A portfolio of solid dividend stocks is one of the most surefire ways to create wealth over the long run. Dividend payers generally outperform their non-dividend-paying counterparts, and they also tend to be less volatile, helping to ensure a good night's sleep.
But how do you know which dividend stocks to pick for your portfolio? Here are a few things to keep in mind when making your next investment in a dividend stock.
When will you need the income?
One of the most important considerations when formulating a dividend strategy is your investment time frame. Someone with 30 years before retirement can afford to accept a lower dividend and a little more risk, while those who plan to retire soon need to think more about their current income.
On that note, don't ignore stocks just because their dividends are low. Some stocks that yield around 2% are among the best dividend investments on the market because their dividends are raised regularly and substantially. Sure, a 2% annual yield now isn't much, but if the company boosts the dividend by 8% per year, in 30 years you'll be receiving yearly income equal to more than 20% of your initial investment.
Low-paying dividend stocks can still make great investments if they have a solid track record of raising their dividend -- 25 consecutive years or more is a good rule of thumb. A healthy payout ratio is important as well. The payout ratio shows us how much of its earnings a company pays out as dividends. So a stock that pays $1 in dividends in 2014 and earned $2 per share has a 50% payout ratio. A high payout ratio can mean a stock could have trouble paying out its dividend in the future, whereas a lower payout ratio indicates that the dividend is sustainable and has room to grow. A payout ratio of less than 60% is generally preferable.
Two names that immediately come to mind are Colgate-Palmolive and Wal-Mart, both of which pay about 2% but are excellent long-term dividend stocks, based on the characteristics I just mentioned.. These two companies have raised their dividends for decades, and . And, their respective payout ratios are 49% and 38%, based on the current year's expected earnings.
Of course, if you need income now (or in the near future), you may want to look at some of the dividend aristocrats with slightly higher payouts. For example, Consolidated Edison (NYSE:ED) has a 3.8% yield, has paid out less than 60% of its trailing 12-month earnings, and has raised its dividend for 39 consecutive years.
The past tends to repeat itself
I mentioned looking for companies with a solid track record of dividend increases. Well, there is a group of companies, known as the Dividend Aristocrats, that have raised their payouts for at least 25 consecutive years, no matter what the economy or the rest of the market is doing. While past performance is no guarantee of future results, if a stock behaves a certain way for a number of years, chances are it will keep doing so. This is particularly true of older, established companies like the two I mentioned above.
Some of these companies have impressive track records. For example, Procter & Gamble and 3M have both raised their dividends every year for nearly six decades. You can see a full list of the Dividend Aristocrats here, and there are plenty to choose from.
Beware of extremely high yields
Don't those mortgage REITs and business development companies look tempting with their double-digit dividend yields? How about beaten-down energy stocks like Transocean, which has a yield of 17.3% as of this writing?
While some of these super-high-yield stocks can make good speculative investments, they have no place in a retirement portfolio, where you generally keep money you can't afford to lose. There are a few reasons that a stock's yield can be too high, making the stock a bad fit for retirement.
For example, if a stock has declined in price recently, like the aforementioned Transocean, the high yield is a result of a problem with the company or an industry. A stock may also produce a high yield if it is in an inherently risky industry, such as mortgage real-estate investment trusts and business development companies. These types of stocks tend to be very reactive to market conditions, and as a result, their profits can be fragile. For example, mortgage REITs are sensitive to changes in interest rates.
A recipe for success
A well-constructed portfolio of rock-solid dividend stocks is a great way to create wealth over the long run. Many investors consider stocks like these to be "boring," but I disagree.
As a final thought, consider that I have named nine stocks here as good examples of solid dividend investments. Every single one of them beat the S&P 500's total return over the past 20 years. That's saying something, because the S&P averaged a 9.6% annual return during that time period. Returns like these can really add up over long periods of time.