There are plenty of common misconceptions among investors. For example, many people believe that the more risk you take on, the more potential for reward you have. Other people believe that higher-dividend stocks are always better than lower-dividend stocks. And, worst of all, many people think they don't have enough money to even start investing.
In reality, none of these are necessarily true. We asked three of our experts to clarify these "myths" so you don't fall victim to them.
One myth that many investors believe is that in order to maximize your potential returns, you have to take on maximum risk. It's true that you'll never get rich keeping all your money in an FDIC-insured bank account, and taking on the risk of the stock market can pay off with outsize long-term returns.
However, when it comes to which types of stocks you should buy, research has shown that the stocks that have the highest volatility aren't necessarily the best-returning investments. In fact, low-volatility stocks, which tend to underperform during bull markets but outperform during bear markets, have produced better long-term returns than their high-volatility counterparts. Analysts have tried to explain this risk anomaly, arguing that volatile stocks tend to be more interesting to investors, drawing more attention than boring but steady stocks.
Now, some investors fear that the flood of money into low-volatility stocks has made them overpriced. In particular, many low-volatility stocks also pay lucrative dividends, and the hunger for portfolio income has driven valuations of dividend stocks up dramatically over the past several years. Yet even if low-volatility stocks are temporarily pricey, in the long run, they're still worth more of your investing attention than most people give them.
One investment myth is that stocks with higher dividends are better investments than those that pay lower dividends. For example, Chevron (NYSE:CVX) pays a significantly higher dividend than ExxonMobil (NYSE:XOM) -- about 4% versus 3% -- but that fact alone doesn't make Chevron a better investment. Further, some stocks with extremely high dividends can actually be some of the worst possible investments you can make.
There are a few ways to look at a dividend stock other than the current annual yield. For example, a company's payout ratio measures its dividend payments relative to its earnings; it's a good indication of whether a dividend is sustainable and has room for future growth. For example, a company with annual earnings of $10 per share and a $3.50 annual dividend has a payout ratio of 35%. For most companies, I consider a payout ratio of 50% or less to be healthy, but this is just one piece of the puzzle.
Another good way to evaluate a dividend stock is to check out its history. Does the company have a consistent history of raising its dividend? While past performance doesn't necessarily guarantee future results, past dividend behavior tends to continue.
Also check out a company's history of share buybacks, which some companies use in place of a dividend. For example, Goldman Sachs' (NYSE:GS) 1.4% dividend yield may not sound like much, but when you consider the company bought back more than 6% of its outstanding shares over the past year, you'll see that a lot more capital was returned to shareholders than the dividend leads you to believe.
In short, a company's dividend yield only tells a small part of the story. Higher yields are not always better, and the opposite is often true.
I hear it frequently: "I can't invest. I don't have enough money!"
Actually, you do.
Thanks to the Internet, investing has a lower barrier to entry than ever before. The major discount brokers like TD Ameritrade (NASDAQ:AMTD) and Fidelity offer commission-free trades on more than 100 funds. That means you can get started with practically nothing and buy diversified funds without ever paying a dime in commission.
And there's always the "low-tech" option of making a direct investment in your favorite stocks. Hundreds of the stock market's largest companies offer free direct-investing programs, which allow you to buy shares starting investments as small as $5. The best part is that you can even buy partial shares of expensive stocks. Shares of Scotch Tape maker 3M (NYSE:MMM) trade for more than $165 each, but its program allows investors to buy fractions of a share with a minimum investment of only $10.
We have it easy. Early investors would be astonished to find that stocks are no longer traded person-to-person under the shade of a cottonwood tree on Wall Street.