Investing in stocks gives people two sources of potential income: capital gains when the stock price goes up in value, and dividends which are paid out on a regular schedule, such as monthly or quarterly. Dividends can be withdrawn for income to pay your household expenses, or they can be reinvested in additional shares in order to build wealth. I’m mainly an index fund investor, so today I’m turning my blog over to Dividend Power to share with us how to get started with dividend investing.
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Some of my readers have asked about getting started with dividend investing. I think the main desire for dividend investing is to generate wealth. Along with real estate investing, dividend investing is one of the proven methods for accumulating wealth. It is not sufficient to be frugal in order to build wealth. That is only half of the equation, the other half of the equation is, what you do with those savings in order to build wealth. In my opinion, investing in dividend stocks, particularly those that pay a growing dividend, can be part of a wealth building strategy. In general, I will be discussing a do-it-yourself or ‘DIY’ approach to dividend investing.
Appeal of Dividend Investing
The appeal of dividend investing has risen, especially since the Great Recession from 2008 – 2009. Interest rates on savings accounts, money market deposit accounts, and certificates of deposits or ‘CDs’ dropped so low that they no longer generated sufficient income for small investors such as retirees. For instance, if a savings account hypothetically had an interest rate of 4% before 2008 and 2% in 2010, then income was cut in half assuming the principal remained the same. This leads to a roughly 50% cut in income in a couple of years, which is painful. When the dividend yields are greater than the interest rates on savings type accounts then the appeal of dividend investing tends to increase. There is also the benefit of capital appreciation in dividend stocks.
In general, investing in dividend stocks will lead to higher total returns over time compared to savings accounts, money market deposit accounts, and CDs [Kari: these are comparable to GICs in Canada]. My expectation is between 8% and 12% total returns will be generated over longer periods of time. This is generally the range that many stock market indices, such as the S&P 500, have returned over longer stretches of time.
Risks of Dividend Investing
There is a caveat though. Stocks are riskier than savings accounts, money markets, or CDs. For example, savings accounts are typically insured by the FDIC in the U.S. up to $250,000. In Canada, savings accounts are insured up to $100,000 by the CDIC. However, stocks can lose principal and are not insured so your original principal is at risk. In addition, dividends can be cut or suspended during periods of financial distress, like during the coronavirus crisis. So, although the appeal of dividend investing has risen, they are riskier than safer savings type accounts.
Two Types of Dividend Investing
Generally, there are two types of dividend investing. One that focuses on higher dividend yields and one that focuses on dividend growth. There is overlap between the two. However, stocks that have higher yields tend to have lower dividend growth and vice versa.
Small investors seeking current income, e.g. retirees, tend to focus on higher yielding stocks. Companies that have high dividend yields are often mature and have predictable earnings over time. They can pay out a larger percentage of their earnings since their earnings are more predictable. In some cases, these companies have little competition. For instance, stocks in the utility sector or consumer staples often fall into this category. Many utilities are regulated monopolies, leading to more predictable earnings over time. Consumer staples companies sell essentials or basic necessities and often have scale or oligopoly.
The second type of dividend investing is dividend growth investing. Investors in this community are referred to as dividend growth investors or ‘DGI’. This is also the type of dividend growth investing that I prefer and blog about at the Dividend Power blog. In this case, the focus is on growth of the dividend and reinvesting it over time to build wealth. This permits the dividend to compound with time. There are advantages to this. Some research has shown that companies that grow their dividends lead to better annual returns with lower volatility.
Saving So You Can Invest
There are really two parts to getting started with dividend investing. First, one must save the difference between your income and expenses. Second you must invest your savings and compound it exponentially over time, which I will talk about in the next section.
The first step is to save money. Most people who are successful small investors save the difference between their income and expenses. So, the trick here is to maximize this difference. There are two ways to do this, either increase income or cut costs. There are plenty of blogs about frugal living and many have excellent ideas. I will leave it to you to explore those options. But there is also the option of increasing income. That can come about in several ways including asking for a raise, getting a higher paying job, making money with side hustles, and starting a part-time of full-time business.
Getting Started with Dividend Investing
Make a Plan that Works for You
The next step is to actually invest your savings with a goal in mind. From my perspective, that means making a plan and picking a dividend investing strategy that works for you. The plan and strategy should allow you to invest and stick with it over time. It is a fairly simple concept; however, many people do not succeed and just stay afloat since their expenses are too high relative to their income and they are not able to generate savings. Alternatively, some people do not take the time to learn about dividend investing or take responsibility for their investing.
The strategy that you prefer whether high yield dividend investing, or dividend growth investing will largely depend on your goals. If your goal is income, then investing in higher yielding stocks will likely be your approach. If your goal is to build wealth over time, then investing in dividend growth stocks will likely be your approach.
When I first started investing there was generally few resources available. There were some newsletters on stocks, but they were fairly pricey to me at that time; there were mutual funds; and there were financial advisors and stockbrokers. Today, the landscape is much different. It is much easier to be a DIY investor in dividend stocks. There are also myriad resources on dividend investing. There are many services available as well. The key for a DIY investor is to read and learn about dividend investing.
Select a Brokerage Firm
Further, the costs to place a trade for dividend stocks has been decreasing for years. Now, almost all online and discount brokerage firms do not charge a commission. This is a significant change from 20 years ago when I was paying close to $20 per trade. Now one can buy much smaller quantities of stocks with no commission. When you research brokerage firms you can look for either full-service ones or discount ones. For a DIY investor just getting started, discount brokers with low yearly maintenance fees and a low minimum account size are preferable.
Next pick a platform to manage your portfolio. Most online brokerages have some kind of investment platform that they offer free. Alternatively, you can use a third party one that serves to aggregate different investment accounts and also track spending. Some of these third-party platforms are free.
Choosing Stocks and Diversifying Risk
The key to getting started is to start small and dollar cost average or invest over time. This strategy is simple. One must buy shares periodically in regular intervals over time. This has the advantage of removing emotions from investing decisions. It also prevents small investors from trying to time the market. In any case, since trades are now commission free, the expense of dollar cost averaging is low.
If I were just getting started again, I would probably pick five stocks and buy them in equal amounts. I personally would focus on large capitalization stocks that have paid a growing dividend for many years. These companies tend to be well known. For example, the Dividend Aristocrats have paid a growing dividend for 25+ years. There is also a list of Canadian Dividend Aristocrats. These lists can serve as starting places for investors desiring to research dividend stocks further. There are many other sites to get ideas and research stocks including Seeking Alpha and Morningstar, which are two of my favorite sites. There are also many popular newsletters that can serve as starting points. They often provide lists of stocks based on their internal selection criteria.
The next step is to diversify in order to reduce risk. Some investors make the mistake of staying too concentrated with a small number of stocks. That may work for Warren Buffet who is arguably one of the greatest investors of all time. For the rest of us though, we should think about diversifying to reduce volatility and risk. This is now much easier since commissions in trades are zero. How many stocks does one need for adequate diversification? There is a significant amount of research on this topic. As a rule of thumb, many research papers place the number somewhere between 20 to 30 stocks. However, one must understand that there is no consensus on this number.
Do-it-yourself dividend investing is not for everyone. It takes time, discipline, research, and ability to learn from mistakes. There will be mistakes since no one bats 100% in DIY dividend investing. If you are intimidated by the idea of having to research, select, buy, and monitor your dividend stocks then a DIY approach is likely not the right one for you. But for those of you that think DIY dividend investing is the right approach for you, take a look at the story of “Dividend Millionaire” Hayford Pierce, for inspiration.
Biography: Dividend Power is self-taught dividend growth investor. He is the founder and author of the Dividend Power investment blog. He writes about dividend growth stocks for the long-term small investor seeking to invest in dividend stocks for income and growth. His focus is on undervalued stocks with sustainable dividend growth and capital appreciation potential. His work has appeared on Seeking Alpha, Sure Dividend, ValueWalk, and other financial sites.