There are good reasons why everyone seems to be talking about dividend stocks. The benefits of dividend stocks shine during a bear market. Paying a consistent dividend (as long as it's not being funded with debt) implies that a company generates excess profit and free cash flow that can be returned to shareholders -- a valuable advantage when interest rates are rising and capital becomes more expensive.
When the economy is growing rapidly, prospects and projections can be more exciting than a dividend-paying stalwart like Coca-Cola or Procter & Gamble. But when the economy falters, those same stodgy companies look like beacons of safety amid a sea of volatility.
One of the best places to look for quality blue chip dividend stocks is in the Dow Jones Industrial Average (Dow).
The Dow is currently down just 7.1% year to date compared to 28.8% for the Nasdaq Composite. But that doesn't mean that buying a Dow index fund is necessarily the right move. Here's how to use the stability of the Dow as a source of inspiration for finding good dividend stocks, why quality high-yield dividend stocks are rare, and how you can integrate stable companies into your portfolio and beat the stock market.
Why high-yield dividend stocks are rare
The average dividend yield of a stock in the S&P 500 is 1.8%. And while over 80% of stocks in the S&P 500 pay a dividend, only 60 stocks have a dividend yield above 4% at the time of this writing.
That 4% number is important for a couple of reasons. For starters, the 4% rule is a common retirement strategy that involves withdrawing 4% from your portfolio per year. It's not perfect, but it provides a good baseline. A stock that has a dividend yield above 4% would essentially provide enough passive income on its own to avoid having to sell stock.
An added layer of importance for a 4% dividend yield is that the risk-free three-month Treasury rate is now 4.3%. For a risk asset (like a stock) to be a worthwhile investment, there has to be an argument that its total return will exceed the risk-free rate. Otherwise, it's not worth it.
Any stock with a dividend yield below the risk-free rate has to have the attributes (such as growth prospects, industry leadership, or a history of consistency) necessary to justify the company growing in value at a compound annual growth rate above the risk-free rate. There are many ways to make that argument. But a quality stock with a yield above 4% effectively gives an investor the same yield as the risk-free rate with the added potential upside (and danger of losing money) on the equity.
The Dow offers a bit of everything
The Dow is a gold mine for dividend stocks in terms of both quality and yield. Twenty-seven out of the 30 components pay a dividend, six of the components have a yield over 4%, and over 10 of the components have a dividend yield of at least 3%.
Companies with higher yields tend to have low growth but strong balance sheets, like Verizon. But many Dow components blend an attractive yield with a track record for raising dividends over time. For example, Coca-Cola has a dividend yield of 3%. Not bad, but Coke is also a Dividend King that has paid and raised its dividend for at least 50 consecutive years. Procter & Gamble, 3M, and Johnson & Johnson are also Dow components that are Dividend Kings. While Chevron, Walgreens Boots Alliance, Walmart, McDonald's, and Caterpillar are all Dividend Aristocrats that have paid and raised their dividends for at least 25 consecutive years.
Instead of investing in a Dow index fund, you can parse the list of Dow components to find the type of company that's best for you -- from high-yield dividend stocks, Dividend Kings, Dividend Aristocrats, and even lower-yield companies with better growth prospects like Apple and Microsoft. Aside from the yield and track record for raising the dividend, Dow stocks have the added advantage of being reputable companies. The Dow is constantly evaluated. And it no longer represents solely the industrial and manufacturing side of the economy. Companies that have remained components for a long time tend to do so for good reason, which gives these companies a rare stamp of approval.
Timeless lessons to beat the market
Some of our worst decisions are made when there's a dissonance between our personal risk tolerance and our holdings. If your investment portfolio is down much more than the S&P 500 or even the Nasdaq Composite this year, then there's a good chance it was heavily focused on growth over value or income.
Investing is all about finding balance. Most of the greatest gains for the best investors in history come from just a handful of holdings. Having sound position sizing and a diversified portfolio ensures that hidden gems get the chance to grow over many years, often decades. Including dividend-paying Dow stocks in a diversified portfolio helps to insulate those higher-risk companies and your portfolio from broader market volatility. And by not over-allocating toward one stock, you'll be able to handle a massive drawdown in a single stock without it wiping out your portfolio.