Successful dividend investing is an outcome from following a sound investment strategy and having a small dose of luck. Another very important factor however is investor psychology. If investors have incorporated unrealistic objectives when they set up their strategy, they might end up setting themselves up for failure.
One example of unrealistic expectations that quite a few dividend investors have is the hunger for high yield stocks. These investors are searching for companies yielding 6 percent or more. The typical dividend growth stock with sustainable distributions and with reasonable chances of continuing future dividend increases yields anywhere between 2% - 4%. The reason why these investors need a high yielding stock is most probably because of inadequate retirement savings. An investor with a $500,000 nest egg can easily earn $15,000 - $20,000 from a diversified dividend portfolio today, which would boost distributions above the rate of inflation for decades to come. However, if our investor requires at least $30,000 in annual distributions from their income portfolio, they have only two options left. The first one is to come up with an extra $300,000 or to focus on higher yielding stocks in order to address the income shortfall.
This increase in dividend yield however, carries with it a disproportionate increase in risk to the principal and income.
The issue with most high yielding stocks is that they are typically concentrated in just a handful of sectors. Currently, it is possible to easily find stocks yielding above five to six percent in master limited partnerships, real estate investment trusts, some utilities, tobacco, and telecom stocks to name a few sectors. This exposes the investor to sector risk, as it leaves the portfolio undiversified.
The second issue is that most of these companies already have very high distribution payout ratios. As a result, they cannot afford to boost dividends above the rate of inflation. This inability to boost dividends, leaves retirees exposes to the decreases in purchasing power of their income over time. Over a typical 30 year retirement, this could mean consistently downgrading your lifestyle.
Third, because these companies have very high distribution payout ratios, they have a higher chance of dividend cuts than your regular dividend stocks like Procter & Gamble (PG) or Coca-Cola (KO). When a company with a high payout ratio experiences declines in earnings, it would be much more likely to cut distributions than a company with a low dividend payout ratio.
Fourth, most companies that pay high dividends can lose principal much faster if the distributions are cut or eliminated. For example, when Centurylink (CTL) cut distributions in 2013, its stock fell by more than 30% in a single day. When American Capital (ACAS) eliminated dividends in 2008, its stock fell by 40% on the day and was down 90% within a couple of months.
Fifth, the concentrated portfolio of high yielding stocks could be more vulnerable to certain types of risks such as a rise in interest rates, than your normal dividend growth portfolio. The low interest environment has led plenty of yield hungry investors bid up income stocks to unreasonably high valuations. When interest rates start inching up, these companies would likely drop in price. In addition, because many of these high yielding companies rely on continuous debt and equity offerings to grow or maintain their asset base, this increase in cost of capital would increase the risks of dividend cuts.
Unfortunately, investors cannot expect to construct unrealistic portfolios while having only their own goals and objectives in mind. Instead, investors need to realistically focus on what the market offers right now, and make the best out of it. Investors need to focus on building a diversified income portfolio, which grows dividend income every year, includes companies with strong earnings growth potential that have been purchased at attractive valuations. Each of these investments needs to be analyzed in detail, with its past record and prospects researched very well. Investors should not tell the market what they want from it, but what market can offer them at the moment. Imposing your will on market will likely lead to disappointment down the road.
Full Disclosure: Long PG, KO
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