Progressive dividends are the Holy Grail for many investors. They want steady, reliable dividends paid out from the companies they own because they want a progressive income from their portfolio as a whole.
But you don’t have to have an obsession with progressive dividend-paying stocks just to get a steady, inflation-beating income from your portfolio.
The problem with focusing completely on progressive dividend-paying stocks is that you limit the number of companies that you can invest in. You can also sometimes end up overpaying for those companies because there are relatively few of them.
Another problem with obsessing over progressive dividends is that it often leads investors to rush for the exit if a dividend ever does get cut. I think that’s usually a mistake that can lock in huge capital losses rather than accepting a small, often temporary dividend cut.
Instead of focusing completely on progressive dividends, it can make sense to occasionally invest in companies where the dividend isn’t necessarily growing every year or where perhaps there was even a cut or two in recent years. This can widen out the range of options enormously, and it often means you can get far higher yields for your money too.
Fortunately, it’s relatively easy to get a progressive, inflation-beating income from a portfolio of dividend-paying stocks, even if not every single one of them has a progressively increasing dividend.
Start with a cash buffer
The first step is to make sure the portfolio has a cash buffer. This will allow you to create a smooth and progressive income from your stocks, even if the incoming dividends are less than perfectly smooth.
There are no hard and fast rules on this, but I think a buffer around the size of one year’s income should be sufficient. So if you’re looking to draw 4% from your portfolio each year, then a 4% buffer might be a good place to start.
At just 4% or so, this buffer is unlikely to be a huge drag on performance, even though it is sitting in cash earning virtually nothing. If you’re really allergic to low yields, then you could store the cash in anything that has good liquidity and a fixed capital value (like short-term savings bonds, for example).
Be conservative with how much you draw
Unless you want to start eating into your buffer immediately, or worse, your capital, you may want to limit your initial drawings to no more than the dividends you got last year.
If your stocks do badly next year and your dividend income falls, you could dip into the cash buffer to make up the difference. With the buffer set at one year’s income, it should easily be able to cover any temporary shortfall.
If you get more dividends next year than you were expecting, you can let the buffer build up as protection against any future downturns.
Be progressive and beat inflation
If you have a portfolio of quality dividend stocks, then the odds are that next year’s dividends will beat this year’s. This will usually be the case even though you’ve drawn down this year’s dividends rather than reinvesting them.
This means that in most years, you should be able to increase your income by at least the rate of inflation.
If your dividend income is good this year, then you may decide to give yourself a bumper pay rise, but make sure it’s sustainable; otherwise, your progressive income won’t be so progressive.
If dividend inflows are weak, then you could make up the difference from the cash buffer and perhaps increase the payout by slightly less.
But over the long run, I would expect a well-run portfolio to easily produce a steady, inflation-beating income essentially forever.
A progressive income model portfolio
Since March 2011, I have been running a defensive value investing model portfolio. That portfolio is managed using a dividend reinvestment policy in order to show total returns over time, so it’s focused on capital growth rather than income. However, I know that many investors, myself included, are also interested in drawing a perpetual, inflation-beating income from their shares.
To illustrate how shares can produce a steady and progressive income, I’ve created an income version of the existing “growth” portfolio. In order to have something sensible to compare it to, I’ve also created an income benchmark based on a FTSE All-Share tracker trust. You can see the results since March 2011 below:
The holdings of the income portfolio are exactly the same and have been bought and sold at the same prices as the growth portfolio. There are slight differences in the number of shares bought because the growth portfolio is growing faster because of the reinvested dividends.
I have made the buy and sell dates and prices the same as the growth portfolio so that they are exactly as they would have been if I had managed the portfolio in real-time from 2011 (because they match the growth portfolio’s trades, which were done in real-time).
The goals of this income portfolio are:
- To have a higher pay-out yield than the FTSE All-Share benchmark (focusing on the amount actually paid out rather than the dividends received from the constituent companies)
- To pay out a higher absolute amount than the benchmark every year
- To grow the income faster than the benchmark and inflation
- To grow the capital value faster than the benchmark in the long term
- To have less capital volatility than the benchmark
Only time will tell how achievable those goals are, but I’m looking forward to managing this income portfolio alongside the existing growth model portfolio. I hope it shows how the occasionally wild and manic stock market can still be used to produce a reliable, progressive and inflation-beating income.