Dividend investing enables investors to earn from regular payments of dividends and capital appreciation. If you’re an investor looking to earn extra income or grow your wealth, you should look out for high-yield dividend stocks.
However, before settling for dividend investing, you should learn the risks involved and the optimal strategy to use to minimize the risks.
This article will tell you what dividend investing is, its benefits and pitfalls, what strategy to follow to become a successful dividend investor, and which stocks you can buy for high returns.
Table of Content
- What does dividend investing entail?
- Are dividends good for investors?
- How much do I need to invest to live off dividends?
- Dividend investing strategy
- Which shares pay the best dividends?
What does dividend investing entail?
A dividend is a payout made by a publicly-traded company to its shareholders as part of returns from earnings made in a given period. The process of approving dividend payouts is preceded by a meeting by the company’s board of directors, who review the financial reports to assess if to pay dividends or not. Once the board approves and declares the dividend stock payment, they announce its size and the payment date.
Dividend investing enables eligible shareholders to gain returns from the dividend payout declared by the company. The dividends are paid out monthly, quarterly, or annually.
As an investor, you can earn from regular or one-off dividend payouts. The former are payments done consistently, while the latter are payments made when a company makes high profits or after the sale of an expensive asset.
Are dividends good for investors?
Dividend investing can pay off because it generates recurring payouts for investors. However, keep in mind that during an economic crisis or when a company uses its earnings to expand or invest in technology, there are chances the dividend payments will be cut or minimized.
Dividend investing is also worth it because it rewards investors through capital appreciation. Capital appreciation refers to the rise in the price or value of a company’s assets, enabling investors to gain from a stable flow of income.
Investing in dividend stocks for retirement is also a good idea because many firms increase their dividend payouts over time. This progressive growth helps to offset the negative effects of inflation on income.
A dividend investing strategy preserves and grows your principal amount injected over the long-run, something you might not experience in some annuity arrangements. This is a benefit many wish for, especially when you aspire to leave a legacy for your family or community.
This approach also gives investors the flexibility to sell off their assets to fund other investments or retirement activities.
However, while dividends are good for investors, you should keep a diversified portfolio of dividend stocks – this strategy will guarantee you returns every period.
How much do I need to invest to live off dividends?
Living off dividends is something many of us would want upon retirement. But is it practical?
I would say yes and no. It is always advisable to diversify your portfolio to lower risk exposure. You can live off dividends if you have a high-risk tolerance, but in a real-life scenario, many people invest in more than one asset class.
Focusing on a company paying safe and growing dividends over the long-term rather than on the dividend stock’s price volatility can save you from the emotional risk of investing.
You can surely live off dividends if you diversify your portfolio to reduce the shocks experienced from the market value variability. This dividend investing strategy can grant you a source of consistent income.
But how much is enough, and for how long?
According to an article by the Wall Street Journal, this example best explains how much you need to live off dividends.
Assuming you had $1 million at retirement, you could earn up to $40,000 in annual income, after adjusting for 2% inflation.
To do so, we would assume that the stock dividends will grow by 3.0% per annum – you would then invest $400,000 in treasury bonds (they match the inflation rate) and $600,000 in stocks. The stocks could earn you $18,000 (3%*600,000) in dividend income per annum. Within 21 years, the earnings from the dividend stocks could have hit $24,000 per year (after inflation), while you use part of the gains from bond interest to cater for other expenses or to divest.
This dividend investing calculator can be adjusted depending on your earnings target, by for instance, dividing or multiplying the figures by 10 or 100. It confirms that you can live off dividends if you diversify your portfolio and invest in safe, growing dividend payments.
Also Read: 6 Tips for Better Money Management
Dividend investing strategy
The recommended dividend investing strategy requires the investor to identify the best investment opportunities by reviewing select well-financed companies.
According to AAII Dividend Investing, the following are some of the characteristics to look out for when selecting companies to invest in:
- A long record of earnings and dividend growth,
- Positive free cash flow,
- Reasonable valuations, preferably “low,”
- A reliable outlook for price appreciation and dividend growth in the future.
Once you settle for the type or nature of companies to invest in, you should consider the following strategies in dividend investing:
1. Diversify your stock portfolio
Established investors, such as Warren Buffet, run concentrated portfolios.
However, not all of us have the same resources, insights, and connections as Buffet to give us the courage to run a concentrated portfolio successfully.
Instead, I recommend you go for a reasonable range of different stocks. In fact, the American Association of Individual Investors (AAII) warns that investing in a single dividend stock rather than diversifying heightens the annual volatility (or risk exposure) by approximately 30%.
The AAII study also indicates that holding 25 stocks reduces the dividend investing risk by about 80%, while 100 stocks can minimize the exposure by about 90%.
The FIRN Research Paper confirms these findings by suggesting that a higher number of stocks are needed to diversify your dividend investing stocks during financial distress.
Therefore, it is reasonable to hold between 25 and 100 stocks while considering other factors, such as your financial situation and portfolio size.
Also Read: 5 Tips on How to Invest Money Wisely
2. Diversify across the industry
Holding many dividend stocks is not safe enough if they’re concentrated in one or two industries.
Such investments are risky because they hold similar characteristics. For instance, if the price of oil were to drop during an economic crisis or interest rates were to rise, stocks in the same industry would behave almost the same way because they’re correlated.
When you pick stocks from companies operating in different industries, you diversify the risk – when some sectors are struggling, others would be thriving.
As per the below sample portfolio by S&P, it is advisable to invest not more than 25% in a single sector.
3. Review the capital structure or leverage
When evaluating prospective companies for dividend investing, financial leverage is a crucial factor to consider because it signifies the amount of returns equity holders are likely to receive.
The more a company is financed through debt, the more its dividend stock is exposed to unfavorable business conditions, such as changes in interest rates and credit conditions.
When constructing your dividend investing portfolio, it is advisable to go for firms whose debt-to-equity ratio is not more than 50%. You should also lookout for a strong grade credit rating and interest coverage ratio.
4. Small-cap or large-cap stocks?
Market capitalization (market cap) measures the market value of the outstanding shares of a publicly-traded company. It is obtained by multiplying the total outstanding shares by the current market price of one share. It shows how much a company is worth at market value and what investors are willing to pay for its stock.
As a dividend investor, it is advisable to go for large-cap companies rather than small-cap firms.
The former are more liquid than the latter because they have more buyers and sellers, making it easier to buy and sell dividend stocks at reasonable margins.
Businesses making up small-cap stocks are also less diversified, making these kinds of dividend stocks more volatile.
For instance, the figure below shows that between 1989 and 2017, Russell 2000 demonstrated higher volatility (standard deviation) of 18.5%, compared to Dow Jones and S&P 500’s 14.8% and 16.8%, respectively.
How to start dividend investing
In case you’re wondering where to start from in dividend investing, here is a simple guide which you can use with the help of an investment advisor:
- Screen high dividend-paying stocks – you can use financial sites or online broker websites.
- Evaluate and select specific stocks – you can compare the dividend yields. For instance, you can choose companies with a high dividend payout ratio, as this measure indicates how much of the company’s earnings are spent on dividends. Learn how to research stocks here.
- Decide the percentage to invest in each stock – for instance, you can diversify by injecting 5-10% of your portfolio in each of the 25 stocks selected.
As you seek companies likely to yield the highest dividend payouts, keep in mind that too high yields are unsafe.
High payouts can be unsustainable in the long-term and could signify that investors are selling the stock, pushing the share down and increasing the dividend yield in the process. Remember, the dividend yield is a factor of the dividend per share and the price per share – the lower the share price, the higher the return.
Dividend yields within the 4% mark are safe, but factors, such as your risk tolerance, can allow you to be flexible. The following diagram demonstrates the top 10 high-dividend stocks to invest in as of June 2020:
Dividend investing is a good long-term goal because it enables you to generate recurring income and is a source of capital appreciation by accumulating the principal amount invested.
If you are looking for a sustainable way to live during retirement, you can diversify dividend investing stocks with other sources of income, such as treasury bonds.
Stock and industry diversification, coupled with a reasonable selection of the target companies, can help keep your portfolio safe from risky industry conditions.
Would you like to learn more about dividend investing? Intellini are here to conduct more research for you. Feel free to contact us.