Dividend investing is a fantastic way to build wealth and construct a solid portfolio, but novice investors should be wary of jumping into dividend investing without properly educating themselves. There are many investors who dive right in, head first, and make mistakes that could be avoided. Here are some of the biggest faux-pas that dividend investors make.
First: What Exactly are Dividends?
A dividend occurs when a company redistributes its profits. A corporation who earns a profit or surplus can choose to make a payment to its shareholders: this payment is known as a dividend. These payments are generally allocated a fixed amount per share. For example:
Moody’s (MCO): The world-famous credit rating agency has a dividend yield of 1.3% and pays a quarterly dividend of 34 cents a share.
Wells Fargo (WFC): One of Warren Buffet’s top stock holdings, the provider of consumer and commercial financial services has a dividend yield of 2.6%, and pays a quarterly dividend of 37.5 cents a share.
British American Tobacco PLC (BTI): has a dividend yield of 5.4%, which is considered high-yield for the British multinational tobacco company considered one of the largest in the world.
The fixed amount per share is incorporated into the dividend yield ratio which is measured as the annual dividends per share divided by the price per share in question.
So if British American Tobacco is trading for $100, then an annual dividend of $5.40 translates to an annual dividend yield of 5.4%.
Pretty great, right? If you invest $10,000 in British American then you’re earning $540 in dividends every year just for holding the stock….assuming the price at least holds.
But this leads us into the first mistake that dividend investors often make, which is chasing yield.
Mistake #1: Chasing Yield
Some investors are so seduced by dividend yield that they chase after it to the exclusion of other factors such as a company’s financial health, earnings, profitability and really anything else that makes a company worth investing in.
Imagine you come into a sudden windfall. Someone has left you $250,000 and you want to invest. You learn about dividend investing and construct a portfolio of high-yield dividend stocks. Your average dividend yield: 8.5%.
Wow, that’s not possible. Is it?
It’s not not possible.
Linn Energy LLC (LINE) for example, has an annual dividend of $2.90 which translates to a dividend yield of 9.99%! A lot of smaller energy companies have large dividend yields actually. Legacy Reserves (LGCY), BreitBurn Energy Partners (BBEP) and EV Energy Partners (EVEP) all have dividend yields greater than 8% and you could easily invest your entire windfall in these companies and earn a dividend yield of 8.5%.
That means every year you could be collecting $20,000.
That sort of math really messes with people’s heads.
The problem is that chasing high yield can end in disaster if the company’s fundamentals don’t match its ambitions.
Paying out large dividends means a company has less money to fund new opportunities or conduct research and development. That makes it harder to grow the business and maintain a leadership position in their industry.
Mistake #2: Forgetting About Total Return
Both dividend yield and total return describe the performance of a stock, but a beginner dividend investor tends to focus on dividend yield to the exclusion of total return.
In reality, you need to take both into consideration before making a decision to invest in a dividend earning stock.
Dividends are powerful because you can reinvest the proceeds from your shares, increasing your equity without having to commit any extra funds. Dividends can also provide a stream of passive income without getting involved in fixed-income.
But dividend yield can mislead investors: signalling strength even if, in reality, the company is operating at a loss.
Total return is a measure of how much the investment is making for the shareholder and takes into account interest, dividends and increases in share price as well as any other changes in capital gains. On the face of it, total return is a more inclusive metric.
Imagine a company named Proctor and Gamble that rose 20.5% in share price over one year. Starting with that we can calculate the total return. Add the stock’s yield (say..4.1%) and you get a total return of 24.6%. But also P&G raised its dividend twice in our year time frame so we have to take that into account. Also, total returns assumes that all interest and other income are reinvested so we need to look at that too.
That sounds complicated, but there are online calculators that can do the calculations for you. You could run over to a website like longrundata.com and play around to see how total returns are calculated.
Total return is a useful measure to get a complete picture of how a dividend paying stock has performed, and you get a better idea than if you had just focused on yield alone.
Mistake #3: Not Keeping Track of Investments
One good thing about dividend investing is that it can be easy.
There’s a class of dividend stocks called the Dividend Aristocrats. The companies that constitute this group are known as the blue bloods of the dividend investing world. They are the royal family so to speak. They are known for having increased their dividend payments for 25 consecutive years.
People who invest in them might think its ok to sit back and just let their money grow because their money is “safe”.
That’s a mistake.
Even good companies run into trouble. You can never be guaranteed of a return. (And you can learn this the easy, pain-free way by investing and competing in our [free] stock market simulation game.)
On the other side of it, if you aren’t paying attention you won’t be able to capitalize on opportunities as and when they present themselves. The best part about fundamentally sound companies is that any time there is a setback in the share price, it represents a discount for the investor. If you are attuned to the market then you can buy up more shares on discount and really leverage your money.
So pay attention, dummy!
To learn more, head over to Wall Street Survivor 🙂