Risk & Reward: Income Investing via Dividend Stocks
By Lee Sherman
As wealth-building strategies go, income investing is a relatively risk-free approach. Income investing ensures you have enough to pay your bills and enough income to live on today while ultimately earning enough to be able to retire at a reasonable age. It’s really about earning the most money possible while taking the lowest risk.
A diversified portfolio that contains a mix of asset classes including dividend stocks, mutual funds, ETFs, real-estate and high-quality (not junk) bonds will allow you to let your wealth accumulate over time without your having to obsess over the ups and downs of the stock market. This is what is known as passive income. As we’ll see below, dividend stocks can play a starring role in income investing.
So what are dividend stocks and why does it make sense to invest in them?
With dividend stocks, you purchase shares in individual companies and receive regular income based on their profitability according to the number of shares you own. While this class of assets includes both common and preferred stock, for income investing purposes, we are generally referring to common stock. It’s tempting to want to invest in companies that you admire or who manufacture products you use but keep in mind that doing so may be riskier than investing in the other asset classes in your portfolio. Generally speaking, you should be looking at what are known as “blue-chip” stocks. Your financial advisor can help you make this determination.
Companies vary in terms of their dividend payout ratios but typically they will distribute around 50 percent of annual profit to their shareholders, reinvesting the rest back into the company for future growth. Another important number to be aware of is the dividend yield. The dividend yield is determined by dividing the annual dividend by the current stock price, expressed as a percentage. For example, if company X has a share price of $50 and an annual dividend of $1.00, the yield would be 2%. Financial advisors will tell you that you should look for a dividend yield of 4 to 6 percent. Your actual payout will, of course, depend on the price you bought the stock at.
While it’s tempting to want to invest in the latest startup that’s just gone public, a good income investing portfolio includes companies that have:
Generated positive earnings with no losses every year for the past three years.
A proven track record of increased dividends over 25 years.
A high return on equity.
Little to no corporate debt.
The biggest potential downfall with dividend stocks to remember is that stocks are stocks and therefore subject to the whims of the market. So even if you pick well, there is some risk involved.
Other asset classes (particularly bonds) take years to mature and are built to withstand the vagaries of the market but dividend stocks can provide you with regular income that can either be reinvested or used to live your life (and that’s the primary goal of income investing).
Lee Sherman is a contributing writer to www.myperfectfinancialadvisor.com, the premier matchmaker between investors and advisors. Lee is an experienced journalist and editor with over 30 years of expertise with a significant history of writing in the personal finance and technology arenas.