Last Updated on January 4, 2021 by Oddmund Groette
Quite an obvious answer to this question would be yes, we can lose money on dividend stocks – as is the case with any investment. Stock picking is difficult. DIY investors need to construct a properly diversified dividend portfolio and at the same time overcome the investment biases we all have within. Thus, it’s easy to pick the wrong stocks. Most dividend investors should rather buy mutual funds.
In a world that changes with the passing minute, nothing is certain. Dividend stocks are no exception to that rule. Apart from the many factors that influence the returns that come from investments, it’s after all in the hands of the investor to analyze and choose the right stock along with building the right strategies.
But the whole concept of investing in dividend stocks may get motivated for the wrong reason. Misconceptions can get built up in many investors. The most common one of them is investors thinking of dividend stocks as coupons. A dividend is a distribution and comes directly from the company’s earnings. But it’s not obligatory for a company to pay them. They choose to pay.
A company, on the other hand, can also choose not to pay and reinvest the funds back into their business as retained earnings for further growth and future projects with potentially higher returns. However, we also find companies that pay dividends regardless of any decrease in profits just to keep a regular track record of dividend payouts.
Don’t focus on the dividend, focus on the total return
There are many cases while investing in dividend stocks where investors tend to forget the concept of total returns. Their focus lies more on their cash account. That’s where compounding enters, which means investing the dividend payout back into the company to buy more shares and further increase your total earnings. The entire point lies in evaluating the stock you are planning to invest in, not just by its dividend payout history but also by the sectors it belongs to, potential growth, etc.
Misconceptions about dividend investing
As mentioned above, the uncertainty that comes with the ever changing world, there is only so much one can do about it. And at times there are factors that we have no power over. So what one can do is learn how to avoid the risks or the least, minimize them and clear out the common misconceptions that can actually cost you money while investing in dividend stocks.
High Dividend Yield
Probably, one of the biggest misconceptions when it comes to investing in dividend stocks is considering high yield as king. But to many investors’ surprise, a high yield is not always a good thing and there are many reasons behind it. Following behind this misconception, investors tend to choose a collection of the highest dividend-paying stocks and just sit and hope for the best. For many reasons, this is not a good idea.
If you go on to screen the companies with the highest dividend yield, you will come to notice that even though they were the best in terms of dividend yield, their total return was hardly impressive. Moreover, it is crucial to remember that a dividend is a percentage of a company’s profit that it is paying to its shareholders in the form of cash, formally quoted as its payout ratio.
But the back end of the story is that every penny that the company is paying out as dividends is every penny they are not reinvesting in themselves. So when a business is significantly paying a higher percentage of its profits, it could mean that the company’s management is hesitant in reinvesting in the company. That’s the reason why investors are advised to watch out for the dividend payout ratio that measures the profit percentage going out to the shareholders because it becomes a key metric for an investor to analyze the flexibility to reinvest and grow their earnings.
A company that can reinvest the earnings back into the business grows faster than if you were to DRIP:
Choose the right industry
In a bid to choose the highest profit-making dividends and the business that is issuing them, sometimes investors skip out on the broader aspect of the situation. Keeping in check with the trends and evaluating the stocks based on them is a critical aspect of constructing a future with improved and integrated returns.
Choosing stocks based on industry and sector trends goes a long way while investing in dividend stocks because it helps pick more profitable stocks as well as makes sure that the potential growth of the company becomes an imperative part of the process. Moreover, it helps in skipping out on those companies that are more prone to dividend cuts. Healthcare, for instance, is a great example of a sector that is strong enough to take a few hits when the market plunges. Such a sector behavior creates a steady and consistent increase in dividend payouts with time.
It is also important to keep in mind that trends are capable of changing as time passes. Take the example of soft drinks. Investing in the soft drinks industry is generally considered a strong bet. But as people grow more accustomed to the idea of taking care of their health, which they are now, consumers can potentially lose trust in the consumption of the product altogether. Hence it is important for investors to identify and consider these checkpoints that come with the changing sector trends while committing their money.
The bottom line: most private investors fail to beat the market
Hendrik Bessembinder wrote a paper in 2017 that has got a lot of press coverage: Do Stocks Outperform Treasury Bills? The shocking result of the study is that just a very few stocks manage to outperform short-term Treasuries over the long-term. Moreover, most surveys show a grim result of the abilities of the small retail investor: on average they underperform the indices substantially.
Dividend investor or not, the odds of beating the market are not great.
So what should you do? Don’t put all your eggs in one basket, and make sure you additionally have some holdings in mutual funds, perhaps both active and passive funds. Make sure you have done proper research before you invest.
Dividend stocks pose great opportunities for investors and indulging in them can be highly profitable. But it is crucial to understand the process of evaluating them. When it comes to making or losing money in dividend stocks, it is based on an investor’s skills to pick out stocks (and sometimes luck). There are often situations that influence the stocks and market that investors have no control over.
Diversification is what one should keep in mind. Don’t put all your eggs in one basket. Diversifying the risks away helps create a strong portfolio which can get you quite a passive income later in time. And most important of all, evaluate your tolerance for risks. Before jumping into investing, one should realize how much they can invest in research about the stocks they are planning to put their money in, how much risk they can take, and more importantly how much they can invest.
It is actually advised for investors not to go far out of their comfort zone and knowledge base. Make sure you understand the components that influence returns and avoid unnecessary risks.
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