Imagine you have a certain amount of cash in your possession, which you do not plan on using for say 10 – 20 years. Or imagine that you are just starting out, and have a small amount of cash that will be added to your savings account every month.
You decide to invest that amount. You have been reading about dividend investing, and think it sounds cool to be paid more dividends every year from the investments you made years ago.
However, you have an uneasy feeling – there is so much information out there, you get information overload and you cannot do anything as a result. Where do you start?
Not all dividend stocks are created equal. A company is not an automatic buy, just because it happens to pays a dividend. You need to develop some knowledge to develop a framework to evaluate companies, and then need to use that knowledge to select companies for long-term income for your diversified portfolio.
So how to gain the knowledge if you are a complete beginner? What steps should you take?
I think that first, you need to be willing to learn. But, you need to start with a skeptical attitude.
I have been skeptical of people who only talk about motivating you ( Rich Dad), because they are good at marketing, not investing. They can ignite passion for knowledge, but it would be difficult to translate that into something actionable that is not potentially dangerous to your wealth. If someone is selling you a course, a subscription service, or a book, chances are you should stay away from them for now. This skeptical attitude should be translated into the companies you invest into. Do not believe the hype, but follow the data, If something doesn’t make sense, do not invest in it.
Remember the words of a wise US president – “Trust but verify”. It is important to start with a skeptical attitude to matters. In addition, do not rush to make investments right away when you are starting out. While the earlier you start investing, the better for compounding purposes, the problem is that for a complete novice investor making a first purchase could be a disaster waiting to happen.
Most investors I have come in contact with end up rushing and buying the first stock they see, which is usually a mouthwatering dividend yield that ends up not being sustainable. This leads to losses, and loss of confidence right away. So if you want to start ASAP, at least put token amounts to work. Put the rest in a savings account, until you have done everything I discuss here.
Before you start investing on your own, I would encourage you to consider maxing out your 401 (k) accounts, assuming you have access to those and the financial means to do that. Hopefully your plan has some low cost mutual funds, preferably something on the S&P 500 and/or some international stock index.
These are good options for beginners who know absolutely nothing about investing. These are also good for many other investors too, particularly those who have no time to dedicate to investing. A 401 (k) allows you to defer taxes upfront, and also lets your money compound tax-deferred way for decades. Plus, many employers match your contributions, which is essentially “free money” ( though in reality is part of your compensation that you need to take advantage of). With a pre-tax 401 (k), you get a tax break upfront, and you won’t owe taxes until you need the money.
I prefer the pre-tax 401 (k) to the Roth 401 (k), because I believe that most people will have lower tax rates in retirement than when they are working and contributing to their retirement plans. Before you start dividend investing, I would encourage you to maximize your 401 (k), and then IRA if you are eligible for it. Then, I would encourage you to maximize your Health Savings Account (HSA).
Investing through those accounts in low cost funds is probably going to be the best for you the beginner, as you get tax breaks, matching contributions, and investing takes almost no time. If you pick the right funds, and do not touch your accounts too much, you may do well with those. Then, at or close to retirement, you will have a nice collection of funds, that you can turn into a dividend portfolio that you can life off.
Depending on where you live, it may also make financial sense to buy a home. I personally rent, because I have often moved around for work. After getting your basic financial house in order, you are then free to pursue your quest for knowledge.
Perhaps maxing out your 401 (k) and IRA and investing it in index funds is one of two ways to accumulate assets, due to tax benefits. However, I believe that dividend growth investing is the best strategy for tapping that nest egg, and pensionizing it into a reliable stream of income in retirement.
I like dividend growth investing, because it makes it very easy and intuitive when you need to tap your nest egg to pay for expenses in retirement. Dividend income is usually much more stable than capital gains, and dividends have historically increased in 95% of years since 1926. Since the 1920s, dividend growth has outpaced inflation by a little over one to one and a half percent per year. The amount and timing of dividend payments is more predictable, and more reliable than the amount and timing of capital gains. The stability of dividend payments takes the guesswork over deciding how many shares I need to sell and whether I should sell any if they are at a depressed valuations for example.
I just plan to spend my dividend checks in retirement, and if history is any guide, those will be growing above the rate of inflation. All of this will ensure that I never run out of money in retirement, and that my retirement income will not only maintain, but increase purchasing power of retirement. I believe that dividend investing is the perfect strategy for retirees who are looking for a sustainable source of income during their golden years.
But to get started on learning about dividend investing, I would start by checking what others are doing. I would stress that your goal is to be learning, not acting yet. There are several sites dedicated to dividend investing.
I like my site, you can check the complete list of dividend articles since I started in 2008. This could possibly cover pretty much anything you could think of on the topic of dividend growth investing.
You can also read brokerage/analyst analysis, which are available from most brokers. I often read up the reports from Standard & Poor’s, Morningstar and Valueline. The last one is usually available through my local library for free electronic access. The first two are complementary from most brokers such as Schwab for example.
You should also try to read books about dividend investing or investing in general. I would also encourage you to read books about Buffett as well as his letters to shareholders. You may find a list of books that have shaped my investing strategy. But this list does not include a lot of other books that taught me what “not to do”.
Read why investors are buying certain companies. Read their analysis, and try to understand why they buy that business, whether their analysis and expectations make sense, and then whether you understand how that business makes money. If you do not understand it well, then you should put it on the too hard pile. This means, never consider investing in any business that you do not understand how it earns its profit. If you don’t, you are very likely to get scared the minute the stock price goes down, or the minute you get some “bad news” that might be nothing more than a newspaper writer just trying to sell doom and gloom in order to collect their paycheck.
Knowledge is cumulative, and accumulates like compound interest. The longer you spend acquiring practical knowledge, the more you will know.
Next, you need to work on developing a strategy that fits your goals. Your strategy needs to focus on how to find qualifying companies for further research, how to research them, at what approximate prices to consider them and at what set of circumstances should you consider selling. Your end goal is to build a portfolio that sends out cold hard cash every month, that can pay for your bills. This is why it is important to spend time looking for companies that can provide a growing amount of dividends every single year.
You also need to develop systems to protect you from mistakes. And you will make lots of mistakes, but this is ok, as long as they do not result in you losing your entire nest egg.
The first system I have created is that I am selective about the companies I purchase and prices I purchase them at. I try to avoid paying more than 20 times earnings for a company, in order to avoid buying too high without an adequate margin of safety.
The next system is called diversification – I own a portfolio consisting of something like 60 – 90 individual companies, which I have built over the past 9 years. If one fails, the dividend stream from the rest more than compensates with its organic growth. I am not relying on a single company for my retirement expenses, which is great. My goal is to have an equal weighted position in each company when I build my portfolio. However, I am not a fan of rebalancing, so I just let my winners run, but usually cut the losers out ( dividend cutters).
The third system is the fact that I buy shares almost every month, and spread my purchases over time. For example, I have bought some Johnson & Johnson in 2008, 2009, 2010, 2011, 2012, 2013. Therefore, it is so surprise that I have more Johnson & Johnson than say Disney (DIS), which I only recently started buying.
The fourth system I have in place is the fact that I elect to receive dividends in cash, rather than reinvest them automatically.
With every dividend I receive from a company, the amount of initial capital at risk is reduced. I can use that cash to buy shares in other companies, thus reducing risk of total loss in the event that the first business loses and also am building out my portfolio too.
The last system is to actually hold on to a company for as long as possible. This is very hard, because every day there is some “reason” to act – either the stock price is going up and someone is telling you the smart thing is to take the profit off the table. Or someone is scaring you about prospects of a company, which causes you to act and sell in order to cut your losses. Your goal is to ignore those urges and then keep on holding. Studies have shown that those investors who routinely switch in and out of stocks end up trading good companies for poor ones, and also pay taxes, commissions and time in the process. Buying and holding is the recipe for success, while trading frequently is a recipe for the poorhouse. Of course, if your goal is to trade actively, then this list is not for you. I would suggest learning about stock charts, patterns, seasonality, cycles and candlesticks.
All of this is the amount of work you need to do to form an opinion. You have not even started considering whether to buy shares, and which shares to buy.
I believe that practicing the art of dividend investing will hopefully help you learn it, and improve your skills over time. This skill could be helpful in devising a plan on how to live off your investments in retirement. That mutual fund portfolio could be gradually shifted to a portfolio of carefully selected individual dividend growth stocks, purchased at attractive valuations, which should pay a rising amount of income during your retirement.