Income Investing: Avoid Making This Mistake With Your Dividend Stocks

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Let's face it, we all make dumb decisions when it comes to finance and investing. These often happen because we are unable to control our fear, overconfidence, or impatience. And there is one particular error many people make when they move in an out of dividend stocks: They may be moving onto other pastures that aren't as green as the one they just left.

Let's look at two important metrics that will help you avoid making this mistake: the cost-based yield and the yield hurdle.

Cost-based yield: so simple, yet so overlooked 
Quick question: what yield are you receiving on any one dividend-paying stock in your portfolio? If you went immediately to your favorite finance ticker page and looked up the yield there, chances are that isn't the yield you personally are receiving on your investment. 

The difference between the yield shown on those stock ticker pages and your personal yield is that, in all likelihood, the price you paid for that stock isn't the same price as what it is trading for today. Also, depending on how long you plan to own that stock, the dividend is likely to change over time. 

This is known as your cost-based yield. It's the future dividend payment divided by the cost price at which your investment is carried in your portfolio. As you can imagine, this metric can vary greatly depending on when you buy a stock because the original price -- and yield -- play such an important factor. To give you an idea of how important knowing this number is, let's run through a hypothetical scenario. 

Say you make a $10,000 investment in dividend Company X that is worth $100 per share and has an annualized dividend payment of $2.50 paid quarterly -- a 2.5% yield. You hold that position for five years and reinvest the dividends, while over that time the company increases its dividend by 8% annually and the price of each share grows by 8% per year. If you look at the stock ticker page exactly five years after the initial investment, it would say the stock price of Company X is $148.60 and the dividend payment is $3.71 -- a 2.5% yield, just like when you bought it.  

However, this is not your cost-based yield, because a majority of your purchase is tied to that $100 per share purchase. With dividends reinvested, your cost position in the stock would be $102.31, making your cost-based dividend yield 3.63%.

Pretty big difference, eh? Even better, the longer your investment stays in the same place, the more your cost-based yield improves.

This chart illustrates the importance of buying rock-solid companies that continuously increase their dividend payments. Share prices are no sure bet when it comes to investing, because so much of it is based on the whims of people's attitudes. Investing in a dividend-paying company that increases the payout, though, can be an incredibly powerful method to building wealth.

Chasing yield you had all along
When it comes to dividend stocks, many investors make the mistake of chasing yield. Say another person bought shares in Company X at the same time you did and held them for 10 years. When he or she looks at the stock ticker page, that person might decide that Company X's 2.5% yield isn't sufficient, and that it is time to sell the stake in favor of a higher yield with Company Y.

Unfortunately, the logic of dividend investing isn't that simple. When you sell out of a position for a higher-yielding investment, you need to know your yield hurdle. A yield hurdle is basically the yield that you need to make the cash payments from the new investment equal to those you received from your original position. The simplest way to determine your yield hurdle is with the following equation:

Let's run a scenario using this equation. You sell out of your dividend stock yielding 2.5%, and the capital gains taxes and brokerage fees take 18% of that sale. Plugging those numbers in, your next investment would need to yield better than 3.05% to provide the same cash payments you received with your old investment. So before you sell your dividend stock for a new one, be sure the yield hurdle shows you are actually getting an equal or better deal. 

What a Fool believes
If you want to get more yield from your stock portfolio, be sure you know your cost-based yield and your yield hurdle, as they should play a large factor in your investment strategy. These simple steps illustrate the power of holding on to your positions for a long time, as well as what it should take to convince us that moving to another stock is worth it. Who knows, you might realize the position you own today is much better than you thought.