How to build an income portfolio
Investors love dividends but creating an income stream involves more than just picking the highest yielding shares.
There are not many things I have in common with John Rockefeller. But Rockefeller loved dividends. And I must admit that I do too.
Rockefeller once said, “Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.” If the world’s first billionaire was a fan of dividends, who am I to argue?
My view on dividends is a bit more nuanced. While I derive a certain amount of satisfaction from seeing a dividend appear in my account my true joy comes from spending those dividends.
I began my income investing journey at the ripe age of 22 during the wreckage of the .com crash. I was still a new investor and with the irrational exuberance and nonsensical hype crashing around me I yearned for something tangible. And what is more tangible than a dividend?
Below I outline the steps investors can follow to build an income portfolio.
The appeal of dividends
A dividend is a reminder that what we are doing as investors is real.
We own real companies that generate real profits and a portion of those profits are shared with us as the owners of the business.
I was immediately hooked. In a moment of clarity, I saw dividends as a pathway to independence at an age where a lifetime of work seemed so daunting.
Here I am 20 years later and still working. But my dividend income is also contributing to traveling which is one of my joys in life. And my ability to travel in a manner and quantity that wouldn’t be supported by my income is a form of independence.
How to build an income portfolio
There is a common theme in the approach to income investing - or any investment strategy - and that is time.
Successful investing is all about accruing the benefits from the passage of time and not wasting the opportunity that time affords. Saving and compounding for years and years is the pathway to success.
Step 1: Balance dividend growth and current yield
Everything in life involves trade-offs and income investing is no different.
Many income investors search for shares with the highest current yield thinking that is the way to develop an income stream. If you have time before you need that income a better approach may be finding shares with a long runway of dividend growth ahead of them.
My revelation on dividends may have been a eureka moment but developing my strategy took a lot of time in a spreadsheet. My initial forays into Excel were an attempt to see the trade-off between dividend growth and a higher current yield.
High current yields can indicate a dividend trap where the market has bid down the share price because of fears that the dividend is unsustainable and will be cut. It is obvious that those situations should be avoided. But a high current dividend yield is often the result of a high payout rate. That means that more of the earnings generated are paid out in dividends.
This can leave less money to reinvest in the business which may hamper future earnings and dividend growth.
An example is illustrative of this trade-off. Genesis Energy (ASX: GNE) is currently yielding a healthy 7.6%. That compares favourably to American Tower (NYSE: AMT) which is a recent purchase of mine with a current yield of 3.17%.
As an investor looking for the highest possible income stream in 10 years the current yield may not be the key driver of total income in a decade’s time.
If you invest $10k in each share you would have a current income of $760 from Genesis and $317 from American Tower.
Over the past 5 years Genesis’s dividend went from 17 cents a share to 15 cents a share. If we assume they reverse this trend and manage to grow the dividend 2% a year for the next decade your total income in 2033 would be $719 a year.
To match that with American Tower you would need dividend growth of 11.25% a year. That does sound like a tall order. But American Tower has managed to growth their dividend at an average of just under 19% over the last 5 years.
Predicting future growth in dividends is not easy. They are after all a product of management’s willingness to keep growing the dividend and the underlying performance of the company to support that growth.
The point of considering this trade-off is to understand that building an income portfolio may involve a mixture of high yielding shares, and shares that have the opportunity to grow their dividends.
Relying too much on the former can stunt your overall dividend growth.
Astute readers will point out that just because you don’t need to withdrawal income over the next 10 years doesn’t mean that it serves no purpose and has no use. The beauty of pre-draw down income investing is that you can turbocharge growth by dividend reinvestment.
That brings us to the next step of the process.
Step 2: Compound your income growth
Rising dividends is one source of income growth in your portfolio but another powerful driver is using the dividend income you receive to buy more shares.
Those additional shares will also pay a dividend which will grow your income further.
This can be done either through a dividend reinvestment plan (“DRIP”) which will give you more shares of the company paying the dividend or by collecting the dividends and investing them in other companies. This is compounding for income.
Once again, an illustrative example might be helpful. In 2013 I bought 860 shares of Cisco (NYSE: CSCO). I turned on the DRIP plan and have left it on ever since. I now own 1,654 shares without having ever made another purchase.
In 2013 Cisco paid $0.68 a share in dividends. If the dividend stayed the same my income would have grown from just over $584 a year to $1,124 a year. Luckily for me the dividend did not stay the same and Cisco paid $1.52 a share in 2022. That represents dividend growth of 8.28% a year. Yet my income from Cisco was $2,514 a year in 2022 which is a growth rate of 15.72% per year. I’ve almost doubled my per year income growth through the compounding effect of dividend reinvestment.
An important disclaimer is that I’ve cherry picked a position that illustrates the impact of compounding. I thought giving a personal example would be more powerful but like every investor there have been some misses in my portfolio.
Dividends that have been cut and growth that has never materialised. I’m not a fan of manifesting, but understanding what success looks like can help identify potential opportunities while maintaining the patience to see them through.
I’ve covered off two sources of income growth with dividend increases and the compounding effects of dividend reinvestment.
The third is new contributions you make to your portfolio.Â
Step 3: Determine the source of income growth in your portfolio
The more you save and invest the more you grow your income.
The market cap weighted dividend yield of the ASX is currently around 4.5%. Contribute $10k a year to your portfolio and you will add $450 in income (assuming you achieve the average yield).
My initial goal was to grow my total dividend income by 10% a year. This was easily achievable in my early years as my contributions were relatively large in comparison to my total portfolio size.
Expanding on my example above, if you have a $100k portfolio that matches the 4.5% yield of the ASX you will have total income of $4,500 a year. Investing $10k and getting $450 a year in additional income gives you 10% growth, before accounting for dividend increases or the impact of reinvestment.
But that becomes harder to achieve when your portfolio grows.
For example, if you have a $500k portfolio generating $22,500 in income, you will need income growth of $2,250 to hit that 10% goal.
Even if your contributions double to $20k a year you will only add $900 of income per year (based on a 4.5% yield) which leaves a shortfall of $1,350 to be made up from dividend increases and the impact of reinvestment.
I confronted the reality of this math after several years of investing which sent me back into a spreadsheet to try and solve this problem.
Unfortunately, there is no formula for this insurmountable reality of income investing. I’ve since come to the realisation that a tiered approach to income growth is more realistic.
Perhaps a double-digit goal is possible as you are just starting out but that will get lower over time. Account for this in your projections.
It is worth exploring the source of income growth in your portfolio. Figure out how much you can contribute and how much additional income that gets you.
Look at the growth achievable from dividend reinvestment. The quick way to do that is looking at the total expected yearly dividends and the yield of your current portfolio.
This will slightly underestimate the total income growth from dividend reinvestment as you will get a quarterly compounding effect from quarterly dividends and semi-annual compounding effect from semi-annual dividends. The remainder will come from dividend growth.
Step 4: Reap the fruits of your non-labour
Everyone has different goals and circumstances. For me, I made the decision that I would start to spend part of my dividends to fund travel.
I did this for several reasons.
Primarily, I was comfortable with my pathway for building a retirement nest egg. For retirement I will take a total return approach and fund withdrawals with both asset sales and income. A concept that Morningstar Investment Management Portfolio Manager Jodie Fitzgerald recently discussed on our podcast Investing Compass. I’m on track to achieve my retirement goal provided I can stay employed.
I’m also comfortable that I have enough of a cash buffer in my emergency fund to ensure that a period of unemployment won’t derail my plans.
And finally, I’ve used a bit of mental accounting as encouragement to keep saving in non-retirement accounts. I’m aware that in a rational sense putting more money into one account nets out when I’m withdrawing money earned in dividends from another. But I do find this approach mentally comforting.
Every 5 years I turn the dividend reinvestment off in an account and add another source of funds to my travel income stream. I then direct my savings into the next account that will go through that transition and try and grow the income as much as possible before that time.
As previously stated, this makes little sense as I could simply fund travel with my salary but there is something about passive income that just makes it a bit more special than labouring for it. This may be simply a mental trick to for self-encouragement, but it works for me.
My passive income just took me to France in September to the Rugby World Cup.
I finally saw the Wallabies win a match after they have failed to achieve that in the double-digit number of matches I’ve attended. The fact that they imploded afterwards made this a pyrrhic victory.Â
I want to hear your own experience investing for income and what goals you are working towards. Send your thoughts to mark.lamonica1@morningstar.com and I will send you a spreadsheet template that allows you to find the equilibrium between a high current yield and a growing dividend and the way to explore the sources of income growth in your portfolio.
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