A common goal for investors, particularly dividend investors, is to build savings to the point where they can replace their salary income with dividend income. I have this goal as well, although I’m happy to generate this income from a combination of dividends, capital gains and interest.
A critical factor in determining whether you’ve truly reached your goal is whether your capital is still expected to grow at least as fast as inflation after you take your income each year. Some investors say they don’t care about the amount of capital they have saved as long as they hit their income targets. This is fine if the capital isn’t shrinking, but could be a disaster if the capital can’t keep pace with inflation.
An investor with the wrong focus could hit an income target quite easily – just find a few stocks with ultra-high dividend yields. I did a simple screen of Canadian stocks that showed 21 stocks with dividend yields between 10% and 20%, with an average dividend yield of 14%. So, a $500,000 portfolio invested in these stocks would earn an income of $70,000 per year. Many people would be happy to retire permanently on this income. But the important question is whether the income will stay this high. High dividends are often unsustainable. If a company consistently pays out more in dividends than it earns in business profits, eventually it will have to cut its dividend, perhaps drastically.
The iShares Dividend Aristocrats ETF (ticker: CDZ) has a dividend yield just over 3%. On a $500,000 portfolio, this is just $15,000 per year. This income level is depressingly low compared to $70,000. But what is the point of the $70,000 income if it drops drastically in future years? You’re effectively spending your capital even if you own the same number of shares from year to year. With dividend aristocrats, at least there is a reasonable hope that the income will continue and even rise over time.
In my opinion, an even better strategy than investing in dividend aristocrats is to be more broadly diversified. This drops the dividend yield to a little over 2%, but the possibility of higher capital gains makes up the difference.
Dreaming of leaving a hated job is understandable, but reaching too far for yield is dangerous. Investors are better off focusing on the profitability of the businesses they own rather than the dividend yield. This is true whether you buy individual stocks or buy funds that hold many stocks. Not all income streams are sustainable.