For those who want to trim back their risk in volatile growth stocks, moving into value and dividend stocks in 2021 might be worth consideration. Dividend stocks are those that pay you to own them. You get a dividend check paid into your account every quarter from the company. Today you can find very solid companies paying very solid dividends if you know where to look.
But you are wise not to buy on dividend yield alone. A high dividend yield — 7% to 10% for example — generally indicates real trouble and is not sustainable for any company. You may win with the dividend but lose with the share price. That’s not smart investing.
Please Avoid This Common Dividend Mistake
Yield-starved investors often make the mistake of hunting down high dividend yields as a proxy for yields they can no longer get with municipal and government bonds. It is very important to realize two things about dividends:
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- Dividends are not guaranteed. They are voluntarily paid by the company, ideally as a share of rising earnings and profits.
- The term “dividend yield” fools many investors. The dividend yield is a mathematical expression, not an interest rate. It merely states the percentage of the share price that you are receiving in dollars.
Here’s how it works. If a stock is priced at $100 a share and is paying $4 per share annual dividend, the result is a 4% dividend yield. If the company loses government contracts and the share price falls to $50 a share, yet keeps on paying the same $4, your dividend yield is now 8%. That doesn’t automatically make the stock a “bargain.” Consider Boeing. Things got worse and kept getting worse until they suspended the dividend. You could have lost 50% on your investment and then lost the dividends too. Shopping for yields is simply not the safe way to invest in dividend stocks.
Imagine any business shelling out 10% of its profits to shareholders. No company with investment grade credit ratings can afford to do it. They could not afford to keep running their business or invest back into infrastructure. A high dividend yield is an immediate warning sign to the experienced dividend investor who is looking to build a comfortable retirement.
Dividend Investing Basics
Let’s keep it simple. A dividend is a share of the company’s profit. Therefore, when choosing dividend stocks, several questions are mandatory: How profitable is the company? How secure is the industry the company does business in? Will that industry be as relevant next year and the year after as it is today? And how safe is the dividend?
It’s important to understand where the dividend is coming from and what the probability is that the company will continue to pay the dividend. But if you really want to get selective and increase your odds of long-term success, it’s wise to focus on companies that have raised their dividends every single year for at least 10 years or longer.
If you start with that requirement, and add a number of other quality screens, odds are good that you will own stocks that grow both their share price and their dividends over time. One more point should be made: The smartest dividend investors put the mathematics of compounding on their side by reinvesting their dividends automatically.
How Reinvesting Your Dividends May Grow Your Retirement Wealth
By allowing your growing dividends to buy you more and more shares every quarter, you can eventually double the number of shares you own over time, and thereby continue growing your dividend yield. Many established dividend growth investors start out with quality companies yielding 3% the first year. By reinvesting the dividends, they are in position to accumulate and pile up higher and higher quantities of shares. The result is that in five, 10 and 15 years, their dividend yield may be 5% to 15% in relation to their original investment.
If you do your research, you’ll find that it is very important to focus on companies that dominate their fields in industries that are necessary for everyday life. You want to own companies that drive the economy. Demand is high for their services and products and has been for years. Their profits grow every year. When you own companies that keep growing their profits and are important to everyday life, you may once again get that solid feeling you want as you plan retirement.
Investing in dividend growth stocks has created many millionaires over time. The nice thing is that a dividend growth strategy, properly managed, can even benefit during market downturns.
Building Future Wealth During Down Markets
When the share prices of profitable companies are falling, and those companies keep paying dividends that are constantly rising, the result is that you may accelerate the growth of your portfolio. Your rising dividends may buy more shares when the market is down. Those new shares in turn pay you more dividends in what can be a never-ending cycle.
Whatever you do, don’t jump into dividend stocks without understanding how to put the power of dividends to work. Just because a stock pays a dividend and is a company you are familiar with, such as Procter & Gamble for example, it still may not be your best buy right now. In fact, I’m not a big fan of P&G for several reasons.
You not only need to have rules for buying high-quality dividend stocks but also for selling stocks that you determine aren’t going anywhere. The global economy is changing. It makes sense to own dominant companies in industries that are going to continue to be relevant. For that reason, at my firm, we shy away from oil and tobacco stocks.
Tips on Smart Dividend Stock Selection
One of the methods we use at IQ Wealth Management is getting rid of stocks that suspend or cut their dividends. Why invest in a company that’s struggling? A dividend cut or suspension is a “no-no” in a quality dividend portfolio, and I believe there is no excuse. When that cut or suspension is announced, “shoot first, ask questions later” and sell the stock is the path I follow.
Here is an important point not to be missed: Even during the COVID crisis and the 2008 crisis before that, there were a good number of dividend stalwarts that did not cut their dividends. In fact, a select group of companies raised their dividends during these major setbacks. You may be wise to focus on companies with that kind of strength and staying power.
The IQ Wealth Black Diamond Dividend Growth portfolio selects and keeps only those stocks that raise their dividend every year without fail and are in relevant, necessary industries. We cut any stock that does not raise its dividend. All of our companies have investment grade credit ratings, are dominant in their industry, and have raised dividends a minimum of 10 consecutive years or longer.
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This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.
