Dividend investing is a great way to build wealth, but it's not foolproof.
Plenty of investors – including yours truly – make mistakes along the way. Here are some of the biggest boo-boos dividend investors make. See which ones apply to you.
Reaching for yield
This is probably the most common dividend investing trap. Some investors are so seduced by a stock's juicy yield that they fail to consider other factors, such as the company's financial health, the sustainability of the dividend or the outlook for revenue and earnings growth.
Companies such as Yellow Media and TransAlta demonstrated that a high yield can end in tears if the dividend isn't supported by a company's fundamentals. I'm not saying all high yields are unsustainable, but they do require close scrutiny of a company's cash flow and balance sheet. I prefer to err on the side of safety and generally stick with yields in the range of 2 to 6 per cent.
Not considering future dividend growth
Some investors pooh-pooh stocks with yields on the lower end of the spectrum. I know, because they occasionally leave disdainful comments on my columns whenever I mention low-yielding stocks. What these folks are missing is that, if you buy the right company, the dividend will grow – and so will the share price.
One of the best-performing stocks in my Strategy Lab model dividend portfolio is the pipeline operator Enbridge. When I added it in September, 2012, it was yielding 2.9 per cent – the third-lowest yield of the 12 securities in the model portfolio. Since then, Enbridge has raised its dividend twice – by 24 per cent in total – and the share price has also shot up, delivering a total return of 37.8 per cent. If I'd given Enbridge a pass based on its modest yield, I would have missed out on some nifty gains.
Not being diversified
For Canadian investors, it's easy to find great dividend stocks. Problem is, they tend to be concentrated in a few sectors such as banks, pipelines and utilities.
For proper diversification, investors should consider adding other sectors such as consumer staples and health care. This may require shopping in the U.S. market, which has a much better selection of large dividend-paying companies that provide global exposure – stocks such as McDonald's, Johnson & Johnson and Procter & Gamble, for example (disclosure: I own all three).
I realize that some people are comfortable owning a portfolio that's 100-per-cent equities. And certainly, when the stock market is rising, nobody wishes they had more bonds or guaranteed investment certificates. But you heard it here first: the stock market will tumble one day. And when it does, you'll be glad – for emotional and financial reasons – to have a portion of your money tucked away in safe, albeit low-yielding, investments.
The sooner you will need the money, the more important it is to play it safe. That's why I keep a significant portion of my kids' registered education savings plans in GICs but have higher exposure to equities in my own portfolio. After all, they'll probably be needing the money sooner.
Not paying attention
One of the great things about dividend investing is that, if you stick with large, blue-chip companies, it doesn't require a lot of monitoring. Notice that I didn't say "no monitoring." Even good companies can run into trouble, and in some cases it may make sense to take your lumps and move on. Other times, a setback may present a wonderful opportunity to buy additional shares at an attractive price. In both cases, you have to do your research before you make a decision to buy or sell.
That said, if you invest only in companies that have grown their earnings and dividends for years, and which have a competitive advantage that you expect will endure for many more years to come, you'll minimize the chances of one of your investments turning sour.