How to Build the Ultimate Dividend Portfolio
Building a Dividend Portfolio
Are you wondering how to construct a dividend portfolio? A profitable dividend portfolio is made up of more than just the so-called “right” stocks. Yes, the ultimate dividend portfolio is made up of great stocks that provide solid annual capital appreciation, but the best dividend portfolio also contains stocks that will provide you with a dependable, steady income stream for years to come.
When you think of your retirement portfolio, what comes to mind? It depends on where you are in life. If you’re young, you might want to pad your portfolio with growth stock. But your priorities will likely change the closer you get to retirement; by then, your investing strategy will probably zero in on creating income that you can live on during retirement.
And in this environment, additional income is a must. Thanks to four rounds of quantitative easing and artificially low interest rates (currently hovering around zero) the Federal Reserve has taken the “income” out of “fixed income assets” like certificates of deposit (CDs), bonds, and Treasuries.
That’s terrible news for anyone that was hoping their fixed income investments were going to provide them with a steady income stream throughout retirement. This is especially true when you consider the average monthly social security payment is just $1,350. That’s not a lot of money to live on. (Source: “Monthly Statistical Snapshot, August 2016,” U.S. Social Security Administration, last accessed September 28, 2016.)
For the ultimate dividend stock portfolio, you need reliable income in your golden years. That’s why it’s important to design your dividend portfolio with a regular cash flow in mind.
Ever wonder how Warren Buffett, one of the wealthiest people on the planet, lives off $100,000 a year? He doesn’t. Berkshire Hathaway Inc. (NYSE:BRK-B) may not pay a dividend, but the companies it invests in do. And each year, Berkshire Hathaway brings home approximately $62.0 million in dividend payouts.
You may not have as much money to invest as Warren Buffett, but the dividend income strategy remains the same: free money in the form of dividends.
In addition to free money, there’s another reason to invest in dividend stocks: higher returns. Between 1972 and 2014, dividend stocks returned an eye-watering average of 9.3%. During the same time frame, non-dividend-paying stocks returned just 2.6%. Simply put, high-dividend stocks trounce the market.
Add it up and it’s no wonder that dividend stocks are the best kind of equities to build a retirement portfolio with.
A High-Yield Dividend Portfolio Diversifies Risk
Not just any high-dividend stock should find its way into your retirement portfolio. Whereas a poorly constructed high-dividend yield investing strategy can be volatile and unpredictable, a well-constructed high-dividend-yield growth stock portfolio can provide you with reliable income and capital appreciation.
Dividend stocks outperform the broader market, but you can make your retirement portfolio even more profitable if you pick stocks that increase their payout on a regular basis. There are a lot of excellent high-dividend-yield stocks that have a long, long history (25 years plus) of raising their annual dividends. These are called high-dividend growth stocks.
Finding a stock that has raised its annual dividend for 25 years or more means the company makes a lot of money when the markets are bullish and bearish and that they make money when the economy is firing on all cylinders and in a recession. Best of all, these stocks return that money back to investors with consistently higher annual dividend yields.
You don’t need to limit yourself to stocks that have raised their dividend for more than a quarter of a century. There are also a lot of excellent high dividend yield growth stocks that have been increasing their annual dividend payouts for 20, 15, 10, and five years too.
Keep in mind that chasing the dividend simply because it’s high can lead to financial ruin. That’s because there is a risk/reward tradeoff with stocks. The higher the dividend, the greater the risk.
In fact, many companies with dubious financials provide high dividends to attract investors. The dividend yield is calculated by dividing the dividend payout per share by the stock price. A very high yield could simply mean a stock has a low price. When companies get into money troubles, the first thing to go is the dividend yield. After the company cuts its dividend yield, the next thing to go is the share price.
How can you make sure the stock you’re interested in can afford to keep paying its dividend and increase it annually? You need to ensure the company doesn’t pay out too much of its profits in dividends; if so, its future payouts might be unsustainable. It also means the company isn’t retaining any money and reinvesting it into the business.
A good way to decide whether or not the company can maintain and build upon its annual dividend yield is to look at its free cash flow. This is the amount of money left over after capital expenditures.
How Many Dividend Growth Stocks Are Needed?
How many dividend stocks you should hold in your retirement portfolio is really up to you. That said, a lot of investors have a concentrated portfolio, with the top 10 stocks making up at least 65% of the portfolio’s value. That means you’re investing most of your equity in your 10 best stocks.
It can be pretty tough though to have all of your money invested into just 10 stocks, especially if one of the 10 stocks you’re heavily concentrated in turns sour.
Having a diversified portfolio also further diversifies risk. That’s because having a single stock rather than a diversified portfolio increases volatility. An investor with all of their money in a single stock can expect to increase their annual volatility by 30% and could outpace the annual returns of the S&P 500 by 30% or more. At the same time, they could even have annual returns 30% below the markets. (Source: “How Many Stocks Do You Need to Be Diversified?,” American Association of Individual Investors, last accessed September 28, 2016.)
According to some sources, diversifiable risk can be reduced based on the number of stocks you own:
- 25 stocks reduces diversifiable risk by about 80%
- 100 stocks reduces diversifiable risk by about 90%
- 400 stocks reduces diversifiable risk by about 95%
It’s tough to be a retail investor and have a portfolio with 100 to 400 stocks, as that would entail a lot of research and trading costs and create a need to monitor the portfolio. And instead of owning 250 stocks, it might be a lot easier to own a high-dividend-yield exchange-traded fund (ETF)
The goal of most investors is not to be as diversified as the market; it’s to outperform the market. This is why it’s important to have a portfolio of high-yield dividend growth stocks that covers a broad range of sectors. That includes having a portfolio that contains the number of stocks you’re comfortable researching, understanding, and tracking.
Fortunately, most high-dividend-yield growth stocks are big companies with huge cash positions, products and services that are mostly recession-proof, a strong international footprint, and a long-term business strategy.
As a result, you don’t really need to track them on a daily basis. They may hit short-term volatility, but if you’re investing horizon is retirement, you don’t need to worry about the markets’ daily gyrations. You can rest easy knowing you’re invested in high-dividend-yielding growth stocks that provide investors with double-digit annualized returns and consistently higher annual dividend payouts.
Capital appreciation and steady, free dividend income; they’re what make the ultimate high dividend yield portfolio.