Understanding Homemade Dividends & Why Some Investors Prefer Them
Today, our goal is to understand homemade dividends fully. Key questions that we will answer include…
What are homemade dividends? And, how do homemade dividends work?
I will also include a homemade dividends example. And discuss some of the pros and cons of making dividends in this way. Versus earning traditional dividends from dividend-paying stocks.
Next, let’s get right into today’s topic…
Disclosure: At no cost to you, I may get commissions for purchases made through links in this post.
Homemade Dividends: Key Takeaways
1. Homemade dividends are created by selling a portion of individual investments held in an investment portfolio.
2. Creating homemade dividends is a viable strategy. Useful for generating cash to fund one’s lifestyle, meet diverse financial goals, or provide for a secure financial future.
3. The concept is based on dividend irrelevance theory. It states that investors do not care how they get their return on investment. Maximizing total return is what is important.
4. The pros and cons of choosing homemade dividends versus a more traditional dividend investing strategy are fairly straightforward. Much depends on your investment objectives and preferences.
5. Exactly how to earn dividends is not an “either, or” decision. The two strategies, homemade versus traditional dividends, can be effectively blended to meet your individual circumstances.
With those highlights taken care of. Let’s set our foundation and be clear on what we are talking about today.
What Are Homemade Dividends?
Homemade dividends are a form of portfolio income. Also known as investment income.
They are created by selling all or a portion of individual investments. Held in an investment portfolio.
Ideally, homemade dividends are created from asset appreciation. Also, called capital gains. In this way, dividends are made from realizing the paper profits an investment portfolio generates.
In the most sustainable case, the investor leaves their original investment amounts intact. And, positioned for growth into the future. Thus, allowing for additional cash flow from dividends and capital gains over the long-term.
At times, homemade dividends may come from the original investment. This is referred to as a return of capital. However, collecting dividends from a return of capital is not a viable long-term strategy.
Finally, the concept of homemade dividends is based on dividend irrelevance theory. Let’s discuss this next…
Homemade Dividends & Dividend Irrelevance Theory
First of all, dividend irrelevance theory was developed in academia. By economists Franco Modigliani and Merton Miller.
The dividend irrelevance theory states that investors do not care how they get their return on investment. Only, the total investment return is what is important.
No matter if it comes from capital gains. Traditional cash dividend payments or both.
Furthermore, this theory indicates that a company’s traditional cash dividend payments are meaningless. And, a company’s stated dividend policy is irrelevant. Because they have no impact on the value of the company or its stock price.
Finally, the dividend irrelevance theory argues that dividends can even hurt a company’s prospects. Since the money paid out in dividends, can and should be used by management in more productive ways.
Followers of dividend irrelevance. Will definitely debate the advantages and disadvantages of dividend stocks.
Why Should An Investor Make Homemade Dividends?
Most investors, like you and me, invest for one primary purpose. What is that? To meet financial goals that will secure our financial futures. That’s what homemade dividends are for.
This can mean different things to different people. For example, it may mean funding your children’s education in 10-20 years. Or for some, enjoying financial independence at an early age.
But for all of us, investing is necessary to create the resources for a comfortable retirement in our advanced years. Because we can’t work forever. And, who would want to?
If your goals include saving for a comfortable retirement. Be sure to do so in an IRA for the tax benefits those accounts provide. You can open an IRA account online quickly and easily.
Whatever the case may be. Securing one’s financial future means having cash flow.
And being a follower of dividend irrelevance theory is one way to create cash flow. To fund all or a portion of your expenses. And secure your financial future.
But, you may ask, what about regular cash dividends? How do traditional dividend payments work?
Let’s discuss…
Homemade Dividends Versus Traditional Dividends
Traditional dividends are distributions of economic value made by a company to owners of the company’s stock.
Dividend distributions can come in a variety of forms. But, by far, the most common form is cash dividends.
Furthermore, the cash payments are made from a company’s profits. Thus, dividends are 1 very important way for stockholders to share in the financial success of a company.
On the other hand, not every company chooses to pay dividends. And many that do, pay such a small amount that they do not provide the cash flow to meet an investor’s financial goals.
So, by relying only on traditional cash dividends. An investor must limit his or her investment options. To only those companies and investment types that pay high and recurring distributions of cash.
To be perfectly honest, I’m still a big fan of dividend-paying stocks. And dividend stocks can coexist nicely with a strategy for homemade dividends.
Are you looking for dividend stock ideas? Then try the Simply Investing Report. Simply Investing delivers excellent dividend stock recommendations to your inbox every month. You can learn more about Simply Investing here.
Now we know what homemade dividends are. Why they are important. Plus, how they compare to traditional dividends.
With that knowledge in place. Let’s look at an example of how can an investor create a homemade dividend.
Homemade Dividends Example
Let’s say you were diligent and were able to save $10,000 by the end of 2015. And, you put that money in a savings account.
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Back to our example…
But, that savings wasn’t earning much interest. And you were on the hunt for better investment options.
Your goal is to create a side income from your investments. And then work part-time in 5 years starting in 2021. You want to slow down a little and have more time to enjoy your life.
Building Your Homemade Dividends Portfolio
So you decide to try your hand at investing. Back in 2015, you were a big fan of Amazon.
And thought Amazon would continue to grow and become more profitable. Amazon stock seemed like an excellent investment opportunity to you.
However, your research indicated that Amazon did not pay a traditional cash dividend. And you could not be sure if they would do so in 5 years.
When you would be ready to work part-time. And draw money from your investments to support that objective.
But that was okay. You did not care about cash dividends. Furthermore, you believe in the dividend irrelevance theory.
You only care about getting the highest total investment return possible. Most importantly, you intend to make homemade dividends from your Amazon stock starting in 2021.
Thus, you invested your $10,000 in Amazon stock on December 31, 2015. And didn’t touch it for 5 years.
Amazon’s historical investment returns tell us that at the end of 2020, your $10,000 invested at the end of 2015 was worth nearly $50,000.
Making Your Homemade Dividends
Looking forward, your investment research suggests that Amazon stock would not perform as well in the future. As it did over the previous 5 years.
However, you believe the company’s stock performance will be in line with average historical stock market averages. Let’s say, 10% annually.
So, each year you intend to sell 10% of your Amazon stock. Thus, making homemade dividends of $5,000.
Or, about $4,000 cash in your pocket after paying capital gains taxes. Using this cash to support your new lifestyle of part-time work.
Furthermore, each year starting in 2021, we will assume the price per share of Amazon stock rises by about 10%. Thus leaving your $50,000 investment intact.
Congratulations! You know how to make money on dividends from the paper profits generated by an investment portfolio. Just a 1 stock portfolio in this case.
Mmmmm! That’s a pretty tasty recipe for making money from dividends.
But, before we get carried away. Let me caution you…
A Word Of Caution About This Homemade Dividends Example
I designed the previous example to dramatize a point. That point being how to make dividends from investments.
Maybe you live in a perfect world. But, I certainly do not. So be aware…
First of all, a 1 stock portfolio does not provide adequate diversification. It is too risky if that 1 stock you choose does not perform well.
Furthermore, it is unlikely the investments you choose will do as well as Amazon stock from 2015 through 2020. Even if you use excellent but inexpensive investment advisory services. Like the Motley Fool, for example. You can learn more about the Motley Fool stock advisor here.
Because if you can consistently pick stocks with that kind of return. Give me a call. You can manage my money!
Finally, there is no guarantee that Amazon stock, or any stock for that matter, will continue to rise in the future.
Okay. Consider yourself warned.
Furthermore, this makes for a good transition to our next subtopic. The disadvantages of relying on this specific investment strategy for cash flow…
Limitations Of Homemade Dividends
Let’s talk about the pros and cons of homemade dividends. Starting with some reasons you may not want to rely on them.
Stocks Do Not Always Go Up
Stocks and stock markets can and will go down. And they can stay that way for long periods.
When investments decline in value, you may not be making your homemade dividends from capital gains. You may be taking a return of capital.
As I said at the beginning. To get dividends by a return of capital is not a sustainable approach for steady cash flow from investments.
On the other hand, the highest-quality dividend stocks will continue to pay regular cash dividends. Even during a bear market.
Giving you the option to not sell your original investments. When their prices are down.
Transaction Costs
Some brokerage firms still charge for stock trades. If you pay for buying and selling stocks, your transaction costs eat into the dividends you receive.
This is a disadvantage that is easily overcome. Get a zero-commission brokerage account and trade stocks for free.
I use the Webull. It is fast and easy to use.
Plus Webull has excellent stock research capabilities. You can learn more about Webull here.
Reduction In Ownership
Every time you sell shares of an investment. You reduce your ownership percentage. Thus, by selling, you limit your participation in future asset appreciation.
On the other hand, by owning traditional dividend stocks. You receive dividends in cash regularly to support your lifestyle. Without ever having to sell shares.
Bird In Hand Dividend Theory
There is a counter-argument to dividend irrelevance. It is the premise of bird in hand theory.
Bird in hand is based on an adage. It is “a bird in the hand is worth two in the bush”.
The saying means that it is better to hold onto something you have now. Or can count on receiving soon.
Versus the risk of losing whatever “it” is. By trying to get something bigger and better in the future.
How does this relate to making money off dividends? Well, it is quite simple…
Cash dividends paid by a high-quality dividend stocks are something you can count on. It is the bird in hand.
In contrast, to the potential for large increases in the share price of a stock. Like Amazon. That may or may not come in the future.
Share price increases. As the Amazon example showed. Are the 2 birds in the bush. Or, something potentially better in the future than a dividend today.
Future Tax Changes
It’s hard to speculate about future tax policy. But, I am hearing rumblings from the current administration about raising taxes on capital gains.
Done without a corresponding tax increase on cash dividends. Then selling stock to make homemade dividends may no longer be the most tax-efficient strategy for getting cash from investments. But, this is just my speculation at the time of publishing this article.
Next, it’s time to switch gears. Because I want to present a balanced view.
So, let’s talk about the advantages of this one approach for making money from dividends. Then, I will wrap this dividend investing article up.
Benefits of Homemade Dividends
Choosing to create dividend payments from scratch is no different than any other investment strategy. It depends on your investment objectives, personal circumstances, and preferences.
Regardless, here are a few benefits of the approach…
Deferring Income Taxes
By investing to achieve only capital gains, you defer taxes. And pay them only when you make a sale of an investment.
Don’t need the money from homemade dividends at any point in time? Then keep it invested.
And never pay a penny of income taxes. No matter what the tax rates happen to be.
On the other hand, cash dividends are taxed when received. Leaving you immediately with a tax bill and less money to do with as you choose.
Companies Can Make Better Use Of The Cash
A company with profitable growth prospects should retain all of its earnings. Rather than paying all or some of their profits out as dividends. And invest those profits for a high rate of return.
This assumes the company can reinvest those funds in its business at high rates of return. Let’s say at the very least a 15% return on investment.
Proponents of this benefit say… Why invest in any company that does not have ample and profitable investment opportunities for growth?
Think about Amazon for a moment. Certainly, the company was wise to retain its cash. And invest it back into the rapid growth of their e-commerce and cloud computing businesses.
Companies like Amazon continually increase their value for investors. Before I invest, I always check the stock analysis and fair value estimates that Morningstar investment research provides. You can learn more about Morningstar here.
More Flexible Investment Options
Traditional dividend-paying stocks tend to be clustered in relatively few sectors of the stock market. By focusing on finding dividend stocks in specific sectors, an investor targeting only dividend-paying may miss out on some of the best investment opportunities.
We have already talked about Amazon. But there are others.
High-performing companies and their stocks that come to mind include Facebook. And, Alphabet Inc., the parent company of Google.
Neither of these stocks has paid dividends. Nor did Apple during some of its highest growth years.
Also, make a note of this point. Just because a company pays a dividend. Does not preclude it from being part of a homemade dividend investment strategy.
For example, Apple started paying financial dividends in 2012. Furthermore, Apple would have been an excellent stock to have in your portfolio over the past decade.
Never Worry About When Dividends Are Paid
Traditional dividend investors sometimes concern themselves with when companies pay dividends. They invest in stocks based on the timing of their dividend payments.
By earnings dividends that are homemade. There is no need to worry about when dividends are paid.
When an investor needs cash. They sell all or a portion of 1 or more investments. As a result, the investor has full timing of his or her cash flows.
Homemade Dividends Wrap Up
For those of you who know me and are regular readers. Don’t get yourself all worked up.
Understand that I still prefer traditional cash dividends. But like to examine the other point of view. To see what I can learn.
Making homemade dividends is a viable strategy. To fund one’s lifestyle, meet diverse financial goals, or make for a secure financial future.
Finally, this cash flow strategy versus traditional dividend investing is not an “either, or” choice. The two strategies can be effectively combined. To make money on dividends and your investment dollars.
And, I pull my total financial picture including spending and investments together in one place. Online with Personal Capital. You can learn more about Personal Capital here.
More Reading About How To Earn Dividends
You may also enjoy these investing articles about making money from dividends:
- Our neatly arranged archives of dividend related articles
- Get $500 a month from traditional dividends
- Creating your very own dividend snowball
My Favorite Dividend Investing & Finance Resources
Throughout this article, I suggested some of my favorite personal finance and investing resources. They are summarized here for your convenience.
- Trade stocks for free with the Webull app
- Get dividend stock recommendations from Simply Investing
- Get top stock picks from Motley Fool
- Use Morningstar for insightful investment analysis
- Manage all of your finances with Personal Capital
- Use Rakuten to save on your online purchases
Author Bio: Tom Scott founded the consulting and coaching firm Dividends Diversify, LLC. He leverages his expertise and decades of experience in goal setting, relocation assistance, and investing for long-term wealth to help clients reach their full potential.