Investing in stocks that pay out dividends is a strategic way to establish a reliable income stream and build wealth. While investors are taking on a higher degree of risk, there's also the potential for greater returns.
Finding success with these investments isn't necessarily rocket science, but it does require an understanding of some basic principles. Here are six tried-and-true rules every savvy investor should be aware of when investing in dividends.
Choose Quality Over Quantity
One of the most important considerations for investors when choosing investments is the dividend yield. The higher the yield, the better the return, but the numbers can be deceptive. If the stock's current payout level is not sustainable over the long-term, those market-beating dividends can quickly dry up. REITs are a good example of how fluctuations in the market can directly affect dividend payouts.
Selecting an investment that offers more stability may mean sacrificing a certain amount of yield in the short-term, but the result may be more favorable, particularly for investors who prefer a buy-and-hold approach. The income generated by lower-risk dividend stocks may be less, but it's likely to be more reliable over time.
Stick With Established Companies
The stock market moves in cycles and it has a tendency to repeat itself now and then. When choosing dividend investments, there's no better measuring stick than a stock's past performance. Specifically, investors should be targeting those companies that have earned "dividend aristocrat" status.
These are established companies that have increased their dividend payouts to investors consistently over the previous 25 years. Their brands are easily recognizable, and they generate a steady flow of cash with a high likelihood of continuing to do so in the future.
Look for Growth Potential
While newer companies can pay out some impressive dividends, investors shouldn't be jumping on the bandwagon without doing their research. Aside from looking at past and present returns, it's also important to look at the company's future potential to increase its dividend payouts.
This is the primary difference between growth investing and value investing. With growth investing, rather than focusing on what the stock is trading for currently, you would look at the long-term outlook for growth to gauge how profitable it would be from a dividend standpoint.
Be Mindful of the Payout Ratio
A company's dividend payout ratio can reveal how safe the investment is. This ratio tells investors not only how much is being paid out to shareholders, but also how much income the company can retain.
If you come across a high-yield dividend stock, but the company is paying out a substantial percentage of its income to investors, that's a sign that you need to tread cautiously. If the company were to see its income stream reduced, the amount of dividends you're receiving would go on the chopping block.
Mix It Up
There's a strong argument to be made for concentrating assets on a handful of stocks or targeting a specific sector of the market. If the companies or industries you've zeroed in on have an exceptional track record, that bodes well for your future dividend earnings. On the other hand, that can be problematic during a market downtown.
Spreading assets out over multiple dividend-paying investments adds diversity to your holdings, and it allows you to minimize risk. When dividends are reduced in one area, the loss may not be felt as deeply when the rest of your portfolio continues to perform.
Know When to Hold and When to Fold
Investing guru Warren Buffett firmly believes in taking the long view when it comes to investing, but like any smart investor, he knows when to cut his losses. With dividend stocks, there's a fine line between waiting for the investment to pay off and hanging on too long.
This is a particularly easy mistake to make when purchasing stocks that on the surface appear to be an excellent value. The problem occurs when the company fails to deliver regarding growth. Being able to recognize when a stock is sinking is vital, but you also have to know when to act on it and when to sit tight.
The Bottom Line
With the right approach, dividend investing can add an exponential amount of value to an investor's portfolio. The key lies in knowing how to evaluate stocks to pinpoint those that offer the strongest returns while minimizing risk and maintaining diversity.
It's nothing short of a juggling act, but by adhering to the guidelines laid out here, investors may be better able to position themselves for maximum success.