Dividend investing is supposed to be easy: You buy stock in a company that regularly pays its shareholders, and then you watch the checks come in.
But beginner investors can often wind up in tangled tax situations, tricked by losing stocks that eat up all their dividend payments and then some.
In this video from our YouTube channel, we break down the big mistakes that can get in the way of making money with dividend stocks.
Narrator: Hey there, I'm Kirsten from The Motley Fool and in this FAQ we're going to go through some of the BIGGEST mistakes dividend investors make, and how to avoid them!
Generally dividend investors are looking to generate income by owning stocks that pay them cash, so it would stand to reason that they should generally focus on the companies that pay them the highest amount in dividends relative to the dollars they invest.
There's a metric that tracks exactly what an investor will get per dollar of stock bought in a company -- it's called yield, and it can be helpful but also misleading.
You see, yield is calculated by taking a year's worth of dividend payments and dividing it by the price you have to pay for one share in the company. Seems pretty straightforward, BUT ...
Like any metric created by division, yield can go up for two reasons:
- The dividend payments increase -- awesome. --- OR --
- The stock price decreases -- not so awesome.
Let's show this off in practice.
Say one share of a company costs $10, and it pays $0.50 in dividends over the course of the year. That would give the stock a yield of 5%, which is pretty great.
If the stock price dips to $5, the yield on the dividend payments would shoot up to 10%, but investors who owned the stock would be down 50% on the money they originally invested.
Bargain hunters that are new to the company might look at the stock that's fallen so far and say -- why not buy shares, I can get a 10% return on just the dividends!
This is called "chasing yield," and it can ruin investing for newbies.
Stocks that have been cut in half are often "on sale" for a reason -- there are major business issues they need to address.
Often a company's dividend policy will slightly lag its business results, so even if the company posts bad financials that spell doom and gloom in the future, its dividend will remain intact for another couple of months.
And remember, yield looks at what the company has paid over the past 12 months in dividends, not what it will pay in the future.
For all these reasons, you need to look at the company's yield, but also the overall strength of the business that's paying the dividend. That's a far better indicator of whether or not those dividend payments will stick around.
One more handy metric to look at is payout ratio -- it takes the total amount the company pays in dividends and divides it by net income. If the metric is over 100%, it means the company is paying out more than it is bringing in, which isn't sustainable over the long term and a sign the company's dividend could be cut soon.
The "right" payout ratio varies by company and industry. What you want to avoid is buying companies that have had their payout ratios spike to unusually high levels.
By the way, if you want more info on how to analyze dividend stocks, head over to Fool.com/PayMe, where we have our FREE dividend investing guide, complete with 3 stocks to get you started.
Okay, back to the show with our second dividend investing mistake -- getting too fancy too fast.
Don't get too fancy too fast
There are certain kinds of stocks that tend to have above-average dividend payments, giving them great-looking yields compared to other companies.
I'm talking about REITs (or real estate investment trusts) and MLPs (master limited partnerships), and the reason these kind of businesses generally pay high yields is that they are given favorable tax treatment because they pass most of their earnings along to their shareholders.
Owning these kinds of companies can be a great way to collect dividend income ... if you know what you're doing.
The problem is that they are different than your standard company and need to be evaluated with industry-specific metrics to see how they truly stack up.
And when it comes to tax time, dividend payments from these businesses are generally treated differently than those from your average company.
For these reasons, it's important to do your homework on special-structure businesses before jumping in and buying shares.
If you want some help doing that, head over to our REIT center, we've got a link down in the video description.
Don't focus only on the dividend
If you're buying dividend stocks, what you're really doing is investing.
The best way to put your money to work for you is to put it into quality businesses with long-term competitive advantages. There are dividend payers that might not have the highest payments, but have proven to be wonderful investments for people who want to see their money grow and be paid dividends in the process.
For example, in the beginning of 2018, shares of Apple (NASDAQ:AAPL) had a dividend yield of less than 2%, so it might've flown under the radar of dividend hunters. But over the two years that followed, the price of the stock shot up over 70%!
Investors that owned shares enjoyed seeing their accounts swell in value and they got paid to watch!
The point is even if you're buying a dividend stock, you're still buying shares in a company, and the best way to do that is by focusing on growing businesses with market-leading positions. Those are the kinds of companies that will stick around for the long-term and reward their shareholders with share price growth and dividend payments along the way.
Okay, so to recap, dividend investors should:
- Avoid chasing yield
- Start out with simple businesses, not ones with more complicated structures
- And focus on the whole business, not just the payment
And again, we have waaaay more dividend tips in our dividend investing playbook, and it's FREE. Just head over to Fool.com/PayMe to get our dividend investing guide, it comes with three income-generating stocks to get you started!
We want to know which dividend stocks you're watching, drop them down in the comments section below, and if you haven't already, hit that thumbs-up button to like the video, it tells YouTube we're doing good stuff over here, and so does subscribing to our channel -- it's free and it keeps you up to date with all of our investing content here on YouTube.
That'll do it for this FAQ, until next time Fool on!