Wealth Systems: Dividend A Day, Part VII

Building the Ultimate Income Portfolio

We have reached the conclusion of our epic 7-Part Series!

We live-built wealth engine #1, and we are going to complete four more in the coming months.

Part I - https://wealthsystems.ai/p/wealth-systems-dividend-a-day

Part II - https://wealthsystems.ai/p/wealth-systems-dividend-a-day-part

Part III - https://wealthsystems.ai/p/wealth-systems-dividend-a-day-part-432

Part IV - https://wealthsystems.ai/p/wealth-systems-dividend-a-day-part-f18

Part V - https://wealthsystems.ai/p/wealth-systems-dividend-a-day-part-824

Part VI - https://wealthsystems.ai/p/wealth-systems-dividend-a-day-part-d6a

We built a current income engine containing 90 stocks that yield just under 5% per year, with the benefit of diversification across asset classes, geographies, macroeconomic exposures including interest rate risk, and the thousands of other levers that collectively influence the grand economic system.

In Part VI we listed the 90 names and now we’re concluding with advice on optimizing the financial returns from this wealth engine.

Quick Refresher on the Power of Dividends

At the most basic level, dividend stocks allow investors to earn consistent cash flow without having to sell shares of their investments. Steady dividend payouts year after year can contribute significantly to long run total returns.

Mature, established companies are most likely to pay out consistent dividends over time. These companies often have predictable levels of earnings and cash flows, allowing them to fund reliable dividends. This forms a virtuous cycle for investors – as the companies succeed and grow profits, they share a portion of earnings growth by consistently increasing dividend payouts.

When looking at the total return of the S&P 500 over the past nine decades, dividends have contributed about 40% on average. So while capital appreciation garners more headlines and investor excitement, dividends have quietly delivered nearly equal half of the market’s historical total returns. Even for investors focused on growth, dividends provide a form of stability, downside protection, and income during volatile markets.

With dividends offering such a substantial contribution to long-run returns, strategically enhancing the yield of a dividend stock portfolio can drive outsized growth over time, while also generating elevated cash flow.

Let’s look at the most popular strategies to enhance returns.

Strategy #1: Diversifying with High-Dividend Yield Stocks

One of the more straight-forward approaches to boosting portfolio yield is by selectively investing in stocks with abnormally high dividend yields. These types of stocks can provide amplified income, which when reinvested, leads to accelerated compounding effects.

High dividend yield stocks are those that pay out higher than average dividends relative to their stock price. For example, a stock trading at $50 per share that pays a $2 annual dividend would have a 4% dividend yield ($2 dividend divided by $50 stock price). Compared to the S&P 500’s average dividend yield which fluctuates between 1-2%, a 4% yielding stock would be considered high.

Typically, high dividend yields are found among stocks in more mature, slow growth industries such as consumer staples, utilities, telecom, and real estate. These companies tend to deliver reliable profits and cash flows year after year, allowing them to support generous dividend payouts. However, every high yielding stock has unique risks, so careful research and scrutiny is required.

Just because a stock pays a high dividend, does not necessarily make it a good investment. Occasionally, troubled companies will pay unusually high dividends in a desperate attempt to support their struggling stock price. When business fundamentals decline, these fragile dividends can quickly be cut, resulting in painful losses.

Meanwhile, stable high dividend payers with proven track records can provide reliable portfolio income for decades. The key is evaluating each company’s profit margins, debt levels, competitive position and cash flows to gauge dividend safety and growth potential. Integrating a selectively chosen basket of high-quality, high-yield dividend payers has proven an effective way to amplify portfolio income streams.

Strategy #2: Dividend Growth Investing

Rather than prioritizing absolute dividend yields, an alternative approach involves focusing on dividend growth rates. There is a subset of companies that have track records of steadily increasing their dividends year after year, providing investors with raises to their dividend income. Targeting stocks with strong dividend growth can accelerate portfolio yield and compounding over time.

Dividend growth stocks may not necessarily have the highest current yields, but they demonstrate consistent growth in both their underlying profits and dividends paid. Leaders in this category often have competitive advantages in their industries that allow for steady expansion.

Just a few examples of well-known dividend growers include Microsoft, Home Depot, Visa, and Texas Instruments.

HD and MSFT made our portfolio.

One way investors track dividend growth consistency is by looking at a company’s dividend increase streak. There is a group of elite stocks called Dividend Aristocrats that have raised their dividends for 25+ consecutive years. Companies like Coca-Cola, Proctor & Gamble, and Johnson & Johnson are examples. The longevity and persistence of these dividend increase streaks highlight their reliability.

Beyond current streaks, studying a company’s historical dividend growth rates can determine their income compounding potential. Stocks increasing dividends in the high single digit to low double-digit range year-over-year can substantially raise income levels over 5-10 year periods.

Integrating a selection of consistent dividend growers is a cornerstone of my own portfolio strategy.

Strategy #3: Utilizing Dividend Reinvestment Plans (DRIPs)

Another great tool for amplifying a stock portfolio’s compounding power is taking advantage of Dividend Reinvestment Plans (or DRIPs). We discussed this back in Part II and Part III.

Many dividend-paying companies offer these specialized programs that allow shareholders to automatically reinvest dividends to buy additional company stock commission-free. This incremental compounding can supercharge total returns over long periods.

Here is quick example to illustrate the power of DRIPs: 

If an investor owned $10,000 worth of a stock paying a 3% dividend, they would earn $300 of dividend income in the first year. If the dividends were taken in cash, income would stay flat at $300 per year. However, by reinvesting instead, they could purchase $300 more worth of shares annually through the DRIP. After 25 years reinvesting like this, the original $10,000 investment could accumulate over $30,000 in value!

Now imagine applying that DRIP enhanced compounding across a diversified portfolio of dividend stocks. The income from each position steadily buys more shares, which in turn earn bigger dividends themselves next year. This allows investors to accelerate wealth building by exponentially growing their share counts and dividend income streams.

Many of my ex-Wall St peers use DRIPs to generate amplifying income for life.

Strategy #4: Selling Covered Calls for Extra Income

Moving up the complexity scale, another advanced technique to juice portfolio yields is an options strategy known as “covered call writing”. This involves temporarily selling away some stock price upside in exchange for immediate income paid today. Utilized sensibly on long-term dividend holdings, covered call writing can provide remarkable boosts to total returns.

Here is quick primer on how covered calls work: 

Investors already own shares of a given stock (the “covered” part). They then sell short-term options contracts that give the buyer the right to purchase their stock shares at a fixed price in the future (the “call” component). The stock buyer pays the option seller an upfront premium payment for this right. If the stock price stays below the call option’s target price, the seller keeps the premium as 100% profit when the option expires.

Applied to dividend stocks, this options strategy generates supplemental income in addition to the dividends - amplifying total cash flow. Every 1-3 months, the process can recycle over and over as option expiration dates pass. This premium income can supercharge annual yields by 5-15% or more, turbocharging compounding.

Of course, there are cautions around covered call selling. The temporary upside cap limits home run returns if a stock suddenly soars higher in a short period. And the strategy often underperforms in flat or downward drifting markets. But pursued opportunistically during rangebound or mildly rising markets, covered call writing can catapult portfolio yields to new heights.

Options represent the 2nd Wealth Engine we’ll be unpacking and studying in detail.

A lot more to come on this topic.

Strategy #5: Focusing on Tax Efficiency

Shifting gears, savvy income-oriented investors also consider tax efficiency to avoid leaking hard-earned returns to Uncle Sam. When it comes to dividends, there are substantial tax reduction strategies to employ, enabling investors to keep more of what they earn.

While still favorable compared to ordinary income, dividend tax rates have crept higher in recent decades. Under current U.S. tax brackets, dividends face headline rates as high as 23.8% at the Federal level when factoring in healthcare surcharges tied to investment income. Long-term capital gains still maintain preferential rates around 15-20% maximum. State income taxes can add further tax burdens of 5-10%+ on top depending on residency.

Given the mounting tax drag, investors seeking enhanced dividend income strategies should account for tax efficiency.

Some simple yet effective tactics include holding dividend payers within retirement plans like IRAs or 401ks which shield income, targeting stocks with lower dividend taxes, tax-loss harvesting around dividends, and more.

Moreover, certain types of high dividend yield securities offer preferential tax treatment. For example, real estate investment trusts (REITS) which pay 90%+ of profits as distributions are taxed differently, often at lower effective rates compared to traditional dividends. Master limited partnerships (MLPs) focused on energy infrastructure also provide varying tax advantages.

Integrating a mix of these tax-advantaged securities can sustain higher after-tax income.

While not always top of mind, being thoughtful about managing dividend taxes allows more income to compound for growth rather than disappearing to the government. Over decades of consistent investing, utilizing tax reduction strategies makes a monumental difference in long-term wealth building.

Balancing Yield Enhancement with Risk Management

“Picking up pennies in front of a steamroller”

This is how a buddy of mine on Wall Street described strategies where you make a little bit of money pretty consistently, but every once in a while, you get clobbered in such a way that it's almost impossible to recover.

This is the essence of poor risk management.

People executing strategies like this feel cash flow coming in and sense security, but this is a false sense.

They are taking risks they don't understand.

While they might be collecting cash in the moment, there is just a clock running above their heads that will eventually reach :00.

Avoid this fate by not being mesmerized by current income or high yields.

If the interest rate is high, there's almost certainly a good reason for that, that reason is risk. That's why the aggregated yield of this portfolio is less than 5%.

I could easily have built a portfolio of REITs / mREITs / MLPs + pref securities and gotten closer to a 9 or 10% yield… and for a time we’d be picking up slightly bigger pennies.

But the steamroller never stops and it moves faster when the yield is greater.

I’ve seen it first hand.

Tempted by eye-popping yields, many investors chase unsustainable dividends from shaky companies. When the underlying businesses stumble, these fragile dividends get slashed in a hurry.

This sends the stock price in a tumble - after all, that yield is the reason anyone cared about that stock. Now the stock price drops faster and faster.

Keep your wits about you.

Chasing maximum yields often leads investors into classic value traps – cheap stocks with declining fundamentals.

Alternatively, seemingly “safe” blue chip dividend payers can also face disruption over time. Iconic dividend stocks like GE, Kraft Heinz, and Eastman Kodak were once seen as unassailable….

But evolving business conditions, debt burdens, or competitive threats can challenge any company over a long enough horizon.

While frustrating to some investors, even the most shareholder friendly brands will cut or pause dividends during periods of excessive industry stress. Bank dividends were halted for years after the 2008 financial crisis until balance sheets healed. Energy and consumer names took similar measures amidst COVID shutdowns. And the Fed has stepped in to restrict bank dividends during this year’s economic uncertainty.

Moral of the story – no dividend is 100% safe forever.

To counter these risks, maintaining balanced diversification and thoughtful position sizing is critical. Despite their positive attributes, high-yield dividend stocks should only occupy supporting portfolio roles. And while dividend growth compounding can work wonders over time, expectations must be tempered during periods of economic turbulence.

Following a methodical, research-based process – identifying durable businesses, understanding risk factors, focusing on cash flow reliability over headline grabbing yields – serves prudent dividend investors well over long time horizons.

Embracing discipline, diversification, and risk management allows income compounding to work its magic.

Dividends may seem mundane, but reinvested and compounded across quality stocks, they wield tremendous potential. Backed by methodical analysis and prudently balanced among risk managed stock positions, rising dividend streams can elevate investor outcomes beyond the stock market’s average returns.

For investors willing to embrace a patient, long-term perspective, dividends mechanically drive growth and lay the foundation for life-altering wealth accumulation.

Once you build a large dividend portfolio you can leverage these holdings for Options strategies, or use them as collateral for loans and other wealth building efforts.

We’ll discuss all of these in greater detail in upcoming series.

In closing, while enhancing dividend yields is no get-rich-quick scheme, it is a proven wealth building practice. Like a sturdy tortoise gradually accumulating resources, portfolio dividend compounding plods along year after year, faithfully generating incremental income and growth through steady perseverance.

Over long horizons, this humble progress can utterly transform financial futures.

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