Investing for passive income – The danger with dividends

The potential to earn passive income is what gets many people excited about investing in the first place. It’s an attractive concept, allowing you to earn money through dividends and interest while you sleep. So in this article we cover some of the investments that pay passive income, and discuss why chasing passive income through investing might not be such a good idea…

This article covers:
1. What is passive income, and how can you earn it by investing?
2. Pros of investing for passive income
3. Cons of investing for passive income
4. What’s the best approach?

1. What is passive income, and how can you earn it by investing?

What is passive income?

Active income is a concept most people are familiar with. It involves trading your time and effort for money. For example, active income could look like:

  • Employment – Getting a job where your employer typically pays you for the time you work.
  • Self-employment – Running your own business or doing a side-hustle e.g. driving Uber.

As for passive income, this is income earned with little ongoing effort. For example, passive income could look like:

  • Creating content – E.g. Creating a course and selling it online, or creating a YouTube video which earns ongoing ad revenue.
  • Investing – Using your money to buy assets which generate ongoing income in the form of dividends or interest.

Passive income is an attractive and powerful concept. Firstly it allows you to earn money while you sleep. Secondly it is scalable – While your potential for earning active income is limited by the number of hours you have in your day to work, your potential to earn passive income doesn’t have the same limits.


Examples of investments that pay passive income

There’s a few ways to earn passive income from investing including:

High dividend paying companies

The first type of investment you can use to earn passive income is dividend paying companies. This is where a company pays out a portion of its profits out to their shareholders. Lots of companies pay dividends, but some pay much more than others. Here’s some examples of high yielding NZ companies (not recommendations to invest):

Further Reading:
Dealing with Dividends – 5 things to know about them

Dividend funds

If you don’t want to pick individual companies to invest in, there’s always the option of investing in a dividend focussed fund. These funds invest in a diversified portfolio of relatively high dividend paying companies:

  • Smartshares NZ Dividend ETF – Invests in the 25 highest dividend yielding companies within the NZX 50 index. Has a yield of 4.66% versus 2.37% with the regular S&P/NZX 50 ETF.
  • Smartshares Australian Dividend ETF – Invests in the 50 highest dividend yielding companies within the ASX 300 index. Has a yield of 4.87% versus 3.38% with the regular S&P/ASX 200 ETF.
  • Kernel Global Dividend Aristocrats Fund – Invests in around 90 overseas companies that have a track record of stable or increasing dividends over at least 10 years. Has a yield of 5.26% versus 2.32% with Kernel’s main Global 100 Fund.

Other investments

Other investments that can pay out a regular income are:

  • Bank deposits – Savings accounts, notice saver accounts, and term deposits can all pay interest on a regular basis. The current interest rate on 1 year term deposits from the main banks are sitting around 5.20%-5.30%.
  • Bonds – Bonds essentially involve lending your money to a company or government. You’ll earn interest in return for lending your money. For corporate bonds, this interest is usually slightly higher than bank deposits, while for government bonds, this interest is usually slightly lower.
  • P2P lending – Involves lending your money out to other individuals or businesses. The interest you can earn is usually a lot higher than bank deposits, but these investments come with higher risk.
  • Cash, Bond, and P2P lending funds – You can always invest in the above assets through a fund to save you from having to pick and manage individual bank deposits or bond issues.

Further Reading:
The ultimate guide to bank and savings accounts in New Zealand
Bonds 101 – 5 things to know about investing in bonds
5 things to know about investing in Peer to Peer Lending
Squirrel Monthly Income Fund review – P2P Lending made easy as PIE

2. Pros of investing for passive income

Can provide a regular income stream

Companies that pay dividends typically do so every 6 months, with some companies paying them quarterly. Interest payments on bonds tend to follow a similar frequency, while bank deposits and P2P Lending pay out interest as often as every month. That gives these investments the potential to provide a regular, predictable stream of income that can supplement your active income and help cover your living expenses. Or they could even replace your active income entirely and allow you to retire from your job.


Low effort required

Creating a passive income stream usually requires a lot of upfront effort. For example, if you decided to start a YouTube channel or make course, you’d need to spend hours creating and editing the content required for these. Plus these ventures might require some kind of specialised knowledge or equipment to create the content in the first place.

On the other hand, generating passive income from investing doesn’t require much effort. All it requires is using your money to buy an income producing asset like a dividend paying company or a bond. You don’t require any specialised knowledge to buy such assets, especially if you’re investing funds rather than picking individual companies. The barriers to investing are extremely low, and anyone can do it within the comfort of their own home, with as little as $1 to get started.


Dividend paying companies are usually more stable

Dividend paying companies tend to be larger, more mature companies. They tend to fall less in market downturns, and are less likely to go bust compared to a less mature, non-dividend paying company. They’re also constantly generating a return (even during periods of market volatility), thanks to their regular dividend payments. Investing in them can help mitigate the volatility in share prices you’ll encounter in a market downturn.

For example, the past year has been a poor one for financial markets. Here in NZ the NZX 50 Index has dropped 9.66% over the past year, while the NZX 50 High Dividend Index (representing the 25 highest dividend paying companies in the NZX 50), has performed slightly better, dropping 8.59%. The returns of the High Dividend Index are even better when you factor in the dividends paid over the year:

Price returnTotal return
S&P/NZX 50 Index-9.66%-6.98%
S&P/NZX 50 High Dividend Index-8.59%-4.22%

The results are similar in the US, where the S&P 500 High Dividend Index (containing 80 high yielding companies within the S&P 500), has way outperformed the main S&P 500 Index.

Price returnTotal return
S&P 500 Index-14.41%-12.99%
S&P 500 High Dividend Index-5.39%-1.34%

Bonds and bank deposits are also relatively stable investments. For example, both pay out a fixed amount of income regardless of market conditions, so are less susceptible to fluctuations in value.


Earning dividends and interest feels good

Earning dividends and interest simply feels good. It’s actual money in the bank and a regular reward for investing. And earning dividends tends to be a more comfortable and familiar concept for investors, given they represent a regular, relatively stable form of return, similar to earning interest on a savings account. Whereas investors might be less comfortable with earning returns through capital gains, especially when they tend to be irregular and unpredictable in nature.

3. Cons of investing for passive income

You need a lot of capital

To earn a meaningful passive income from your investments, you need a lot of money to start with in the first place. For example, if you invested $10,000 in a portfolio which gave you an after-tax income of 5% per year, you’d earn just $500 in passive income. That $500 is great, but won’t make a meaningful difference to your finances. If you had $100,000 to invest, that could earn you $5,000 at a 5% yield. Perhaps that could make a substantial difference to your lifestyle, but don’t expect that to be enough to allow you to retire from your job.

At minimum you’d need to invest several hundred thousands of dollars before the passive income is enough to make a meaningful difference to your life. So while investing might not require the same level of upfront effort as creating a YouTUbe video, it still requires you to put in the effort to earn money, save it, then invest it, before you can earn any income from it.


You’ll sacrifice capital growth

Dividends aren’t the only way you can make money from shares. Capital gains (which you can earn if your shares go up in value) is another important source of returns when investing. Usually you can’t have both – High dividend paying companies usually have low capital growth, while high growth companies usually have low dividends. That’s because dividends aren’t free money. Dividends represent cash paid out to shareholders from a company’s earnings – Cash that could’ve otherwise been reinvested back into the company to support further growth of the business.

In other words, high dividend companies pay out high dividends because they have lower growth prospects and fewer areas to reinvest their earnings – therefore have lower capital growth. While high growth companies, pay out no or low dividends because they have more growth prospects and more opportunities to reinvest their earnings – therefore have the potential to deliver higher capital growth over the long-term. It’s possible to find a middle ground (like a moderate dividend paying company that has moderate potential for capital and dividend growth), but in general chasing dividends will hurt your overall returns.

Take the S&P/NZX 50 High Dividend Index for example. While this index may have been great for protecting investors against short-term volatility, it has underperformed the regular S&P/NZX 50 Index over the longer-term. Here’s their returns over the last 10 years:

Total return
S&P/NZX 50 Index10.97%
S&P/NZX 50 High Dividend Index9.67%

The results are similar in the United States:

Total return
S&P 500 Index12.57%
S&P 500 High Dividend Index11.37%

In the case of bonds, they can also deliver capital gains, but these are usually small and don’t tend to be the primary reason for investing in them. And as for bank deposits and P2P lending, while a 5.3% interest rate on a term deposit may be tempting, these offer no potential for capital growth.


Earning income is tax inefficient

Dividends and interest are taxable in most cases, whereas capital gains are often tax free. For example, a 5.3% return on a term deposit is taxable, and will result in a return closer to 3.5% once tax is taken away (at a 33% rate). On the other hand, having your shares go up 5.3% in value often isn’t taxable. So if you could have the choice between earning $1 from a dividend or $1 from capital gains, earning that $1 through the latter would give you the better outcome most of the time.

Further Reading:
What taxes do you need to pay on your investments in New Zealand?


Dividends aren’t guaranteed

A 10% dividend yield doesn’t necessarily mean you’ll get that 10% yield into the future. Dividend yields are often a dangerous and misleading metric to look at when picking companies. Yields are backwards looking, and a high yield may be based on a time when a company was more profitable. Companies can easily reduce or cancel their dividends, for example, if their profitability fell or because of uncertain economic conditions.

Those investing for dividends need to consider factors other than yield alone like a company’s payout ratio or their sustainability of future profits, and perhaps avoid having a heavy reliance on the dividend income of a single company. Otherwise interest payments from bonds and bank deposits are much more reliable.


Your returns might not compound

Compounding returns are an important way to grow wealth. For someone investing for passive income, this could involve reinvesting dividends into buying more shares, so that you can earn more dividends in the future. However, those earning passive income from their investments may face the temptation to spend it rather than reinvest it. In this case your returns won’t have the same opportunity to compound compared to if you had reinvested it.

Take a $100,000 investment portfolio that returns 4% in capital gains and 4% in dividends each year for example. If you reinvested all the dividends, you’d end up with a portfolio worth $466,096 after 20 years. However, if you had spent all the dividends, your investment would be worth $219,112 after 20 years, and you would have spent $119,112 in dividends over that time (for a total of just $338,244).

So just because you’re earning income from dividends and interest, doesn’t mean it’s wise to use it to inflate your lifestyle as it’ll hurt your ability to grow wealth over the long-term. Someone who needs help in staying disciplined with investing might be better off in a fund which auto-reinvests the distributions, or one that doesn’t pay distributions at all, in order to remove the temptation of spending the income.

4. What’s the best approach?

Receiving dividends and interest can be one of the most exciting parts of investing, but chasing these forms of income can be a poor way to invest. Investments that pay a high income generally come with lower potential for capital growth and are often less tax efficient – that might not be ideal if you’re investing to build wealth. So how should you approach your investments instead?

Consider your goals

When deciding what investing strategy to pursue, always consider your individual financial goals and needs. For example, a retiree who wants to generate an income from their investments may be ok to have an investment portfolio stacked with high dividend shares. Meanwhile someone early in their investing career looking to accumulate wealth may find investing fully in dividend companies to be sub-optimal.


Consider the total returns

If you’re investing to accumulate wealth (instead of generate income), then it might be more appropriate to consider your potential total returns (capital gains + dividends). Instead of basing investment decisions on interest rates or yields, don’t be afraid to consider funds or companies with low or no dividends, and take into account their potential for capital growth.


Remain diversified

Even if you’re chasing high capital growth, dividend paying companies are still an important part of a diversified investment portfolio. Having dividend paying companies will allow you to balance out a portfolio of growth companies, perhaps reducing overall volatility of your investments. And if you invest in a broad market index fund, you’ll naturally end up with both types of companies. For example, if you’d invested in the NZX 50, you’d get exposure to lots of high dividend paying companies like Spark and Contact Energy, as well as exposure to higher growth companies like Fisher and Paykel Healthcare and a2 Milk.


Don’t be afraid of having to withdraw capital

Regardless of what you choose to invest in, remember that you don’t have to earn dividends or interest to make an income from your investments. You can always sell off some of your capital (realising your capital gains on a regular basis) to generate an income stream – think of it like dollar cost averaging in reverse.

You might have to pay brokerage, and sometimes you might have to sell at an unfavourable time when the markets are down. But on the other hand, you won’t be bound to investing in dividend paying companies (which should result in the potential for higher capital gains), may have better tax treatment, and your income stream won’t be dictated by a company’s dividend payment schedule.

Conclusion

Investing is an excellent way to generate passive income. It’s incredibly accessible, doesn’t require much effort, and can provide you with a relatively stable and regular stream of income (which could even enable you to retire!). Plus it simply feels good to get a dividend or interest payment drop into your bank account.

But there’s plenty of issues with investing for passive income. You need a lot of capital in the first place to generate a meaningful amount of passive income. And chasing passive income too early in your investing career can be detrimental to building up your wealth, as your overall returns from an income focussed portfolio will likely be lower, especially when you consider the potential tax implications.

So whether you should take an approach of investing for passive income depends on your goals. If you need the extra income and aren’t bothered about growing your capital, perhaps investing in a portfolio full of dividend funds and bonds will be ok. But if you’re in the process of accumulating wealth, it might be less suitable to have an income heavy portfolio.

As for our personal experience, we’ve made the mistake of emphasising dividends when we first started investing, and as a result have missed out on a lot of capital growth. Given we’re still in the wealth accumulation phase of our investment journey, our current focus is investing in broad market index funds – Even though our regular dividends will be lower than with our previous income heavy portfolio, we now have a much more balanced mix of growth and dividend companies which will likely deliver better overall returns over the long-term.

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Disclaimer

The content of this article is based on Money King NZ’s opinion and should not be considered financial advice. The information should never be used without first assessing your own personal and financial situation, and conducting your own research. You may wish to consult with an authorised financial adviser before making any investment decisions.


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