Clearing Up Common Dividend Misconceptions
Stock market investors and analysts often take sides on the issue of investing in dividend stocks. On one side are the cheerleaders who believe dividend stocks are the next best thing to free money. On the other are the naysayers who believe that dividend stocks are the next worst thing to a government takeover.
As is usually the case when people start taking sides, their radical beliefs are based on myths or misconceptions implanted in them by misinformation or someone else’s misdirected advice. Truth tends to lie somewhere in between, and only by stripping away some of the most common and influential myths is the truth revealed.
Myth 1: Dividend investing is only for old, retired folks
Dividend investing is admittedly attractive for seniors, whose goals are typically capital preservation and income. Younger investors, however, can also benefit from a dividend investing model, even if it comprises only a portion of their portfolios. Although seniors may want to stick with large, well-established corporations, younger investors may want to aim more toward the middle to lower end of the dividend spectrum. Younger investors wanting growth stocks should buy up-and-coming companies that are established enough to pay small dividends but demonstrate that they still have plenty of growth potential (in both capital appreciation and dividend payments).
Dividend investing isn’t a get-rich-quick strategy. It’s a great way to build wealth over the long term (which means you want to start when you’re young) to secure a steady cash flow for your retirement years. All affluent older investors were young once, and many of them followed a relatively conservative dividend investment strategy even then to build their wealth.
Myth 2: Dividend stocks are safe investments
Investing is risky no matter how you slice it; the risk of losing money is always present. However, some investments, including dividend stocks, tend to be safer than others.
Don’t put all your investment eggs in one basket. Even when investing in safer options, diversify to spread the risk among several sectors and among companies in the various industries you choose to invest in.
Myth 3: Companies must maintain a stable dividend payout
Companies are not obligated to pay dividends or to keep the payment stable after they start. However, dividend cuts tend to reflect poorly on a company and its share price, so companies tend to be conservative in establishing a dividend policy. Companies protect themselves by choosing a dividend payment method that allows them to manage shareholder expectations:
Residual: With the residual approach, the company funds any new projects out of equity it generates internally and pays dividends only after meeting the capital requirements of these projects.
Stability: A stability approach sets the dividend at a fixed number, typically a fraction of quarterly or annual earnings, called a payout ratio. This gives investors a greater level of certainty that they’ll receive a dividend and how much it’s likely to be.
Hybrid: The hybrid approach is a combination of the residual and stability approaches.
Myth 4: You should always invest in high-yield stocks
Don’t judge a stock by yield alone. Yield is a valuable measure of how much bang you’re getting for each of your investment bucks, but it alone doesn’t determine a stock’s true value; you also need to look at the share price. You can use a minimum yield to screen out stocks that don’t meet your income requirements, but carefully evaluate a company’s fundamentals before investing in it.
A high yield can mean many things — some positive, some negative. High yield may be a sign that the company’s share price is sinking and that the company may be in trouble. If the high yield is out of whack with its sector, that may be a sign of an impending dividend cut. By the same token, don’t immediately write off low-yield stocks.