I hope you had a great Chistmas and were able to enjoy a few days off work with your familiy. I usually use some off my free time during Christmas holiday‘s to review my entire portfolio and adjust my investment strategy for the upcoming year. For me personally, this is the best time of the year to do that because the stock markets tend to be calm during the end of the year. With today‘s post, I would like to mention some of the most common dividend investing mistakes that you should avoid.
In another post, I have already shared 10 Common Investment Mistakes with you that are valid in general when it comes to investing. But this post is meant to focus more on dividend investing in general. However, before we jump right into it, I would like to take a closer look at the purpose of dividend investing.
The purpose of dividend investing
What is the purpose of dividend investing? The main priority of a dividend investor is to gather passive income as an additional income stream from the dividends that are paid by companies. It is a cash flow-oriented investment approach that focuses on a long-term buy-and-hold strategy. Dividend investing does not focus primarily on portfolio growth based on price appreciation.
According to that, a dividend investor considers investing in companies that pay sustainable dividends and have a strong dividend history. Moreover, the companies have sustainable business models and a solid balance sheet. Especially due to the long-term buy-and-hold approach, diversification plays an important role for a dividend investor. But what are the main advantages and disadvantages of dividend investing?
Advantages of dividend investing
- Generate a reliable passive income source, without the need to sell any stocks.
- Income stream is independent from stock price fluctuations or any market events like a correction.
- Dividend aristocrats have been paying and increasing their dividend payments for more than 25 years, e.g. even during the 2008 financial crisis.
- Dividend paying companies can be found in solid and recession-proof market segments, e.g. consumer staples or utilities.
- Gathering passive income even during a market crash or a recession helps you to control your emotions and to not sell your stocks at a loss.
- By reinvesting dividends, you benefit from compound interest effect, which will grow your portfolio steadily over time.
Disadvantages of dividend investing
- To find the best companies that will maintain their market position long-term requires a lot of reseach in the beginning.
- Dividends are not guaranteed like interest. Companies can cut or even stop paying dividends whenever they want, e.g. when they are massively affected by a market crash or recession.
- Dividend investing requires a lot of patience, the portfolio will grow slowly but steadily over many years.
- Only to focus on high dividend paying companies, will limit your ability to benefit from high growth opportunities.
5 common dividend investing mistakes to avoid
1. Chasing high dividend yields
Now let’s take a look on the most common dividend investing mistakes and how to avoid them. Chasing high dividend yields is the most common mistake in dividend investing and often a trap for beginners. Of course, it is tempting to invest in companies that pay a 7-10% dividend yield or even more annually. But it is important to understand that such high dividend yields are often accompanied by a declining share price. Let’s take a look at an example.
Imagine a company that has been doing very well for the last 20-30 years. Revenue grew, leading to an increase in share prices and dividend payments. Let`s assume that just 5 years ago, the share price of this company peaked at €100 and it was paying a healthy dividend of €5 per year (= dividend yield of 5%). Since then, however, the company has struggled and lost market share to other disruptive competitors. Share price decreased to €60, while the company continued to increase its dividend payments to now €6 annually. As a result, the dividend yield is now 10% per share.
There are two problems with this. First, share prices have fallen, leaving shareholders with a loss over the last 5 years. But more importantly, it is uncertain if the company will be able to recover and regain market share as it did in the past. So it is likely that share prices will continue to fall in the future. But in addition to that, dividend payments will probably not be covered by the annual cash flow at some point anymore. The company will either have to maintain dividend payments based on debts or it will have to cut its dividends. Neither scenario is what a dividend investor is looking for.
Therefore, I highly recommend you to take a close look on a company‘s business model and if it is innovative and can keep up with its competitors. Moreover, always take a look at its income statement compared to the last 5-10 years and compared to its competitors. Declining revenues and earnings could be a red flag. The majoritiy of companies in my portfolio for example pay a dividend yield between 1 – 4.5%.
2. Avoiding stocks with low dividend yields
On the other hand side, avoiding companies with a low dividend yield is also a misconseption. As described above, a low dividend yield can also be the result of share price appreciation. Fast-growing companies are attractive to investors and share prices soar over the years. Therefore, even if the company significantly increases its dividend payments, the dividend yield will tend to remain low or even decrease.
If you avoid investing in such companies, you will miss out in several ways. First, you will not benefit from their growth, which results in a higher share price. Second, such companies often increase their dividend payments by 10% or more annually due to rising earnings. This means that your dividend yield on costs, based on your initial investment, will increase very fast in the coming years. And third, you may be missing out on a company with great long-term prospects.
A great company to mention here as an example is Microsoft, which offers a dividend yield of only 1% currently.
Microsoft is paying dividends since 17 years now and has increased its dividend payments every year since then. On average it has increased its dividend payments by 13.77% per year over the last 10 years (CAGR = Compound Annual Growth Rate).
Moreover, revenues and earnings are constantly increasing and Microsoft constantly beats earnings estimates. A great website that offers detailed information about a company’s dividend history and financial statement is Seeking Alpha.
3. Disregarding payout ratios
A very important indicator in addition to the dividend yield is the payout ratio. It describes the proportion of a company’s earnings that are distributed to shareholders as dividends. The lower the payout ratio, the more money a company can reinvest to maintain its growth. The higher the payout ratio, the less money a company can use to invest in its business.
Moreover, the payout ratio is also a measure of how sustainable dividend payments of a company are. Imagine a company that distributes 90% or close to 100% (or even more than 100%) of its earnings to its shareholders. There is litteraly no money left over to stimulate further growth or pay down its debt. This is not sustainable and should be a red flag for any dividend investor. In the event of declining earnings, such a company will immediately have to cut its dividends. Only REIT-stocks from USA typically have a payout ratio of 90% due to fiscal reasons.
I therefore recommend to always take a look at the payout ratio of a company, also in comparison to the past 5-10 years. Additionally, also take a look on the cash dividend payout ratio, which basically reflects the proportion of cash flow that is paid out to the shareholders as dividends. This is important because dividends may be fully covered by a company’s earnings, but not by its annual cash flow. For both indicators, I consider a ratio of max. 50-70% to be healthy and sustainable.
In terms of Microsoft the payout ratio for 2020 is 33.23% and the cash dividend payout ratio is 31.45%, which shows that the dividend payments are well covered by its earnings and cash flow. Moreover, the payout ratio decreased since 2016, altough the dividend payments increased by 13.77% on average during the last 10 years.
4. Selling stocks during a market correction
As mentioned earlier, the main purpose of dividend investing is to build up a passive income source. For this reason, every market correction is an opportunity to buy more shares and increase your annual dividend income. Dividends are paid to you based on the quantities of stocks you own in your portfolio. This means that the more shares you have and the lower your entry price is, the higher your annual dividend income will be.
Selling your shares during a correction only makes sense if your original assessment of why you invested in a company is no longer valid. However, as long as the companies in your portfolio have a sustainable business model, any correction can be considered as a buying opportunity. Therefore, I recommend that you always have a small cash position available in your portfolio (e.g. 3-5% of your total portfolio value) to be able to react properly in case of such events.
5. Impatience and greed
As already mentioned, dividend investing provides less annual growth due to price appreciation. Companies that offer high dividend yields are considered more conservative. They simply do not grow as fast as other large technology-driven companies. But in return, they also offer less risks. I understand, that it is tempting to follow the masses and to invest only in high growth companies.
But I would like to motivate you to stay focused on your investment strategy and to follow your investment approach. Impatience and greed are the most powerful emotions that can distract you from your strategy and literally burn your investments. This is true regardless of your investment strategy, whether your are a growth investor, a dividend investor, a day trader, or a value investor. Always keep your emotions under control and stick to your plan.
Personally, I have an allocation to some high-growth or small-cap companies with great future prospects. But I keep these positions rather small to avoid big losses in case of a higher volatility or in case a company fails. That way, I never feel like I am missing a new trend or opportunity. But I only invest in companies that I consider to own long-term.
I hope that this article helps you to avoid some of the mistakes mentioned above. If you would like to get a notification when I publish a new article, subscribe to my newsletter or follow me on Twitter. You may also like: