All Dividend Stocks Have Their Limitations – Do You Know What They Are?

Each and every one of the dividend stocks in your portfolio can reek havoc on your portfolio. The trick is figuring out what the limitations are and how to overcome them.

Three Limitations

1. All of a sudden they can stop paying dividends

Even a stock with an extremely long history of paying, and even increasing dividends, can one day run into extreme trouble and either stop the dividend growth or worse, stop the dividend payment all together.?

Take Bank of America (BAC) for example (I used to own it). Bank of America was a stock that was part of the Dividend Aristocrats and had paid dividends for a number of years. Look at the chart below from Dividend.com, which highlights one of the biggest risks of holding an individual dividend stock:

Click to Enlarge

2. Management can change and screw it all up

This really applies to all companies, but the performance of a company depends largely on the effectiveness of its management. A dividend paying company with a long history of solid performance can be brought down by one poor management team. Take Home Depot for example.

Home Depot had been on a tear for years. The company doubled in size every 4 years from 1979 to 2001. Even though Robert Louis Nardelli did double sales from 2000 to 2005, his extraordinary pay package while they steadily lost market share to Lowe’s slowed growth and ultimately stalled shore price appreciate and dividend growth.

3. The dividend growth may not be enough to overcome a tanking share price

Dividend growth is often referred to as the holy grail of dividend investing. It is something that I seek out very actively – a large portion of a stock’s growth in value comes from dividends.

However, if that share price is going down drastically and actually stays down then that dividend growth may not matter too much. Sure you will get some of your money back through increasing dividends but it may not be enough.

How to Overcome the Limitations

I can offer up two suggestions for overcoming these limitations of dividend stocks.

1. Build a core portfolio of index funds that adequately diversifies you

Diversification is crucial. My approach to ensuring I am diversified is to hold a well balanced mix of index funds across a number of different asset classes. These low-cost funds provide the foundation for my portfolio.

With this base built up, I am able to diversify further into individual dividend growth stocks. I recognise that I am taking on more risk with individual dividend growth stocks, but this is somewhat balanced with that core portfolio of dividend stocks.

2. Hold enough stocks to be diversified

The second way to overcome these limitations is to hold enough dividend growth stocks to be further diversified. Like point #1, the game is to manage risk. The more dividend stocks you own, the more diversified you will be. However, you also need to be able to keep track of all of these stocks so it is best to be sure you have the time.

Make sure you are diversified across industries, sectors, and markets. The last thing you want is all bank stocks.

Summary

There are always limitations in each and every one of the stocks you hold, even the best dividend growth stocks you own. As an investor, be sure you recognise these limitations and use the above strategies to overcome them.

(Photo Credit 1, 2, 3)