Dividend stocks are just as prone as other stocks to underperforming the market and doing pretty much everything except what you want them to do -- increase and pay out. So, if you want to build a healthy passive income stream, you'll need to avoid making a few basic mistakes.
The catch is that some of the worst dividend investing mistakes are disguised as being juicy opportunities. Let's go over three of the most tempting and most destructive foibles so that you'll be protected against them when you're figuring out which passive income stocks are worth your money.
Image source: Getty Images.
1. Chasing high dividend yields
The most common and tempting mistake that investors make while building passive income via stocks is buying shares of businesses solely on the basis of their high dividend yield. The problem with this approach is that dividend yields rise when share prices fall, and vice versa. Take a look at Takeda Pharmaceuticals (TAK 0.91%) over the last five years:
Investing in Takeda simply because its dividend yield is a lot higher than the market's average of around 1.3% means that you're investing without thinking about why the market's perception of a stock's value can change. An unusually high dividend yield compared to a company's normal range is often a sign that something recently caused the market to adjust its expectations for the company's future earnings sharply downward.
In Takeda's case, it might be a failed clinical trial, which implies that it won't be able to realize any of the anticipated income from the project. In other companies, it might be the result of a worse-than-expected earnings report. You can still choose to buy their shares with a sober knowledge of recent issues, but it's a massive error to dive in on the basis of a high yield alone without finding the warts first.
2. Ignoring dividend growth, sustainability, and consistency
Dividend yields can be deceptive in more than one way. GSK (GSK 2.11%) and Innovative Industrial Properties (IIPR 2.41%) are two very different companies that both have a dividend yield of around 4.5% right now. But that absolutely does not mean that investors will get similar dividend returns from both stocks, and it's not even close. Expecting comparable returns over time because of the yield is a huge error. Consider the following chart:
GSK Dividend data by YCharts
As you can see, Innovative Industrial grew its dividend a significant amount over the last three years, all while consistently paying out each quarter. In contrast, GSK hiked and reduced its dividend from quarter to quarter, and there's no clear trend upward. Some businesses prefer to handle their dividends like GSK, as it leaves the door open for the payout to rise and fall along with earnings, and there's nothing inherently wrong with doing things that way -- it's just a lot harder to plan your passive income strategy around their fluctuating cash flows.
Conversely, IIP's perpetually growing dividend is a core part of the stock's appeal to investors, and that makes them a lot more appealing for passive income investing. But a commitment to incessantly raising dividends introduces the risk that the hikes will be unsustainable relative to a company's distributable cash flows. Slowly growing businesses are at a particularly high risk of cutting. And it also introduces a risk that if investors come to expect an ever-increasing dividend, news of a deferred or canceled hike can cause them to sell and push share prices down.
If you're short on ideas for stocks that have a good track record for maintaining and hiking their payment, check out the Dividend Aristocrats, all of which are large and stable companies that have at least 25 consecutive years of hikes.
3. Counting on (or entirely discounting) special dividends
Sometimes, companies like Costco (COST 0.84%) issue special dividends to return excess capital to their shareholders. Most recently, it paid out a special dividend in late 2020 to the tune of $10 per share. That makes their dividend growth over time look something like this:
COST Dividend data by YCharts
If you were considering a purchase of Costco shares right after it issued its special payout, its dividend yield would look unrealistically high, and investing based on that incorrect perception would be a huge blunder. Furthermore, investing with the expectation of the company declaring more special dividends on a regular schedule is also a mistake. The whole point of special dividends is that they're largely unpredictable one-off events. You can't build a coherent estimate of your monthly or quarterly passive income that incorporates them.
At the same time, it's a mistake to entirely write off the chance of getting a special dividend when you're evaluating which stocks to add to your income portfolio. Most businesses that issue dividends don't have a history of special dividends, but some do, like Costco. You might not be able to plan around when you get the income, but understanding that you might have some exposure to additional upside from time to time could help you to choose between two good options.
