If you invest in individual dividend growth stocks, then you know that there are inherent risks in buying individual stocks. That is why I advocate a basic core portfolio of index funds before venturing into individual stocks. With this structure in place, you drastically reduce the individual stock risk you take on by buying dividend growth stocks. That being said, there are things an investor can do to help their individual dividend stock performance. One in particular has to do with dividend yield.[ad#tdg-embedded]
What the dividend yield tells us
The dividend yield tells investors how much a company pays out in dividends each year relative to its share price. That is the easy part. The dividend yield is also an indication of the risk that a stock has in the market. Basically, it goes like this:
Investors need to get paid for taking on risk so that the money we put at risk has a higher potential payout. The more of a sure thing an investment is, the less risk there is and the potential return of that investment is lower. The higher the risk – or the less likelihood of a really strong positive return – the higher the potential upside must be to make it worth it to put your money at risk.
As such, a high dividend yield is a strong indication that there is a lot more risk in a stock than a stock with a lower dividend yield. When you see a dividend yield of something like 7 – 8% that stock is telling you that there is a high degree of risk in owning that stock and the market is requiring it to pay you 7 – 8% for putting your money in. At any time that money can be taken away from you by the market!
The One Dividend Rule
One suggestion that many investment advisers give, including Charles B. Carlson in his bookThe Little Book of Big Dividends: A Safe Formula for Guaranteed Returns, is to analyze dividend yield in comparison to other companies in its industry. What we want to see is that the dividend yield offered by one company is not way out of line with the dividend yield of that company’s peers. If the yield is a lot higher, then there is a lot more risk and that company and perhaps you should consider putting your money elsewhere.
In addition, an investor can also compare the dividend yield of the company to the yield of the overall market, like the S&P 500. If the stock’s yield is much higher than the overall market yield that is also telling you that there is extra risk in that stock and you needs to be aware.
The rule is simply this, adapted my own rules:
If the current dividend yield of a stock is 2 – 3% higher than its industry peers and /or double the market yield, be very scared
I have found that this rule has helped me in the past – high yields can be very tempting but in the long run have brought me more pain than joy! Keeping this rule in mind tempers those emotions and brings my investment decisions back to basics – the balance between risk and rewards.