Have you ever learned something the hard way? Gone out on your own and fallen flat on your face? I’ve not only done it once, but several times with dividend investing.
I still remember sitting there, going over one of stock lists when I noticed a fairly popular company was down by about 20%. As I looked into the details, the size of the price drop seemed overblown… and like a good buying opportunity. So, I picked up some shares because “Mr. Market” (From Chapter 2 of this story) seemed to be having one of those days.
Unfortunately, a few days later the news worsened and this falling knife cut deep. It dropped another 50% from where I purchased it and to top it off, the company completely eliminated their dividend. A double whammy.
In a similar case, I purchased some shares of a company that was paying a 10% dividend. It had a decent track record of payments, and yes there was some chatter about a potential dividend decrease, but that had been public knowledge for years.
Well just my luck, a few months after owning it, the dividend was cut in half. As a result, the value of the shares dropped by about 60%. Ouch!
Discussing investment mistakes isn’t anywhere near as much fun as sharing success stories but there are key lessons for investors to walk away with.
First, owning individual stocks isn’t riskier than other forms of investing if you take steps to manage it. One consideration to keep in mind is to limit the value of any one holding to 3-5% of the portfolio’s value. In other words, if you have $100,000 to invest, each holding should be between $3,000 – $5,0000 in value. This will ensure that if any one company drops by 50% or 60%, the damage to your overall savings won’t be catastrophic. This form of diversification is referred to as managing single stock risk.
Along the same lines, there are 11 different sectors in the S&P 500. By owning at least 8 of them, investors can minimize the impact that a downturn in one or more areas of the economy has on their portfolio. Sectors can move in and out of fashion without much notice. One year banking and healthcare could provide the most return, only to drop to the bottom of the list as utilities and energy outperform. By spreading their risks across 8 or more sectors, investors can avoid costly concentrations or trying to guess which sectors will do the best or worst in any given year.
Another important ingredient to understand is a company’s payout ratio. This number lets an investor know what percentage of company profits that it returns to its shareholders. The lower the percentage, the more likely a company will be able to maintain their payments. For example, assume Company A has a payout ratio of 40% and Company B has a payout ratio of 89%. If there is a slowdown in the economy, sector, or some negative company news, which company will be able to continue paying their dividend if profits go down?
Track records are also important when it comes to dividend investing. Nearly every time I stepped outside of tried and true companies with a history of increasing their dividend payments each year, I struck out. Yes, I may have made a few extra bucks at the get-go, but it always seemed to come back and bite me. Fact of the matter is, there is no benefit to owning mediocre companies when you can own high-quality ones that reward you for sticking around.
Finally, I think it’s important for each investor to understand the concept of homegrown dividends. This is when you buy a dividend stock and sell it for a profit, effectively creating cash flow equivalent to one of two years worth of dividend payments, for example. It turns out that many investors develop the means for evaluating and buying dividend stocks but forget to figure out what would cause them to sell them. While there are no perfect rules, simply establishing a price point in which to re-evaluate a given stock can help. For example, when the stock price goes up by double the annual dividend, it can serve as a good point in time to make sure the reasons you bought it remain intact.
Overall, I have come to truly love and appreciate the art of investing in individual securities. From the point when mutual funds and annuities first failed me, to understanding the ups and downs of Mr. Market, and from the mistakes I made with falling knives, the entire journey has been fun and educational to say the least. I hope you found it valuable too!