Stock dividends are excellent tools to have in your investment income arsenal. Simply owning an index fund that mimics the S&P 500, for example, would deliver 2% today at a time when most savings accounts yield less than 0.4%.
There are even higher yields available if you want to go beyond that broadly diversified strategy and select individual dividend-paying stocks. Several members of the S&P 500 pay above 4%, and a few pay 6% or more.
That strategy exposes you to greater risks, though, so it's best to keep a few general tips in mind as you put together your income-focused portfolio.
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1. Start with a great business
A dividend is only as good as the company that's sending you those checks every quarter -- or each month. This might sound obvious, but it can be tempting for investors to first screen for a high yield, and then try to evaluate the business' strength and its ability to grow its payout.
Flip that strategy on its head and you'll likely see better long-term results. Start by selecting great businesses that boast prime market positions, strong cash flow, and stellar management teams. That way, you're buying a company first and a dividend second, and your priorities are right in sync with what really drives investor returns.
2. Look for consistency
You've probably seen the warning on investing literature that reads something like this: "Past performance is no guarantee of future results." Just because a stock trounced the market last year, in other words, doesn't mean it's sure to soar again this year.
A dividend's past tells us a lot of useful information, however. A long, unbroken streak of annual payout hike shows investors that the company is willing and able to keep its earnings marching higher under a wide range of selling conditions. That's why Dividend Aristocrats, which have increased their dividends for at least 25 consecutive years, are so popular with income investors. If instead the stock you're evaluating has only recently instituted its dividend, or has left it unchanged for several years, then you can't be as confident in projecting future income levels.
3. Be skeptical of high yields
In general, dividend yields that are far above the market average require that an investor take on plenty of extra risk. And if you dig around with these high-yield stocks, you're likely to find good reasons to pass or at least a few reasons to do more research before pulling the trigger on a purchase.
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Today, with the S&P 500 yielding 2%, any company that pays much above 3% should raise a yellow flag. Sure, it's possible that the yield simply reflects modest growth opportunities paired with an aggressive capital return program. Procter & Gamble (PG -0.26%) is a good illustration of this kind of situation. The consumer products giant has raised its dividend for 61 consecutive years, but its elevated yield is mainly a function of the stock underperforming the market while sales growth stumbled along at near zero.
Rather than seek out a yield that's several percentage points above the market average today, you're better off picking a modest dividend that's growing quickly -- and wait for the payout to improve over time. Home Depot (HD -1.76%), for example, hasn't yielded over 3% at any point in the last five years. However, strong earnings growth allowed management to increase the dividend by over 130% since 2012.
If you bought the stock back then, not only have you seen your shares rise by over 150%, but the yield you're receiving on that initial purchase is likely at least 4% today. Like in the broader field of stock market investing, it gets easier to produce market-beating dividend income as your time horizon increases into multyear, and multidecade, time frames.
