On Monday Jason wrote a great overview about dividend investing . Since you now know what dividends are all about, I figured it would be a good opportunity to do a guest post on the subject. I write about the stock market and personal finance at my blog Stock investing 101.

Photo by gfpeck

Dividend investing is the best way to generate passive income and become wealthy, period. It is the perfect example of making your money work for you.

AT&T pays out a 6.7% dividend yield. This means for every 100 dollars of the stock you own you will be given $6.70 a year from the company as a bonus for just being a shareholder of the company. Compare 6.7% to the interest you could get from a standard checking account or a CD. You are getting at least 3 times the return from owning AT&T versus investing in a CD, and that is not factoring in any potential increase in AT&T’s share price.

Most dividend paying companies also offer a DRIP program, DRIP stands for Dividend reinvestment program. If you opt for the DRIP program the money you receive each quarter from owning stock will be used to buy more of the stock instead of being given to you in cash. This is a great way to take advantage of compound interest.

Jason mentioned he purchased 80 shares of AT&T. If he opted for the dividend reinvestment plan those 80 shares would grow to 85.4 shares after just one year. After 5 years his purchase of 80 shares of the company would now have ballooned to almost 110 shares of the company. After those 5 years, assuming AT&T kept its dividend rate steady [which is very conservative when you consider that AT&T has a long track record of consistently raising its dividend] Jason would then be actually getting a 9.3% yield on his original investment. 110 X 1.68= 184.8/ [25.25[share price]X 80= 2020].

The numbers only get more and more impressive and mind boggling over time. In ten years AT&T could go from paying his Netflix membership to making his car payments, in thirty years AT&T could pay his mortgage.

The best thing about this is that there is almost no work involved. After you make your initial investment everything is on autopilot.

Here is a short overview of 5 different dividend paying companies in 3 different sectors to get you started. Remember that this list is not comprehensive in the least bit and it is far from fool proof:

• AT&T: Jason and I have mentioned this company countless times for a reason. It pays out a whopping 6.7% yield, it is in a stable sector that all of us understand, and I don’t see people getting rid of their cell phones or their Internet connection anytime soon.

• Coke: Coke is another great dividend paying company. Its yield of 3.2% is not as impressive as AT&T’s but it is still a great value. Coke raises its dividend religiously so I expect even more from it in the future.

• Pfizer: Pfizer is a huge health care conglomerate. It pays out a very impressive 4.1% dividend yield at the moment and it is a very solid company. It presents a great value to investors.

You will not get 30% yearly returns from investing in dividend paying companies but you will get the best possible return in the long run along with the most stable investment with the least amount of work involved.

If you are interested in learning more about dividend investing, I highly recommend the book The Ultimate Dividend Playbook from Morningstar (written by Josh Peters).

Note from Frugal Dad: After giving it some thought, and investigating the plan with my online brokerage, I have decided to sign up for their dividend reinvestment program. Dividends will be reinvested in eligible securities held in our portfolio, allowing us to build our positions more quickly without an added fee.

I’ve written before about the various passive income streams available, but up until now I have largely ignored the concept of dividend investing. That was until the recession caused interest rates to drop to levels that don’t even keep pace with inflation. As I searched for higher yields, I was introduced to the concept of dividend investing.

A Quick Introduction to Dividends

If you are not a stock investor, or regularly dig into your mutual fund statements, you are probably like me and are unfamiliar with the concept of dividends. Basically, a dividend is a cash payout by a company to its to stockholders. Companies that raise a lot of cash, and are fairly stable (meaning not growing rapidly or in financial trouble), reward stockholders by returning a sum of cash to them on a per share basis, usually in quarterly payments.

Most companies raise or lower their dividend after quarterly earnings results are released. A handful of companies have long histories of increasing dividends over time, and now offer a healthy dividend yield.

Where to Find the Best Dividend Stocks

AT&T often appears on lists of best stocks to own for dividend investors. They have a long track record of paying dividends. In fact, they have increased their quarterly dividend for 26 consecutive years. While there is no such thing as a sure thing, this kind of long track record is what I’ll look for when selecting single stocks for our dividend portfolio.

How to Calculate a Stock’s Dividend Yield

AT&T (T) last declared a quarterly dividend of $0.42 per share, or $1.68 annually, in December 2009.  At the time of this writing, their stock price is 24.86 per share. Dividing the annual dividend dollar amount by the current share price provides the annual dividend yield of 6.75%. Not too shabby, considering most online savings accounts are yielding around 1.30%.

AT&T Pays for My Netflix Membership

That sounds a little strange, so let me explain how this all works. AT&T doesn’t really pay for my Netflix membership, but the dividends I receive from AT&T stock alone cover that expense. That’s the way I look at dividend investing. Each time I add to my portfolio, and increase the amount I receive in dividends, it covers another expense. One day, it is not unthinkable that dividends alone could cover all of our basic living expenses.

I recently signed up for an online brokerage account and purchased 80 shares of AT&T to begin my dividend portfolio. Every three months, AT&T will return a dividend of $33.60 ($0.42 per share dividend x 80 shares). That works out to about $11.20 a month. After taxes, that is just enough to cover my $9.62 monthly Netflix bill. As long as AT&T continues to pay the dividend (and Netflix keeps its price steady) I’ll have our movies-at-home budget category covered.

Dividend Investing for Early Retirement

Last year, I wrote about the concept of an early retirement freedom chart to track passive income, active income and monthly expenses. It was an idea I got from my favorite personal finance book, Your Money or Your Life. In the book, the authors advocate creating a wall chart to track monthly expenses, actively earned income (from an employer, for example), and passive income (interest accumulation, dividends, etc.). I’ll actually track this in Excel, where I do most of my budgeting. I’ll plot our income, expenses and passive income each month.

As our income increases and we can invest more money, our passive income will rise. If we reduce expenses, or keep them flat, eventually the passive income line and monthly expenses line will intersect at a cross-over point. It is at this point where our living expenses are covered without the requirement to earn more active income. Hello financial independence!

The book’s author achieved this point by investing in Treasuries, but this was back in the early to mid 1990s when they were yielding an attractive six to seven percent. These days, that rate is much harder to find.

We plan to use a mix of cash-based accounts and dividend stocks to get to our cross-over point. We’ll diversify into 10-15 stocks across a range of sectors from utilities to telecom to consumer goods, and try to add a little to our positions each pay day. Slow and steadily, we will be building a portfolio of dividend stocks with the potential for lifestyle-sustaining income for the years ahead. That’s an exciting prospect!

If you are interested in learning more about dividend investing, I highly recommend the book The Ultimate Dividend Playbook from Morningstar (written by Josh Peters).

Disclaimer: Please do not buy any stock mentioned here at Frugal Dad just because I mentioned it. Do your own research and buy positions that match your risk tolerance and income needs. One more note, single stock investing is risky, so aim to keep single stocks a relatively small percentage of our overall portfolio. We have 100% of our retirement funds in mutual funds, but I’ll dabble in single stocks for dividend investing.

Last year was the first year I have been able to make the maximum contribution to my Roth IRA, thanks in large part to becoming debt free. I was also able to fund a spousal IRA for my wife, who stays home with our kids.

Now that it is 2010 I am psyched to make even more contributions to our Roth, but wondered if I should wait until the end of the tax year, make monthly contributions, or try to plunk down all the money up front. Turns out this is a costly decision.

Putting aside thoughts on market timing, and market predictions for 2010, it seemed like socking away the maximum contribution early in the year was the way to go. Of course, this meant trying to come up with $5,000 after already depleting some savings to fund last year’s Roth.

Just as I was feeling nervous about moving another $5,000 from my cash reserves, I was reminded of my own advice:  max out because Roth IRA withdrawal rules allow for withdrawal of contributions at any time without penalty. That’s right! Assuming I had not lost my entire investment in the Roth account, I could simply withdraw a portion of the $5,000 contribution later in the year in an emergency.

The Impact of Delaying Roth IRA Contributions One Year

So what’s the advantage of tying up my savings so early in the year? Using Dinkytown.net, I ran a couple calculations with the following assumptions:

Let’s assume I turn 30 years-old On January 1, 2010, I invest $5,000 in a Roth IRA earning an 8% return. I continue to invest $5,000 on my birthday (January 1st) for the next 35 years. My original $175,000 in Roth IRA contributions would grow to $930,511.

If I delayed that first contribution until my 31st birthday, I’d only have $856,584. This is essentially the same result you’d get by waiting to contribute until the end of the year. And while it is nothing to sneeze at, you would lose about $74,000 in compounding growth by waiting a year to get started.

This certainly underscores the important of starting early. It also reinforces my plan to encourage our kids to open Roth IRAs as teenagers when they begin earning an income – even if we have to help them fund the account up to their income. Imagine what the numbers would look like if you started saving at 17 years old!

If you are concerned about earning too much money, contribute now and adjust later. It is possible to avoid penalties if you take corrective action by the due date for making Roth IRA contributions for that particular tax year (typically April 15th or the day you file your return, whichever occurs earlier, but not counting extensions, etc.).

I Have No Savings – Should I Borrow To Make Roth Contributions?

After being in debt for so long, I am very reluctant to borrow again. However, borrowing $5,000 at a very low interest rate (or even free if you can catch a zero-percent balance transfer) might make sense considering the amount of compounding growth you give up over an investing lifetime. Personally, I would not borrow the money, and look for another way to fund the contribution – a side hustle, selling something valuable, but not sentimental, etc.

Whatever you decide to do, do it quickly, as hundreds of dollars are sliding by for every day you put off funding a Roth IRA.

This question is especially important if you are considering retiring soon or if you have been offered an early retirement package.

If you’re like me, when you try to imagine what lies ahead, you think about your most recent experiences and extrapolate going forward.

Investors do this more than anyone – at least as far as I’ve seen. While I can see why folks do this, it’s really not a very good exercise and I’ll show you why.

If you think back over the last 10 years, you’ll agree that it hasn’t been a picnic for investors. Depending on when you calculate the 10-year average, you could get a slightly negative return or a slightly positive return for that period. But either way, it’s a lousy return.

Based on that, investors might forecast a crumby 10-year return going forward.

Even though we’ve heard that old expression that the past is no guarantee of the future when it comes to investing, what else do we have to base our decisions on other than the past?

Well…I do want you to consider the past when you think about the future.  Just think about it a little differently.

Let’s look at an example to help explain this idea.

If you review the chart below, you can see that the 10-year trailing return in 1974 was an ugly -3.8%. That means had you invested in 1965 and held on to your investments through the end of 1974, your annualized return was -3.8%.

S&P 500 Trailing 10-Year Annualized Return

Real Returns Over the Next:

But what happened over the next 10-year period? The market had an annualized 6.9% return. In fact, after each of the last 5 decade-long market meltdowns, the market did pretty well.

Is that a guarantee that the next 10 years will be years of wine and roses for all?  Not by a long-shot. But it does indicate that history is on our side. It shows the importance of not falling into the trap of thinking our most recent experience is going to be repeated in the future.

Exactly one year ago, did you predict that the market would do so well by the end of the year?  I sure didn’t.

While we face real challenges ahead as a nation and as investors, it would fly in the face of all the facts to become pessimistic right now.

What do you think we’re in store for over the next 10 years?

One of the benefits of writing a blog, and attracting an audience, is that I get to learn from others much smarter than me on a variety of subjects. This is one such opportunity! I am interested in doing some taxable investing because we have maximized contributions to the various retirement accounts for which we are eligible.

Most of you are probably aware that I have an interest in reaching financial independence early, and “retiring” from the traditional nine-to-five grind to pursue other things. To accomplish this goal I recognize that I need to invest outside of retirement accounts to have access to “retirement” income before reaching typical retirement age.

My problem is I’m a bit overwhelmed by all the investment choices, and their various implications for things like risk, taxes, etc. I’m a fairly conservative person, by nature, so the idea of taking a lot of risk does not appeal to me. This is especially true of money outside of retirement accounts, because I recognize these funds will have a shorter lifespan than those socked away in retirement accounts.

To guarantee, strike that – guarantee is a bad word when talking investing. To improve my chances of securing pre-retirement income from some of this money, I’m aware of several techniques and investment vehicles:

• Dividend investing
• CDs and high-yield savings accounts
• Treasuries
• Bonds
• Equities
• Paid-for real estate
• Some combination of all of the above

Obviously, things like taxes are one of the primary concerns when investing outside of retirement accounts. However, before I start comparing mutual fund turnover ratios at Morningstar, I need to settle on a basic strategy. Do I invest and reinvest dividends and earnings with the goal of creating the largest pile of money possible? Or, do I start to build a working capital fund that spins off dividends now that I use to supplement our lifestyle until they are large enough to live off without paid employment?

In the book Your Money or Your Life the authors advocate creating a working “cache” of money that spins off interest and dividends. Of course, this was easier to do in the 1990’s, when the book was first published, through the use of Treasuries. At the time they were yielding around 6.5%.

Unfortunately, this is no longer true, so someone seeking financial independence has to look elsewhere for higher rates (the revised edition of the book points to a couple LifeStrategy funds at Vanguard as potential candidates to house this cache of working capital).

I generally like this approach. I like the idea of knowing how much my investments are earning, and how much more we’ll need to cover our basic expenses. I do recognize, however, that by not reinvesting dividends I’m missing out on the opportunity to grow this savings balance even faster.

I’m interested to hear from others taking a similar approach to taxable investing, or planning to reach financial independence before the traditional retirement age. How are you investing your money? Do you reinvest dividends, or cash out now to supplement income? Anyone using rental income from real estate to help reach financial independence?

Investing seems scary, and investing during a bear market is even scarier. Believe it or not bear markets are an important part of a healthy business cycle, corrections are needed to ensure prices are not overly inflated. It is true that market corrections put a little dent in our portfolios, however the big losses are due to our emotions and investment mistakes in a bear market where we try to reduce losses but actually are losing more. What are some of these mistakes?

Sell, Sell, Sell…

When markets tumble everyone gets freaked out and starts selling without any logical reasoning or attention to long-term goals. As the sell-off continues more investors jump on the train and sell their investments, often they all miss the fact that they are selling at the bottom to only repurchase them back at the top. Stop selling without a reason, only sell if the fundamentals have changed for the long term or the investment does not fit in your plan, not because everyone else is selling in the market.

Stop Investing

The only worse thing one can do than selling out in a bear market is stop investing during the bear market. People get scared and think the markets are falling apart and believe there is no point in investing. Would you stop shopping if retail prices dropped 30%? No. You would probably buy even more because everything is on sell now so you’ll take advantage of the good prices, same concept applies to investing. There is a huge sell going on in the financial markets during bear markets and you should take advantage of it and not hide from it. When you stop investing during a bear market you will miss out on many undervalued investment opportunities which can have great returns in the long run.

Look at Alternative Investment

Some investors start to look at alternative investments because they believe somehow these will perform better than the equity markets. In this recession the focus has been gold investment, gold is reaching all time highs and investors believe gold is a great place to invest. Frugal Dad recently answered a readers question regarding gold, here are my reasons why gold is a bad investment. Although alternative investments have their place in a portfolio the excessive focus during bear markets makes them dangerous.

Timing the Market

Unless you have a crystal ball or have some psychic abilities just stop wasting your time and money trying to time the markets. Investors are more likely to time the markets during a bear market, as there are often big swings, which are seen as opportunities by investors, this strategy will only hurt your portfolio.

I know bear markets hurt, but you trying to “improve” things will only make things worse. Successful investing is not magic, just keep things simple and maybe follow few investing and money rules of thumb and you’ll be fine in the long run.

What were your investment mistakes during this bear market? What have you learned from them? You know anyone who made these mistakes?

Rachel writes in with the following question about investing in gold:

I enjoy reading your blog about wise spending. I have a question and I’m not sure who to go to. My husband is interested in investing in gold. What are your thoughts on investing in this direction? Do you have other sources that you lean on for investing advice?

Photo by Muffet

Rachel, your question comes at a good time. I spend a lot of my day listening to a variety of talk radio programs at work on subjects that range from sports to politics to personal finance. All three tend to run a lot of advertisements for investing in gold. While intrigued, I confess to not knowing much about investing in commodities, so to answer your question I decided to dig into some research while asking the Frugal Dad community for help with your question.

Why Invest in Gold?

A recent check of gold prices shows it is hovering around $1,000 an ounce. It seems like every week or so gold prices set another record. But in the world of economics, it is usually true that what goes up, must come down. That’s not always the case, but I wonder if gold prices will work the same way.

As the market moves ever-so-slowly towards recovery, will gold prices remain high? Who knows? Conventional investing wisdom says gold is a safe bet when times are tough (inflation, weakening dollar, etc.). We’ve certainly had tough times, but to this point it seems inflation has been kept in check. I’m not completely sold on the idea our government will be able to control devaluation of the dollar as more and more money is pumped into the system.

So the real question is, “Is now the right time to invest in gold, or would investors be getting in at the top only to see their investments disappear in a recovery?” I think the answer to this question is the same answer I give to others interested in any form of investing:  Invest for the long term, don’t try to time the market, and diversify.

If you’d like to pick up a few gold coins, or bullion, as a percentage of a broader long-term investment portfolio, that seems reasonable. If you dump your entire nest egg in gold, betting on the continuation of tough times, well, that just sounds too risky for my liking.

Ask the Readers: OK readers, I know there are plenty of you out there smarter than me on the subject of investing in gold. What more can you tell Rachel about gold investments? Is it better to invest in physical gold, mutual funds, etc? What are your thoughts on the timing of making new purchases of gold? Feel free to make any specific brokerage recommendations you may be familiar with as well.