Investing in stable, dividend-paying stocks can be a great way to invest in any market – whether a bull market or a bear market. These tips can help you understand more about dividend investing, including how to avoid costly mistakes.
Are you holding off buying stocks because you think the stock market is too high? Have you overpaid for stocks in the past and are worried about paying too much again? These are questions I ask myself almost every day. Like many other investors, I have been really burned in the past from overpaying for stocks. It is also a task in itself to keep up with all of your investments, look into an online Personal Capital account to help you manage your money!
A few years ago I decided to take a new approach to investing in the stock market.
Instead of trying to time the market, I developed a strategy to invest in only the top dividend growth companies. While not as exciting as investing in the next high growth technology company, a dividend stock portfolio can offer long term growth and a steady income stream.
Even when the overall market is perceived as being too high, there are still opportunities to invest in dividend paying stocks.
Tips for Investing in Dividend Stocks in Any Market
Here are 7 tips that can help create a dividend stock investing strategy and feel safe you will not lose money in the stock market over the long run.
1 – Save on Brokerage Fees
If you are worried about overpaying for stocks in a bull market, look to low-cost brokerages to purchase shares of stock. For example, some brokerages no longer charge commissions or offer reduced commissions. This makes it easier for me to invest when there is uncertainty in the market.
Another option is to look into company sponsored direct stock purchase plans (DSPP) to save on commissions. There are several companies that will waive the fees to purchase stocks through a DSPP.
2 – Dollar Cost Averaging
While I certainly don’t want to overpay for my stock purchases, I also want to make sure my investment dollars are working for me as soon as possible. Investing smaller chunks of money on a more frequent basis allows me to dollar cost average into a stock, helping me to pay market value.
This helps me remain calm if a stock price goes down as I know I can continue buying up shares at a lower price.
One downside of dollar cost averaging is the commissions and fees that could add up by making more frequent purchases. If you can find low-cost brokers or leverage free methods to purchase stocks, then this can help you avoid overpaying for stocks.
3 – Low Price to Earnings
When you are looking for dividend stocks to buy, concentrate on those with a Price to Earnings (PE) ratio under 20. Become a patient investor and buy the top dividend companies when they are offered at a discount.
It is important to use other criteria to screen stocks (i.e. payout ratio, yield, etc.) but buying companies when they have a lower P/E can certainly help stretch your investment dollars and feel comfortable investing in any type of market.
4 – DRiP – Automatically Reinvest Dividends
Take advantage of dividend reinvestment plans (DRiP) to save on costs. Most brokerage accounts allow investors to automatically reinvest their income back into partial shares of the stock. They are usually easy to set up and can help investors start earning compounding interest.
5 – Sustainable Dividend Growth
Look for companies with sustainable dividend growth. The dividend payout ratio is a criterion that can be used to make sure you are buying a company that can sustain future dividends. The ratio represents the amount of a company’s earnings that are being used to pay the dividend. Avoid buying companies with a payout ratio that is greater than 60 to 70 percent.
6 – Focus on Past Dividend Growth
Focusing on past dividend growth of a company is another way to put your concerns about investing at ease. For example, a stock with a solid 5 and 10-year dividend growth rate (6% or more) is a good sign of a well-managed company. The Dividend Aristocrats are an annual list of top performing dividend stocks that have consistently increased dividends over the years.
While past dividend growth is no guarantee for the future, it is still a good indicator of increases in the years to come.
Avoid High Dividend Yields & Other Mistakes
While they can be very tempting, a high dividend yield (over 5% or 6%) is usually not a good sign. Chances are the company will not be able to sustain a dividend that high over a long period of time.
There are exceptions to this rule, but don’t get caught up in chasing high yielding stocks. Focus on the boring ones that consistently pay 2.5% to 5.5% that have a long history of consecutive increases.
When I first started out investing in dividend paying stocks, I really had no clue what I was doing. I had been buying and selling investments for several years but had no experience selecting blue chip stocks that paid a dividend. My screening criterion (at the time) was flawed and it cost me a couple of thousand dollars.
What was my major flaw in selecting these investments for my portfolio? I focused only on the dividend yield of a stock instead of looking deeper into a company’s financial numbers and history. I only considered the highest yielding stocks for my portfolio and didn’t even look at blue chip companies like Procter & Gamble (PG) and Johnson & Johnson (JNJ). The dividend yield on those companies was just too small compared to other investments.
If you are planning to build a portfolio of dividend paying stocks, take my advice and don’t chase the highest yielding companies. Keep reading and I will tell you why.
Highest Yielding Dividend Stocks = Risky Investments
Who wouldn’t love a 10% return on their investment in the form of a cash payment every year? Many of the highest yielding stocks actually have current yields well above 10%. Picking a stock that offers a double-digit payout every year may seem like the best financial decision you ever make. I am here to tell you that it is also probably one of the riskiest investments you could ever make.
The first dividend stock that I ever bought paid a monthly dividend with a yield of 15%. During the first year of owning the stock, I received a $25 monthly dividend payment for my $2,000 investment. Just in the first year, I made $300 in dividends from owning the stock.
Soon after the first year of holding the stock, the bottom fell out and the yield came back down to reality. What once was a hefty 15% yield became a 7% yield in less than a week. My steady $25 per month income stream had been cut by more than half before I knew what had happened. What I learned in the few weeks after the stock price took a tumble was that the company had a payout ratio above 100% and could no longer maintain its dividend at current levels.
Up until that point, I had no clue what a payout ratio even was. The payout ratio is the amount of earnings used to pay dividends to common shareholders. Common sense would have told me that any company that pays more in dividends than they earn is not a good investment.
Types of High Yielding Stocks
Not every high yielding stock is created equal. Many of the highest dividend stocks come from corporations that are set up as trusts. For example, many real estate investment trusts (REITs) have very large dividend payouts. Some of these companies can make for decent investments, but you better do your homework.
Another group of high yielding stocks is from companies that are ready to make a dividend cut very soon. Since the current yield of a stock is calculated using past dividend performance with the current share price, there can be a delayed change in the results. The market saw this kind of behavior after the sub-prime crisis with companies like Bank of America (BAC) and Wells Fargo (WFC).
Here is an example of what could happen when a company is getting ready to cut its dividend.
- Let’s assume company ABC pays $1.00 annually in dividends and trades at $25 per share. The dividend yield for this stock would be 4.0%.
- Let’s also assume that the company has warned they will not meet their earnings numbers for the next quarter and the share price plummets to $15.
- Since there is no immediate change in the dividend paid, the current yield would jump to 6.7%.
In a situation like this, there is a very good chance a dividend cut is looming by the company because of their earnings problems.
In the scenario above, if you didn’t do your homework and invested in ABC with a 6.7% yield, you would be at a disadvantage when the company makes a cut. While this scenario does not cover every situation, it is common to see this happen when a company has cash flow problems.
Picking Top Dividend Stocks
With savings accounts and certificates of deposits currently returning 1% – 2%, it may be tempting to chase the highest yielding stocks. Even if a CD was paying 5%, it can still be difficult not to consider investing your money into a stock that is yielding 10% or 15%. However, I caution anyone considering this type of investment to do their homework on the company before they chase the high yield.
It may sound simple, but the key to picking the top dividend stocks comes down to common sense. If a 10% yield on a stock seems too good to be true – it is. If that double-digit return was a great investment, then everyone else would be climbing on board which would increase demand to own the stock and thus decreases its yield. The main point to remember here is that there is a very good reason why the stock has that high of a yield.
While the current yield of a company is an important way to screen dividend stocks, there are several other ratios and criteria that should be considered as well. Here is a list of a few useful indicators you can use when selecting the top dividend-paying stocks.
Any stock that has a current yield greater than 6% should be studied very carefully. It is almost impossible for a company to maintain a yield higher than that.
How much of a company’s earnings are being used to pay the dividend? The best blue chip companies are able to sustain a payout ratio of 50% or less. While maintaining and growing a dividend is important, it should not come at the expense of growing the company. A company that is allocating too much of their earnings to pay shareholder dividends is not allowing themselves to grow.
The price-to-earnings ratio is another critical indicator that investors should consider to find the best dividend paying stocks. You never want to overpay for a blue chip stock. Look for companies with a trailing P/E under 20 to find the best value in the market.
Does the stock have a history of raising dividends every year? While it is critical that a company not sacrifice additional earnings every year to raise the dividend, it is important to see growth. Look for companies that have a strong history (at least 10 years) of providing raises to their shareholders annually. Look at the dividend aristocrats index or the dividend achievers as a place to start.
The criteria listed above are just a few of the additional indicators that investors can use to weed out the risky high dividend stocks.
Final Thoughts for Successful Dividend Investing
If you want to build a solid portfolio of stocks that can provide a source of income in the future, take my advice – don’t chase the highest yielding stocks.
Instead, put together a portfolio of stocks that have historically increased their distributions annually. Look for companies that are well managed and can withstand any type of economic environment. Most of the time, chasing high dividend stocks will cost you money instead of earning you more.
No matter what the overall stock market is doing, there are always opportunities to invest in top dividend companies. Even when the market is high, there are plenty of ways to limit your risks of overpaying for stocks.
One tool used by dividend investors is to use a set of criteria to buy only the best companies. Screening out stocks based on P/E ratios, payout ratios, and dividend growth rates is one way to find top dividend stocks to invest in.
Another way to feel better about investing when the overall market is high is to try and save on commissions and fees. Investors can also take advantage of direct stock purchase plans to save on commissions. I know that I feel more comfortable buying stocks when I am not paying any fees or commissions.
Finally, investors can leverage dollar cost averaging and dividend reinvestment plans to lower their overall price per share they pay for a dividend stock.
What other tips can you provide that makes it easier to invest in a bull market?