Investors like dividend-paying stocks because they offer both current income and potential share-price gains, and high-yield dividend stocks are especially popular for their lucrative payouts. If you want to make the most of the opportunity that high-yield dividend investing offers while steering clear of common pitfalls, these five tips will give you a good starting point to put together a dividend stock portfolio that will meet your needs.
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1. Don't expect sexy business models
Many investors look for companies that offer cutting-edge products or state-of-the-art services. Those companies might be good candidates for strong growth, but you'll rarely find them among high-yield dividend stocks.
Instead, boring businesses are the norm in the dividend world. Whether you're looking at regulated utility companies, landline telecommunications specialists, or midsized regional banks, most of the stocks that offer above-average dividend yields are in mature, well-developed industries where it makes more sense to return capital to shareholders than to reinvest internally within the business. Boring business models can pay high dividends, so don't ignore stocks just because they don't seem sexy.
2. Look back at history for warning signs
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Stocks that have high dividend yields can be profitable, but they can also be dangerous. Sometimes, a high yield indicates that investors are pretty certain that a company will cut its dividend in the future. If that happens, dividend investors take a double hit: They not only lose the high yield but also typically see the stock price fall as well.
A good gut check on a high-yield stock is to look at its history to see whether that company has made dividend cuts before. In cyclical industries, you'll sometimes see regular oscillations in dividends, especially among companies that tie their payouts directly to earnings results. If that's the case for the stock you're looking at, you have to weigh the risk of a future cut against the benefits from holding the stock. Past cuts shouldn't disqualify every stock, but you should make sure you're getting compensated for additional risk.
3. Look for dividend growth as well as yield
Too many investors focus solely on yield without looking at the potential for future growth. If you know that a company yields 4% right now and will double its payout in the next 10 years, then you should be more intrigued about it than about a stock that pays 5% or 6% now but has no chance of future dividend growth. Your time horizon matters, but the longer-term your goals are, the more important dividend growth is compared to yield.
4. Be aware of the tax situation for your dividend stocks
Not all dividend stocks get treated the same at tax time. Those that pay qualified dividends benefit from a lower tax rate, which ranges from 0% to 20% depending on your ordinary income tax bracket. However, some dividend-paying investments, such as real estate investment trusts and master limited partnerships, don't always get favorable treatment for their payouts. That can turn what looks like a higher-yielding choice on a pre-tax basis into a lower-yielding option after tax, so check to see how your stock gets treated before you buy.
5. Look at high dividend yield ETFs
Finally, if you don't want to pick individual stocks, several exchange-traded funds can give you exposure to high-yield dividend stocks. Vanguard High Dividend Yield ETF (NYSEMKT: VYM), for example, tracks an index that focuses on stocks with above-average yields, and that gives it the ability to pass through distributions of around 3% to investors. Although Vanguard High Dividend Yield doesn't have a dividend-growth requirement, some other ETFs do add in filters to screen for stocks that have a long track record of boosting dividends on a regular basis. With ETFs available at low cost -- Vanguard High Dividend Yield charges just 0.09% per year -- dividend investors can get what they want without doing individual stock research.
Get the dividends you deserve!
High-yield dividend investing can bring in thousands of dollars in extra income. By using these five tips, you can make sure you avoid common mistakes while maximizing the value of your portfolio.
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