Why I Invest in High Dividend Yield vs Dividend Growth

Dividend investing is great in theory; you benefit from income being paid to you on a regular basis, as well as the price of shares rising like with normal stocks. If you do it right, then you can win on two fronts: income and capital appreciation. 

However, there are two, what you might call, branches of dividend investing:

  • Dividend Growth Investing
  • Dividend Income Investing.

Each approach has its unique characteristics, advantages, and challenges, making them suitable for different investment objectives and risk tolerances which you can call an investing strategy. 

Let’s explore the world of dividend investing and conduct a detailed comparison between dividend growth investing and dividend income investing.

By reading this, you’ll have a clear understanding of these two different strategies and be better equipped to decide which one aligns with your financial goals. 

I’ll also explain to you why I personally much prefer dividend income investing.

Dividend Growth Investing 

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Let’s start with dividend growth investing.

Dividend growth investing, at its core, revolves around the principle of investing in companies with a history of consistent dividend increases. 

The primary objective of dividend growth investors is not to just receive a regular income stream but to capitalize on the potential for long-term capital appreciation through these increasing dividends. Here are some key components of dividend growth investing:

Dividend growth: investors focus on a set of key metrics to identify companies with a strong commitment to increasing dividends. 

Some of these metrics include the dividend growth rate, which measures the average annual increase in the company’s dividend payments over a specific period, highlighting the balance between dividend growth versus high dividend yield. 

A higher growth rate is generally preferred. The dividend payout ratio reflects the percentage of a company’s earnings paid out as dividends. A lower payout ratio suggests the company has room to increase dividends.

Dividend history: A consistent history of dividend payments and increases is a significant criterion for dividend growth investors.

Long-term perspective: Dividend growth investing is basically the opposite of a get-rich-quick strategy. It’s designed for investors with a long-term horizon who are willing to hold on to their investment for many years, even decades. 

The power of compounding plays a crucial role in this approach as dividends increase, the compounding effect can lead to substantial wealth accumulation over time.

Quality over yield: One distinguishing feature of dividend growth investing is the emphasis on quality over yield percentage. While a high dividend yield may be appealing, dividend growth investors prioritize the sustainability of dividends and the financial health of the companies in their portfolios. 

They often favour established blue-chip companies with a track record of stability and growth.

Capital appreciation: While the focus is on dividend income, dividend growth investors also benefit from capital appreciation. As companies increase their dividends, it often reflects strong financial performance and market confidence, leading to higher stock prices. This dual benefit is one of the key attractions of dividend growth investing.

Dividend growth investing has proven to be a successful strategy for many investors who value steady income and the potential for long-term wealth creation. However, like any investment approach, it has a set of challenges and risks, which we’ll explore in the next section.

Advantages of Dividend Growth:

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Potential for compounding returns: One of the most compelling advantages of dividend growth investing is the potential for compounding returns. As companies consistently raise their dividend payments, investors see their income grow over time, exemplifying the advantage of focusing on stocks that grow their dividend. 

The beauty of compounding is in the fact that each dividend increase is based on a larger initial investment, leading to exponential income growth.

Income stability: Dividend growth investors enjoy a level of income stability that is often lacking in other investment strategies. Since the focus is on companies with a history of increasing dividends, investors can count on a steady and predictable income stream.

Participation in profitable businesses: Investing in companies with a commitment to increasing dividends means you are more likely buying shares in businesses that are generating profits and have strong fundamentals.

 Such companies, known as dividend aristocrats, are more likely to weather economic downturns and offer a buffer against stock market volatility.

Potential for capital appreciation: While the primary focus of dividend growth investing is income, it also offers the potential for capital appreciation. 

As companies increase their dividends, it often reflects strong financial performance and market confidence, leading to higher stock prices. Dividend growth investing has the potential to offer a blend of income and growth that can be appealing to investors seeking a steady, reliable cash flow.

Challenges and Risks of High Dividend Growth Yield:

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Stock selection: Selecting the right dividend growth stocks requires diligent research. Not all companies with a history of increasing dividends are suitable investments, and investors must assess a company’s financial health, competitive position, and growth prospects to make informed decisions.

Economic downturns: Dividend growth companies can also face challenges during economic recessions. Companies that have consistently raised dividends may face pressure to cut or suspend them when economic conditions deteriorate. Such events can impact the income stability investors seek.

Limited current income: Dividend growth investing, much like the classic marshmallow test, is a lesson in delayed gratification and the allure of becoming a patient shareholder. It may not provide substantial immediate income for some investors. For those who heavily rely on dividends for their living expenses, understanding the difference between dividend yield and dividend growth is crucial.

Time horizon: This strategy requires a longer time horizon to realize the full benefits of compounding returns. Investors who need immediate income may need to complement dividend growth investments with other income sources.

While dividend growth investing offers many advantages, it’s crucial to be aware of these potential challenges and risks. This awareness can help investors make more informed decisions and manage their expectations.

Dividend Income Investing

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Let’s move on to my preferred style, dividend income investing. Understanding dividend income investing: Dividend income investing, in contrast to dividend growth investing, primarily focuses on generating regular income from dividend payments.

Investors following this strategy tend to prioritize high-yield dividend stocks or funds that provide immediate income, making it a popular choice among those seeking a dependable cash flow.

Here’s an analogy from the Income Factory that I quite liked when I read it: Investing in the stock market for growth is like going to the horse races and betting on which horse will be the fastest and then win the race.

It’s an exciting and dynamic strategy, much like picking high-growth stocks with potential for significant price appreciation. However, just as some horses might stumble or fall along the way, some growth stocks can be volatile and come with a higher level of risk for the shareholder.

On the other hand, investing for income is akin to betting that the horses will simply finish the race, a strategy favored by those seeking high yield dividends and good dividend growth. In this approach, the primary goal is to receive a consistent stream of dividends or interest payments from stable investments. 

Much like betting that horses will successfully complete the race without worrying about which one, in particular, wins, it’s a more conservative strategy focused on reliable and predictable income rather than the excitement of trying to pick the winner.

Key Components of Dividend Income Investing:

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High-yield investments: Dividend income investors often seek out high-yield investments, which are stocks or funds with dividend yields that are substantially above the market average. These investments can provide immediate income for investors, making them an attractive choice for those who rely on dividends for their living expenses.

Regular income: The primary goal of dividend income investing is to generate regular income. Investors following the strategy rely on the dividends they receive from their investments as a source of cash flow, which can be used for various purposes, including covering living expenses or funding other investments.

Portfolio diversification to reduce risk: Dividend income investors often focus on diversifying their portfolios by holding a mix of dividend-paying stocks or funds. Diversification can help spread risk across different sectors and industries, mitigating the impact of poor performance in any single investment.

Immediate income needs: Dividend income investing is particularly well-suited for individuals who have immediate income needs, such as retirees or those looking for financial security. The dependable income stream can provide peace of mind and help maintain a comfortable lifestyle.

Risk tolerance: While dividend income investing can provide reliable cash flow, it may not offer the same potential for long-term wealth accumulation as dividend growth investing. This approach may be more appealing to conservative investors with a low tolerance for risk.

Advantages of Dividend Income Investing:

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Immediate cash flow: The most significant advantage of dividend income investing is the immediate cash flow it provides. High-yield investments can offer investors regular income that can be used to cover living expenses, reinvest, or pursue other financial goals.

Reliability: Investors who prioritize income stability can rely on dividend income investing to provide a predictable source of cash flow. High-yield stocks and funds often have a history of consistent payments, enhancing financial security.

Income for retirement: For retirees, dividend income investing can be a dependable source of income during their post-working years. It can help maintain their desired lifestyle without depleting their savings too quickly, especially for shareholders of companies that pay regular dividends.

Lower dependency on market conditions: Compared to growth-oriented investments, dividend income investments are generally less dependent on market conditions. They can offer stability during market downturns, especially those stocks that consistently pay dividends.

Challenges and Risks of Dividend Income Investing:

Yield chasing: Investors pursuing high-yield investments may fall into the trap of yield chasing, where they prioritize yield over fundamentals. This can lead to investments in riskier, lower-quality stocks or funds that may not be suitable in the long term, differing from the strategy of investing in stable dividend growers.

Market volatility: Although less dependent on market conditions, high-yield investments that pay dividends are not immune to market volatility. They can experience price fluctuations, and during economic downturns, some high-yield stocks may reduce or completely suspend dividend payments.

Limited growth potential: Dividend income investments may not offer the same potential for long-term capital appreciation as dividend growth investments. This strategy is primarily focused on providing income, and investors should be aware that their portfolios may not experience significant growth.

Interest rate sensitivity and its impact on share price: High-yield investments can be sensitive to changes in interest rates. When interest rates rise, the yields on these investments may become less attractive, potentially leading to declining prices.

Choosing the right high-yield stocks or funds requires due diligence, and investors need to assess the sustainability of high dividend payments and the overall financial health of the companies or funds in their portfolio.

In conclusion, dividend growth investing and dividend income investing are two distinct approaches to harnessing the power of dividends in your portfolio, focusing on companies that pay and distribute generous dividends. 

Dividend growth investing focuses on capital appreciation through consistent dividend increases, while dividend income investing prioritizes immediate cash flow. The choice between these strategies depends on your financial goals, risk tolerance, and time horizon. 

Dividend growth investing offers the potential for compounding returns and long-term wealth accumulation, while dividend income investing provides reliability and immediate income. Investors can also consider a hybrid approach to create a diversified balanced portfolio that combines the strength of both strategies.

There are three parts to this portfolio, and dividend stocks make up the base – that big chunk at the bottom. The goal with this part is to create a Minimum Viable Lifestyle (MVL). The MVL is the minimum amount of income you need to maintain a basic but acceptable quality of life. 

This is your starting point. The MVL amount is personalized and may vary depending on your life stage, family size, and lifestyle choices. It’s the foundation for your financial goals.

Once you’ve determined your MVL on a monthly basis, multiply it by 12 to calculate your annual requirement. For example, if your MVL is $11,000 per month, your annual requirement is therefore $132,000, and calculating the dividend needed to meet this with a certain yield can guide your investment decisions. 

In the base segment, you aim to generate a stable income through dividend-paying investments. The goal is to generate a specific amount of dividend income annually, leveraging dividend aristocrats for reliable payouts.

This amount should be above your MVL to provide for both your basic lifestyle and growth potential. The yield target may vary, but for me personally, it’s about 5.5%.

To reach your annual dividend income goal, you can calculate the dividend needed by performing a straightforward division: annual requirement divided by your target yield. So, for instance, if we use the $132,000 example from earlier, with a 5.5% yield, that means you’d need around $2.4 million worth of dividend-paying investments.

For me, it doesn’t make sense to employ the wait-and-hope strategy of dividend growth. The growth part of my portfolio comes from elsewhere. In the higher stages, I want the income as soon as reasonably possible to supplement my lifestyle. 

By investing in dividend growth stocks, there’s less stability as you’re predicting outcomes from many years into the future, relying on the dividend discount model. This obviously doesn’t suit the minimum viable lifestyle requirements as it needs the money in the present time period to work. In other words, show me the money.