There are many lessons in investing that seem counterintuitive at first, only to become glaringly obvious in hindsight. While successful investors grasp this and go on to build fortunes, others don't, and thus miss out on the opportunity to live beyond their previously imagined means.
One such lesson concerns dividend stocks.
By now, it's common knowledge that dividend stocks generally beat their nondividend-paying brethren over the long term. My colleague Morgan Housel offered proof of this by showing that a $1,000 investment in the 10 S&P 500 companies with the highest dividend yields in 1957 would have been worth $1.3 million by 2006. Over the same time period, meanwhile, the same investment in the index overall would have amounted to only $176,000.
What fewer of us know, however, is how to pick dividend stocks that will replicate this kind of success. Like the now-discredited Dogs of the Dow theory, many believe that the way to do so is simply by picking dividend stocks with the highest yields. Yet, as we'll see below, nothing could be further from the truth.
What's not to love about a high yield?
Let me be honest with you. Even though I know high yields alone are not the secret to successful dividend investing, I still get excited when I see them.
Take mortgage REITs Annaly Capital (NYSE: NLY ) and Chimera Investment (NYSE: CIM ) , and telecom Frontier Communications (Nasdaq: FTR ) as textbook examples of this. All three of these companies pay monster dividends relative to their share prices, with yields of 12.9%, 15.5%, and 10.3%, respectively.
But with high yield often comes high risk. And one of the risks is that dividend payouts will be cut, if not outright eliminated. Take a look, for instance, at what happened when Chimera and Frontier cut theirs earlier this year:
Dividend Payout Decrease
Share Price Performance Since Cut
Source: Yahoo! Finance.
Needless to say, the implications have been dramatic for shareholders. Not only did they lose out by seeing their dividend income reduced, but they also took a hit on their shares.
As I've discussed before with respect to Annaly Capital, there's often only one direction for sky-high yields like these to go: down.
So what's the secret?
To get to the point, then, the secret to successful dividend investing is to identify stocks that are more likely to increase their dividend payouts over time as opposed to decrease them. Focus more on potential yield, as opposed to current yield.
The hard way to do this is to screen for stocks according to dividend growth rate and payout ratio, select those that have paid uninterrupted dividends for the longest period of time, and only then consider current yield.
The somewhat easier way is to choose the highest yielding stocks on the S&P 500's Dividend Aristocrats index, which contains blue chip companies that have increased their dividends yearly for at least the last quarter-century.
This list reveals well-known dividend stalwarts like consumer goods giant Procter & Gamble (NYSE: PG ) , which, despite being the current focus of activist investor Bill Ackman, has consistently paid and increased its dividend for the last 56 years. It also introduces lesser known, but similarly reliable, dividend payers such as Pitney Bowes (NYSE: PBI ) , the largest global provider of mailstream solutions, which has paid and increased its dividend for the last three decades -- not to mention the fact that its current yield of 11.2% places it at the top of fellow Fool Rex Moore's list of the highest-yielding stocks unlikely to blow up.
Finally, the really easy way is to simply let our team of analysts do the work for you, as they've done in our newest free report, "The 3 Dow Stocks Dividend Investors Need," which you can see instantly and free of charge simply by clicking here.
Foolish bottom line
I don't mean to belabor the point, but I think it's important enough to restate: One of the most important secrets of successful dividend investing is to focus more on potential yield rather than current yield. Over the long run, doing so will maximize the income pouring from your portfolio and also help to protect its underlying principal.
And again, to get you started in the right direction, I strongly recommend that you download our free report which reveals the identity of three high-quality dividend stocks that should be a part of every investor's portfolio.