The Three Rules of Dividend Investing

A lot of people are scared to invest in equities (stocks) because they’re afraid of losing all their money. Strategic dividend investing can help alleviate this fear. This is a method I tend to follow myself that has been fairly successful in keeping my from losing my shirt in the stock market.  You see, in my day to day job I focus a great deal on risk management.  Every day I spend a decent amount of time doing in depth financial analysis of customers and prospective customers, risk rating them and making sure that they have the ability to pay their obligations to us and others.  While this may give me a big advantage when it comes to pouring over the balance sheet and the cash flows, it is not insurmountable to the average investor if they follow several simple rules.  These rules are items I have taken from Benjamin Graham, Warren Buffett and other wise investors on how to invest smart and minimize losses.

First I should probably explain why I tend to use dividend investing as my investment vehicle.  In general, stocks that have dividends tend to be a bit stronger than the small cap or IPO type stocks.  Yes, there isn’t as much possibility for massive growth with them but they are established companies that you know, ie Johnson and Johnson.  My big obsession is the  Standard and Poors list of Dividend Aristocrats.  These are stocks that have increased their dividend every year for 25 years.  These are the blue chip stocks you know and love.  In fact, if you had invested in these stocks 25 years ago, well, you’d be very wealthy right now through both capital appreciation and dividend reinvestment.  Granted hindsight is 20/20 but there is still money to be made in the blue chip, dividend segment.  In general, if you follow these three rules, you can do well in investing.

1.  Never, ever invest more than 10% of your investable funds in one stock.

This should seem simple but to many people, it’s not.  If you’re only investing $10K dollars total for your stock portfolio (not including your bonds and cash), then the most you can put into one stick is going to be $1000.  While this may seem like you’re keeping yourself from realizing some big returns on that stock your cousin Vinnie told you about, dividend investing isn’t about that.  Here we are trying to reduce risk and provide steady returns.  If you have too much of your available cash invested in one area, then you’re at the whim of the market.  If that company goes bankrupt and you had 25% of your cash in there, you just lost a lot of money.

2. Never buy a stock that has had a positive return in the trailing 52 weeks.

I get a lot of flack for this one but it makes a lot of sense.  The stock market is about buying low and selling high.  Warren Buffett one said “[be] fearful when others are greedy and [be] greedy when others are fearful.”  The idea here is that you look for the bargain stocks, the ones whose value is good.  By finding these stocks, with good fundamentals and a healthy dividend, you set yourself up for positive long term growth.  You might hold onto the stock for a year or two years before you see an profit but the point is that you eventually see a profit.  I’d rather buy a good company with consistent sales and earnings and hold onto it for two years for a 20% above market gain than take a flier on an IPO that I could be burned on in one month.  And that leads us to number 3.

3. Buy what you know and understand.

A big part of investing is understanding the company and the product.  A big part of the financial meltdown was that the financial instruments were complex and not easily understood by an average person.  This makes investing in companies and funds that use these instruments dangerous because you don’t know what they are using your money for.  Remember, you’re buying ownership in this company.  If you started a business yourself, you’d want to know what you and your employees are doing.  If you don’t understand it, you can’t make money!  This is one of the reasons Warren Buffett and dividend investors tend to buy companies with easy to understand products, like Johnson and Johnson or AFLAC.  By understanding what they do, it makes it a lot easier for you to review the company and know if they’re halfway to bankruptcy or just a great deal because the stock market says so.

Another rule that isn’t exactly a rule but something I like to follow is that you never buy a stock without looking at the past five years financial statements.  As they’re a public company all of their financial information is available on Edgar, the SEC and Federal Government’s repository of financial and securities information for all public companies.  By looking at this and using basic arithmetic skills (as well as a whole lot of referencing to investopedia.com) you can figure out whether a company is going down the drain or is just undervalued.

In general, I like to use google finance to find all the stocks with a dividend between 3% and 7% that have lost more than 15% of their market value in the trailing 52 months.  I then narrow this down even further with their price to earnings ratios and then, even further with their operating income and net income.  This typically yields only a few (under 40) stocks that are worth looking at and eventually I invest in only about 4 or 5.  I try to stay away from looking at it segment from segment simply because my method will focus on the segments that are performing the worst, market wise.  By doing this once every quarter or so, I allow myself to find the best possible dividend investing deals to invest in.  This will hopefully one day yield even more positive results than it has already.

If you’ve already worked with dividend invest or have comments regarding this, please let me know!  I’m always trying to grow my method and my portfolio so any thoughts pro or con are welcome.  Until next time!

 

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