I realised something recently. Although Peter Thornhill is well-known and investing for dividend income is not a new concept, there is no official step-by-step guide to implement his method.
So, with Peter’s approval, I decided to create this ‘how-to’ article, for those who want to get started and put the strategy into practice. And for the regulars, it will reinforce the old fundamentals and certain lessons which are often forgotten.
By the way, if you haven’t already, check out my earlier interview with Peter Thornhill.
Before we begin, a caring disclaimer: Nothing here is personal advice. This strategy may not suit you for a variety of reasons. Please do your own research before making investment decisions.
An Introduction to Investing for Income
To boil the strategy down to a simple core concept, it’s this: Investing for a growing income stream.
Sounds simple, I know. But somehow people manage to butcher it and have all sorts of pre-conceived notions about how to do it.
Peter’s strategy is implemented by investing in a diversified portfolio of dividend-paying shares. The basic premise is that over the long term, a broad group of Australian businesses will earn higher profits, and will pay higher dividends to shareholders over time.
As the investor buys more shares, and the dividends increase over time, this income will grow to the point where the investor can live off the dividends which the portfolio spits out each year.
Okay, enough intro. I’ve boiled Peter’s philosophy down to 10 steps. That seems like a lot, but don’t worry, it’s easy to understand.
Step 1: Spend less than you earn
You’ve heard this before, it’s called saving money. And it’s a huge fundamental pillar in building wealth over time.
Saving is like eating your vegetables. It’s easy to shrug off saving as boring and uninspiring. But it’s very important. No matter our income level, we need to focus on saving at least some of our income.
So, suck it up and eat your damn vegetables. As we discussed recently, it’s still possible to achieve Financial Independence on a very modest income.
Step 2: Borrow less than you can afford
This sounds simple, but almost nobody does it! In Australia, we seem to love housing so much that we borrow to our limit to buy the best place we can possibly afford.
By the way, I’m guilty of this one. In the early days, I leveraged up heavily to buy investment property (too much, in hindsight). Starting from today, I’d keep it simple and buy shares from the start.
If we really get to the core of this message though, it means buying a moderately priced home to live in. Or rent. This keeps your total cost of living down and enables you to save and invest more. More here: Rent vs Buy – The Aussie Housing Dilemma.
And if you’re renting and using a margin loan to buy shares, it means use debt sparingly.
Step 3: Invest in a diversified basket of dividend-paying shares
The goal is to own a portfolio of productive businesses which earn plenty of cash and send some of it our way each year in the form of dividend payments.
Luckily, there are ready-made baskets of companies we can buy in one hit. One way is to buy all of them, via a low-cost index fund that tracks, say, the top 300 stocks. But Peter’s preferred option is to buy well-established low-cost Listed Investment Companies (LICs).
Anyway, these LICs invest in a broad group of Australian companies (often 50-100+), which they expect to do well over time and pay increasing dividends. The LICs then receive and pay these dividends to shareholders each year, aiming to pay out a predictable and growing income over time. You’ll find the dividend history for a number of large low-cost LICs on my LIC Reviews page.
These investment companies have been around a very long time – most, more than 50 years. They’re low cost, long term focused and have very low turnover. This means they’re tax efficient as they don’t buy and sell often.
Remember, not all companies pay dividends. So while they’re not exciting, these old LICs will always manage the portfolio with a strong focus on providing an income stream to shareholders. And if you’re using dividends to pay the bills in retirement, that’s important.
From here, all investors need to do is open a brokerage account, choose a fund (or a couple) to invest in, and get started.
Step 4: Use your dividends to buy more shares
Once you’ve bought some shares, something fantastic will happen. Every 6 months or so, you’ll get a lovely cash dividend deposited into your bank account.
This dividend is a portion of the profits from all the companies in the fund you’ve invested in. As an owner, naturally some of the money is sent to you, while the companies use the rest to further grow their businesses and future profits.
At this point, you can spend it at the pub or your local cafe. But the best option is to simply put this cash towards buying more shares. This increases your piece of the pie and means your future dividends will now be larger!
And you can use that larger dividend to buy even more shares, meaning higher future dividends again. And then you can use that larger… you get the idea. This is compound interest at it’s finest.
By the way, I created an easy-to-use spreadsheet to keep tabs on our annual dividend income after every purchase, which you can download here.
Step 5: If you have a mortgage, consider debt recycling
I’ve previously written an in-depth guide to debt recycling. In short, if you’re investing and also paying off your home, it’s possible to slowly convert your mortgage into an investment loan. And being an investment loan, the interest is then tax deductible.
But many people get different parts of this concept confused, so a strong understanding is needed before going down this path.
If it suits you and your personal situation, then debt recycling can be very tax efficient. But there’s also a lot to be said for simplicity, and avoiding things that makes your finances more complicated.
So it really depends on a person’s appetite for being debt free, their ability to manage their cashflow well, and also their willingness to deal with more complexity.
Step 6: Keep building your portfolio until your dividends exceed your spending
Use your monthly savings and your increasing dividends to continue growing the portfolio. Because dividends naturally increase over time (due to rising company profits) and you’re constantly adding more money, your annual passive income will increase at a healthy rate.
Sure, the markets and dividend payments will take a few steps back once in a while. But the long term trajectory is overwhelmingly likely to be up, as it has been throughout history.
While it will take many years, eventually this income will grow to be larger than your annual spending. It mostly depends on how much cash you’re putting in – your savings rate!
Because of the backward steps I mentioned, you’ll also need a pool of ‘safe’ assets, that you can use to top-up your dividend income when times aren’t so good. This could be money sitting in an offset account, cash in a high interest savings account, term deposits etc. Peter recommends a couple of year’s worth of expenses. So if you spend $50k per year, perhaps $100k is a good starting point.
It’s also prudent to maintain flexible spending and spend less during scary times (which is a natural reaction for most people anyway). This means you won’t have to dig into your cash buffer as much and makes your financial position more resilient.
Step 7: Retire and live off your portfolio
Hooray! You’re officially retired! If you make it this far, a hearty congratulations are in order!
At this point, you’ve got a healthy-sized portfolio and a decent cash buffer. You can now live off your passive income. Your only job is to manage your income and expenses, which you’ve been doing for a long time already.
If dividends fall due to lower company profits from an economic shock of some kind, you can use your cash and spending flexibility to plug the gap comfortably for many years until dividends steadily recover. Fortunately, LIC dividends also tend to be more resilient than the market as a whole, which is likely to be a good source of comfort during any scary periods.
Step 8: Spend your time wisely
You’re now free to live your life as you see fit. Use your unlimited free time to spend on the things most important to you.
Whether it’s quality time with your family, improving your health, enjoying your hobbies, learning new things, starting a part-time job or volunteering, spending time outdoors in nature, or just kicking back with a good book (or reading your favourite website *cough* Strong Money Australia).
Anyway, you get the idea. It’s your retirement, so do whatever you like! Now, that’s typically where the story ends for Peter’s strategy. But there are two other things that both Peter and I think are extremely important to add.
Step 9: Consider philanthropy if your wealth allows
With any luck, your portfolio will continue to grow over time as you simply live off the income stream. It’s important to consider that, on average, company profits and therefore dividends increase faster than inflation over the long term.
And if you’re even half-good with your money, your portfolio’s income may be growing a bit faster than your overall spending. This is fantastic news!
Because if you manage this extra wealth and income well, it allows you to give back to causes that are important to you. And don’t forget, many readers of this blog are going to retire early, yet will likely continue doing other productive activities that earn further income.
So, many of us will be in a fantastic position to give back and contribute to meaningful things as our wealth continues to grow.
You might’ve seen in my last portfolio update, I’m trying to increase charitable donations each year at a slow and steady pace. I got this idea from Peter, who not only gifts during his and his wife’s lifetimes, but has planned to put half of their estate into a charitable trust which will donate the increasing dividend income each year to causes important to Peter & his wife.
Step 10: Pass on what you’ve learned
With your experience, free time and ‘proof’ that the sharemarket is not a crazy gambling machine, you’re then in a perfect position to help others see the benefits of long term share investing.
I know a number of people who do this on forums and such, sharing their experiences and lessons learned, while expecting nothing in return. Shout-out to “Nodrog” from the shares section of the PropertyChat forum, who has used the ‘shares for income’ approach for decades and whose comments I’ve enjoyed learning from. A number of other savvy long-term sharemarket investors frequent there by the way.
My point is, if you can help one person see that their future doesn’t have to be solely dictated by their workplace and whatever pension is being handed out in 20 year’s time, you can consider that a success!
It’s human nature to want to help others. But we’ve got to help ourselves first. Once people can see the progress in your own life, they’ll be more willing to listen (no guarantees though!).
What NOT to do…
Now that we’ve got the basic steps covered, there may be some questions, especially from any newbies.
So, I think it’d be helpful if we discuss what to avoid. As strange as it sounds, this is likely to provide answers to some common questions.
By approaching things from the opposite side, it can often help us see more clearly how to make better decisions. This is by no means an exhaustive list, but are what I feel is worth mentioning. So here’s what not to do…
— Don’t chase yield. Rather than focus on high yield today, focus on getting the highest income over time. This means you can’t just own a bunch of high yield stocks or funds. You need to own companies that are growing, because that’s what will drive your growing income in the long run.
Luckily, the LICs mentioned own a diverse portfolio of companies with different levels of growth and yield. The result is, a decent dividend stream which grows steadily over time. More on this topic here: Everything You Need To Know About High Yield Investments.
— Don’t try to time the market. You don’t know what’s going to happen to the markets tomorrow, next month, or next year. I certainly don’t. And neither does anybody else.
So don’t bother trying to guess what’s coming next. Focus on what you can control – saving money and increasing your ownership of a large group of companies. That’s where results come from.
Of course, this doesn’t stop you from trying to invest more, if you notice the market is down -20% or more, for example. But playing the waiting game and hoping for better prices to come around is rarely a good approach.
Special comment from Peter Thornhill: A personal experience of mine. Following the GFC, CBA’s share price fell from around $65 to a low of around $25. At $50 I thought, “what a bargain” and bought more. They fell to $40 and I swallowed hard and bought more. At $26 they offered us new shares. I gritted my teeth and bought more.
Whenever I related that story the reaction from most people was, “why didn’t you wait and buy them all at $26?” My response was, “well, I didn’t have you nearby to tell me the right time!” Do any of those purchases look silly with the share price now at $84 and 12 years of increased dividends?
— Don’t compare your performance to others. Avoid competing with your peers, or other speculators you see touting their recent performance.
This will lure you into straying from your strategy, or chasing whatever hot stocks have done well recently – a disaster waiting to happen. Be satisfied with steady progress and focus on your long term investment strategy.
— Don’t make money the focus of your life. Your investments should be simple, so you can spend time on more important things, like family, friends, work and hobbies. I’m guilty of breaking this rule and making things complex, but I’m getting much better!
A few diversified funds will likely get the job done just as well as any fancier approach. Creating a complex portfolio may give you something to do, but it typically won’t make you wealthier.
The best part is, by following a sensible long term investment strategy, work will eventually become optional and you can then devote time however you please. And it’ll be because you made money work for you… not the other way round!
As Peter says, do not become a slave to your money, make money your slave.
— Don’t watch the market constantly. Yes, it’s exciting to see money coming in and your portfolio growing. But don’t be sucked into watching every single movement, up and down.
This delivers no value to your life and typically causes more pain than joy, since unless shares are at an all-time high on the day you’re looking, you’ll be disappointed.
So log into your brokerage account, buy your shares, and go do something else! Remember, each dollar is an employee working for you. But they don’t work harder just because you’re watching them!
— Don’t pay attention to the news. This may seem like a strange tip, but for a long term investor, the news does more harm than good. You can safely ignore financial news, especially gloomy forecast, which is just about all of them! More here: What if Australia Crashes?
The media has no interest in helping you achieve your long term goals. Their only interest is eyeballs and clicks. Besides, even if the stories were accurate, they are very short-term in nature. This means they’re largely irrelevant for people like us who should be thinking in terms of many, many decades.
We’re done! That’s how to implement Peter Thornhill’s investment strategy, step-by-step. Of course, if you have other questions, they’ve likely been answered already in my full interview with Peter Thornhill.
It’s all very simple. Save and invest in a low cost, low turnover, diversified basket of shares, focusing on the growing income stream, rather than the daily share price moves that everyone seems fascinated with. And think in terms of decades and generations, not months, years or this cycle.
In my view, many of the points mentioned here are important, whether you decide to follow Peter’s investment strategy or not.
It’s critical that we each invest in a way that we’re comfortable. And for many, that means focusing on the long term dividend income from the sharemarket. The dividends paid out by companies are a tangible and regular form of positive reinforcement, which can be a huge mental advantage during scary times.
And at its core, this brings you back to a simple fundamental reminder: every day, companies are working hard to innovate, deliver better products and services, to increase their cash profits and dividends for shareholders.
Do you invest for dividend income? You might like my easy-to-use Dividend Tracker, which I use to keep a running estimate of our annual passive income after every purchase. Click here to get it for yourself.