed - principles that passive income investors should keep in mind when making investment decisions.
• Finally, we conclude with some great passive income investment ideas.

Passive income investing is a very smart way to approach retirement saving. This is because passive income solves the two biggest financial needs for a retiree:

1. By definition of being passively generated income, it does not require much (if any) time or effort to produce. As a retiree, dedicating large amounts of your time and/or effort are the last thing you want to be doing to generate income. You have worked hard your entire life and now during this next season of life you want to be able to kick back, relax, and enjoy the fruits of your labor while dedicating your time and effort to other more important things than making money. If you wanted to spend a lot of time and effort to generate income, you would have just kept working.
2. By definition of being income, it means that this approach to investing brings in a pretty consistent and reliable amount of cash flow. As a result, it is much easier to forecast when you will be able to retire using this method. Instead of hoping that a certain nest egg size will be enough to last you through retirement, the passive income investment approach to retirement lets you know right away if your passive income stream is enough to cover your budgeted expenses.

In effect, passive income investing fully takes the place of your job. Instead of devoting 40+ hours per week to a job to generate the income, your investments generate the income for you. As a result, you can divert your time and energy elsewhere confident that your passive income stream will cover your budgeted expenses.

In contrast to investors who merely put all of their retirement nest egg into something that generates little to no yield, such as an S&P 500 ( SPY )( VOO ) fund, precious metals ( GLD )( SLV ), and/or Bitcoin ( BTC-USD ) hoping that they will appreciate in value over time, a passive income investor does not have to worry about short-term market fluctuations. That is because they live off of the income being generated by their investments and should never have to sell any of their investment principal. As a result - as long as the underlying fundamentals of the investments generating their passive income are sound - the latest quoted value of their investments mean little to their lifestyle or retirement's longevity.

What is the best way to approach passive income investing?

With these pros of passive income investing in mind, we will now dig into some of the nuts and bolts of building a passive income investing strategy.

The most important principle for passive income investing is to make sure that your sources of passive income are durable. It does little good to invest in something that offers a 15% passive income yield if within a year or two that income yield disappears or is at least dramatically reduced. As stated earlier, the whole point of a passive income strategy is to be able to sleep well at night and devote your time to other activities while knowing that your income stream will continue to come in on schedule at levels that are in line with your expectations and lifestyle budget. As a result, investors should seek high quality and durable sources of passive income. A classic contrast here can be found in two midstream MLPs: Enterprise Products Partners ( EPD ) and Energy Transfer ( ET ). Back in 2020, ET had a higher dividend yield than EPD did. As a result, passive income investors may have been quick to choose ET over EPD for the higher income yield:

However, if they had looked under the hood they would have seen that ET had considerably more leverage on its balance sheet than EPD did and was in danger of losing its investment grade credit rating. In contrast, EPD's balance sheet remained very strong and it had very little to worry about from a financial perspective. As a result, ET slashed its payout in half shortly thereafter whereas EPD continued to grow its payout.

Another important principle is that - ideally - especially in these times - you want an income stream that will grow over time in line with inflation. This way you know that you can not only sustain your current spending level but actually sustain your buying power/lifestyle over the long-term. With this in mind, it is important to note that fixed income investments - a popular investment for retirees given that they often offer generous and durable passive income yields - generally do not increase their payouts over time. As a result, investors who include fixed income instruments in their portfolios need to either ensure that they are generating more passive income than they plan to spend in order to have excess cash to reinvest to grow their passive income stream, or they need to ensure they are getting plenty of income growth elsewhere.

As a result, while a high yielding fixed income fund might sound appealing for its ability to accelerate your retirement timeline, it is better to take a more conservative approach. You should plan to either only spend a portion of the yield generated by that fund and reinvest the remainder, or invest in a proven dividend grower like Realty Income ( O ) even if the starting income yield is less impressive. This is because it will very likely continue to grow its dividend in-line with the long-term historic average rate of inflation over time instead of seeing the purchasing power of its yield get eaten away each year.

Finally, while durable sources of passive income that also grow roughly in line with inflation over the long-term are great, it is also crucial that passive income investors diversify their income sources enough in order to guard against black swans and other unforeseen misfortunes befalling their investments. For example, in the wake of the COVID-19 lockdowns and lingering uncertainty, many stocks with very impressive dividend growth track records and strong balance sheets had to cut their dividends. Examples of this include prestigious REITs like Tanger Factory Outlets ( SKT ) and Simon Property Group ( SPG ) which had to slash their dividends deeply in the wake of the crisis, leaving many dividend investors out to dry. However, for investors who had properly diversified their portfolios, the impact of these cuts would not have been too severe.

How do dividend stocks fit into a passive income investing strategy?

With those principles in mind, how do dividend stocks fit into a passive income investing strategy and are they the best choice for building passive income?

Given that reliability, growth over time, and diversification are the three most important principles to apply when building a passive income stream, we believe that dividend stocks are the best choice.

Of course, they are not the only option, and there is certainly a place for other sources of passive income (such as rental properties, private market loans, and private equity). However, private market loans generally come with considerable risk and do not grow in-line with inflation over time. Private equity investments generally charge high management fees, are illiquid, and many times do not pay out regularly increasing distributions to investors. Finally, rental properties - while generally a fantastic source of passive income that grows over time - are quite difficult to sufficiently diversify given the massive amount of capital investment required to buy each property. Moreover, rental properties either require an expensive property manager to be hired to properly oversee them or require considerable time and effort to manage. In this sense, rental properties are often more active businesses than they are true passive income investments.

In contrast, dividend stock funds like the Schwab US Dividend Equity ETF ( SCHD ) and the Vanguard High Dividend Yield ETF ( VYM ) are totally passive, charge extremely low fees, are very well diversified, and offer sustainable and growing passive income payments as evidenced by their track records. Since 2012, SCHD has grown its dividend per share at a 12.20% CAGR and VYM has grown its dividend per share at a 7.4% CAGR, making them excellent funds for enjoying income growth at a pace that exceeds inflation.

Of course, there is no free lunch and SCHD and VYM come with starting dividend yields that are on the low side for being passive income focused funds: SCHD has a trailing twelve month yield of 3.6% and VYM has a trailing twelve month yield of 3.1%. That is why at High Yield Investor we have put together portfolios that offer yields ~2x what is offered by these funds while still generating similar annualized dividend growth thanks to a combination of dividend growth in our underlying holdings and opportunistic capital recycling to further grow our passive income stream. Moreover, we have been able to substantially outperform funds like SCHD, VYM, SPY, and even higher yielding dividend funds like Global X SuperDividend U.S. ETF ( DIV ) since our portfolio's inception:

Investor Takeaway

Passive income investing is an extremely rewarding way to save for and fund a retirement, if done correctly. By keeping the following principles in mind and building your passive income stream accordingly you can sleep well and enjoy life in retirement free from financial worries:

• Income sustainability
• Income growth
• Income source diversification

While there are many ways to invest for passive income, dividend stocks are the best all-around approach as they best fulfill all three of the aforementioned principles for successful passive income investing. With funds like SCHD and VYM investors can take the easiest path to passive income investing whereas building your own portfolio involves a bit more active management, but brings with it a significantly higher income yield and total return potential.

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