If you've seen the movie Jerry Maguire, then there's one line you're guaranteed to remember: "Show me the money!" That's how Rod Tidwell, the football player portrayed by Cuba Gooding Jr., asks his agent to get him a pay raise. But he could have been yelling at his financial advisor, too. After all, he was very interested in cash flow, and perhaps the income from his portfolio wasn't cutting it.
If you're fed up with paltry dividends and want more passive income from your portfolio, you can take some simple steps to increase your cash flow. In other words, if you find yourself screaming "Show me the money!" then this is for you.
If you'd rather invest in stocks over bonds, but you like the income bonds produce, then preferred stocks are an option. Companies can issue both common stock and preferred stock, but whenever a company pays a dividend, holders of preferred stocks receive their payout before the common stock holders. Companies that issue preferred stock pay the shareholders a certain interest rate, usually quarterly. Preferred stock often pays a higher interest rate then a bond issued by the same company, because if the company goes bankrupt, will pay back bondholders first. The higher interest is intended to compensate you for the risk that you won't get paid back in the event of a bankruptcy. Preferred stocks are often viewed as a hybrid investment: They're somewhat like common stocks in that they can perform better than bonds (and lose more, too), but they're like bonds in that they pay a higher yield than most stocks.
The yield on most preferred stocks is somewhere around 4%-6%. Riskier preferred stocks will yield more. Compare this to the 2.05% yield on the Vanguard S&P 500 Index Fund, which is a good proxy for large-cap common stocks, and you can see why income investors favor preferred stocks.
There are a few risks to be aware of when investing in preferred stocks. First, most preferred stocks are issued by banks and financial firms. This is fine, but be aware of your exposure to this sector. You don't want all of your portfolio in bank stocks, as that could spell disaster if the financial industry as a whole take a dive.
Preferred stocks may also be more sensitive to changes in interest rates. Investors buy these stocks for their yield, but if interest rates on safer investments such as bonds rise, than they may sell preferred stocks and park their money in bonds because they can get comparable interest for less risk. To offset these risks, it's best to pick a diversified pool of preferred stocks or go with an exchange-traded fund (ETF).
Focusing on asset allocation -- the mix of stocks and bonds in your portfolio -- can help. Treat preferred stocks like common stocks as part of your overall asset allocation, and balance their risk with safer bonds and cash.
As the name suggests, high-dividend exchange-traded funds hold stocks that pay a higher dividend than the the average stock. The yield on the Vanguard High Dividend Yield ETF (NYSMKT: VYM) is 3.2%, which is higher than the 2.05% yield on the aforementioned Vanguard S&P 500 index. On a $100,000 investment, that's an additional $1,340 of income per year -- not bad.
ETFs are one way to invest in a basket of high-dividend-paying stocks and get instant diversification across a smattering of companies -- the Vanguard High Dividend Yield ETF has 396 holdings. Of course, you can pick your own dividend-paying stocks if you have the time and expertise.
One concern with investing only in high-dividend stocks is the potential for overexposure to one sector. For example, the Vanguard High Dividend Yield ETF has 14% of its assets in the consumer defensive sector, because those types of companies usually pay a higher dividend. Consumer defensive stocks typically do well in a recession, as most consumers will continue to buy staples such as toothpaste and toilet paper even in difficult times. However, defensive stocks may not gain as much in a roaring economy as, say, technology stocks.
Like preferred stocks, high-dividend stocks may be more interest-rate-sensitive than other stocks. If consumers buy high-dividend ETFs for yield, but then interest rates increase on bonds, investors may sell the ETFs and buy bonds instead. Keep in mind that dividend paying stocks will fluctuate in value, so it's best to keep an eye on your asset allocation if you're concerned about major losses. Adding in bonds as mentioned earlier can help minimize the volatility of your portfolio. If you can live with these risks, high-dividend-paying stocks are a nice way to add income to a portfolio.
Real estate investment trusts (REITs)
If you're like me and didn't inherit the home improvement gene, but you still want to make money from real estate, then Wall Street has something for you: the real estate investment trust (REIT). A REIT is like a mutual fund in that you pay a professional to manage a basket of securities for you. But a REIT is also different in two big ways. For starters, a REIT invests only in real estate, typically through buying, selling, and/or leasing large properties such as shopping malls, office buildings, hospitals, or residential apartments. Further, REITs are required by law to distribute at least 90% of their taxable income to their shareholders through a dividend, hence the higher payouts. REITs typically offer a yield of 4% to 6%, though some riskier REITs will yield more. The Vanguard Real Estate Index Fund ( VGSL.X ) has a yield of 4.24%.
There are a few risks associated with REITs. First, REITs can fluctuate in value just like equities. Secondly, REITs compete for investors searching for yield, so as bond yields and the interest on cash increase, investors may flee riskier REITs for more stable fixed-income investments. When that happens, REITs tend to lose value. There are also public and private REITs. Private REITs may be more expensive to own and typically come with long lock-up periods, but they may pay a higher yield to compensate for the illiquidity. Public REITs, such as those in the Vanguard Real Estate Index Fund, trade on the public markets and have greater liquidity and usually lower fees, which is why I personally prefer them over private REITs.
I wouldn't go all in on REITs, but having 5%-10% of the riskier part of your portfolio in a diversified real estate investment trust can help increase your income generation. Dividends from REITs are considered taxable income, so it's best to own them in an IRA or 401(k), where the dividends are sheltered from taxes.
Passive income can bring balance to your portfolio and your life
In the end, it's all about the Quan. The Quan, according to Rod Tidwell, is a combination of love, respect, community, and "the dollars, too." If you find your portfolio income lacking, your Quan is out of balance. REITs, preferred stocks, and high-dividend-paying stocks are tools you can use to increase your passive income and get your Quan back in alignment. Now let me hear you say it: "Show me the money!"