Dividend investing sounds simple. Simply buy a high-yielding stock and then sit back and let the cash roll in, right?
Not so fast.
As with any other investing strategy, it’s easy to make mistakes when starting out. Here’s a look at some of the most common dividend investing mistakes that investors make.
Reaching for a high yield
This is no doubt the most common mistake that dividend investors make. Novice dividend investors see a stock yielding 7% and assume it’s a better dividend investment than a stock yielding 4%. This is not necessarily true.
That’s because when a yield appears to be too good to be true, it often is.
You see, when a company has a dividend yield significantly above the market average, say 6% or higher, it’s often because many investors have already sold out of the stock in anticipation of a dividend cut. And if the company does cut its dividend, it’s likely that many more investors will exit the stock, resulting in a further decline in the share price.
Dividend cuts can be toxic for an investor’s portfolio so need to be avoided at all costs. For this reason, it’s wise to be cautious about yields that seem too good to be true. Always check a company’s dividend coverage ratio to see if earnings comfortably cover the dividend payout. Ideally earnings should be at least 1.5 times the dividend payout.
Not examining the growth prospects
Another key mistake that dividend investors make is failing to examine a company’s dividend growth prospects.
Consider two stocks – Stock A and Stock B.
Stock A has a 6% yield, growing at 0.5% per year.
Stock B has a 4.5% yield, growing at 8% per year.
After five years, Stock A’s yield will have grown to 6.2%.
However, Stock B’s yield, will have grown to 6.6%.
After another five years, Stock A will yield 6.3% whereas Stock B will yield 9.7%.
See what’s happening here? Dividend growth rates can make a huge difference to long-term investing returns.
Overpaying for a stock
So you’ve found a stock that has a fantastic dividend growth track record. Great. Is it time to buy? Maybe not.
It’s still important to consider a stock’s valuation when investing for dividends, and the less you pay for the stock, the higher the yield you’ll receive. Patience is the key here and this is one area where the private investor has an advantage over professional fund managers. As a private investor, you don’t always need to be fully invested. If you can’t see any opportunities that look attractive, you can simply wait on the sidelines until an opportunity presents itself.
Over the long term, a little bit of patience can make a big difference to overall investment returns.
Of course, as with any investment strategy, diversification is essential. No matter how good a company looks on paper, things go wrong. Investors should always remember to diversify their portfolios over many different companies and sectors to reduce company and sector specific risk.
This article is provided for general information only and is not intended to be investment advice. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.