Dividend Explanation
Dividend Portfolio Construction
You have learned about different types of income investments, how they are taxed, and the metrics used to evaluate them. Now it is time to put all that knowledge into action. The final and most important step is proper Dividend Portfolio Construction. This process is about more than just picking a few high-yield stocks; it’s about strategically building a diversified and resilient collection of assets designed to generate reliable income for years to come. This page will guide you through the core principles of allocation and rebalancing.
To revisit any previous educational pieces about dividends, please see our Complete Guide to Dividend Investing and Income.
Building a Well-Rounded Dividend Portfolio
Your Investment Objectives and
Risk Tolerance
Let’s walk, step-by-step, through the different aspects of constructing your optimal portfolio.
Current Portfolio Assessment
To begin, you must first know where you currently stand. You would start with an in-depth evaluation of your income, liquid net worth, living expenses, debt obligations, and your liquidity needs.
Evaluating where you stand may take some time, but it will allow you to see the strong points and gaps in your financial plan. This information will allow you to clearly define your investment objectives.
Define Your Objectives
Defining objectives is answering the question, “What do you want your money to do for you?” This enables you to be intentional about how you invest.
Start by making a list of your goals. Common goals include education, retirement, one-time events, and building an emergency fund. To take it a step further, you can categorize each objective as either capital appreciation, capital preservation, income, or a lifestyle goal.
You can also give each goal a timeline. Some goals may be short-term, while others may be long-term or intermediate goals.
Know Your Risk Tolerance
Keep in mind, all investments carry some degree of risk. Assessing your personal risk tolerance is a key component of constructing your portfolio. There is no question that there is a correlation between risk and reward. Investors seeking a bigger payoff must take bigger risks.
In finance, risk is defined as the level of uncertainty that can negatively affect your investments and financial situation. To achieve an appropriate reward in your portfolio, you must be willing to take some level of risk. So, you must ask yourself, “How comfortable are you with uncertainty?” How will you tolerate dramatic swings in the prices of your securities, income, or return?
What Accounts Do Your Have?
You should have different accounts for each of your objectives. Most people have an account specifically for retirement. This account will typically hold a larger percentage of your assets than other accounts. It will also have the longest time frame, since you will need that money to sustain you throughout your lifetime. Because this account is so critical for future security, it will most often be in traditional investments.
Many people will also have investment accounts for other important objectives that have a long-term, or even intermediate time frame. For example, you may have an account for your children’s education. This account will most likely have a maximum timeframe of 18 years.
You may also have accounts for specific goals like a new home or even for subsidizing their retirement account so that they can either retire sooner or maintain a better lifestyle in retirement.
Some investors will also have an account they can “play” with. This account can be used to speculate on higher-risk investments, and it should hold a significantly smaller percentage of assets than your other accounts.
Asset Allocation for Income
What is Asset Allocation?
And, Why Does it Matter?
Once you have determined where you stand, and defined your objectives, timelines, and risk tolerance, you can begin to build the pieces of your portfolio. You will begin with asset allocation. You can think of asset allocation as the foundation of how you manage your portfolio’s risk.
Asset allocation is how an investment portfolio is divided among different asset categories, such as stocks, bonds, and cash. Let’s discuss the risks of different asset classes.
Cash
The biggest detriment to cash is that it doesn’t grow. Because of this, it does not allow you to keep pace with inflation and will decimate your purchasing power over time if you only “invest” in cash.
Bonds and Fixed Income
Bonds are often viewed as an important holding, particularly in a traditional portfolio. Similar to cash, bonds struggle to keep up with inflation. Bonds introduce credit risk which creates a higher expected yield. When you buy a bond, you are buying a certificate of debt. And the company must repay this debt to you, with interest, over time. Your payment depends on the issuing entity’s ability to repay that debt.
Stocks
Most people hold stocks, or stock-backed securities in their portfolios. The quality, performance, and therefore risk of stocks varies significantly from company to company. Moreover, all stocks are subject to price fluctuations. Sometimes these price fluctuations are related to company-specific issues like earnings reports, and other times they are a result of an overall market shift.
Real Estate
A home remains most Americans’ largest financial asset. You may also elect to invest in other types of real estate, like single-family rentals, apartment complexes, offices, or industrial properties. Interest rates play a pivotal role in real estate often influencing supply and demand. Finally, investing in real properties is a very illiquid holding. It will take days or even months to sell a piece of property, whereas stocks can be bought and sold in a matter of seconds.
Historically, the different asset classes have reacted differently to economic conditions. For example, stocks tend to go up as bonds go down. By holding a mix of asset classes, you can reduce your overall risk of loss and smooth out fluctuations in performance.
Diversification Strategy
Since we focus on dividends, we will elaborate on the construction of the stock portion of your portfolio. Many people conflate asset allocation with diversification. Diversification is how you spread risk out within a particular asset class. Simply owning multiple different stocks is not diversification, especially when you own multiple dividend-paying stocks within the same or similar industry.
Keep in mind, the purpose is not to achieve higher returns, but to mitigate the risk of downturns. Diversification allows you to limit your exposure to downturns and potential losses, but it can also limit your potential gains. However, sacrificing yield may lead to greater safety through better diversification.
Sector and Industry Diversification
Diversification can be viewed by sectors. Most investment data firms break out companies into roughly 10 different sectors. They include Basic Materials, Consumer Cyclical, Financial Services, Real Estate, Consumer Defensive, Healthcare, Utilities, Communication Services, Energy, Industrials, and Technology.
A finer measure of diversification can be looked at by industry. With over 100 different industries, it would be difficult for a portfolio to have holdings in each. However, it can allow you to compare two companies within a sector to see exactly how similar they may be.
Individual Stock Holdings
Each stock you own should represent a set percentage of your portfolio. An ideal number of stocks is between 15 and 25. Fewer than that can result in a lack of diversification, and more than that does not have a dramatic effect on diversification.
Remember, the purpose of diversification is to minimize risk for a given rate of return. Multiple studies have shown that adding more companies beyond 30 stocks has a minimal impact on reducing risk without adding to portfolio returns.
You should also consider the complexity of managing so many positions. Each can include commissions, fees, and bid-ask spreads when buying and selling shares. All those costs eat into your returns.
Dividend Paying Stocks
Next, let’s dig into selecting dividend-paying stocks. When you are evaluating companies to buy, it is important to look at whether their stock is considered a value or a growth opportunity. A value stock indicates a mature company that has a lower expected long-term growth rate. A growth stock is an indication of a new company with high expectations of future growth.
Value stocks generally have a lower price-to-earnings ratio (P/E). Although there is no magic number, typically a P/E below 15 is considered a good buy.
Growth stock will have a higher P/E – usually 18 or above. You can also use the P/E of a common index to see if the market views a company as value or growth. For example, if the S&P 500 has an average P/E of 17, stocks with lower P/E could be considered undervalued, and those trading at larger multiples have a higher long-term growth rate factored into their price.
When it comes to dividends, a value stock will likely pay a regular dividend, while growth stocks either do not offer a dividend or offer one at a lower yield. Keep in mind that dividends start with strong fundamentals.
Before you choose a stock, you should always analyze its earnings. You can start with Earnings Per Share (EPS). EPS is a measure of a company’s profitability. It will help you to determine whether the stock is over or undervalued.
P/E is a measure of valuation and tells you if a stock’s price is high or low relative to company’s earnings. By evaluating a company’s earnings trend, you will be able to see if they company is heading in the right direction as well as get an indication of whether a consistent dividend payment is likely to continue in the future.
The payout ratio is also critical to evaluate. Yield is the reason investors choose dividends. But there should be a balance. A stock with the highest yield should not automatically be considered the best holding. In fact, an excessively high yield can be warning sign of future dividend cuts because the yield may be impossible for the company to sustain.
Make sure you also check the company’s dividend growth rate, as well as whether they have maintained consecutive payment growth. You may benefit more in the long run from choosing a stock that with a history of dividend increases rather than one that pays a higher yield at the time.
Dividend Investors
One thing to note, investors solely focused on dividend stocks tend to include a larger percentage of value stocks than the market and often lack growth companies. This could cause you to underperform or miss out on returns when the growth sector performs particularly well. Buying lower-yielding stocks with more growth potential can create a more well-rounded, diversified portfolio.
Building and Maintaining Your Dividend Portfolio
Portfolio Rebalancing Rules
Monitor
We believe TrackYourDividends is the perfect platform for monitoring your portfolio. By linking your brokerage accounts, the tool automatically provides a clear dashboard of your investments. It calculates your annual dividend income, displays a calendar of upcoming payments, and helps you visualize your diversification, making it easy to track your progress.
Rebalance
Rebalancing is the process of shifting the weightings of the securities in a portfolio back to your optimal allocation. You will find it beneficial to set and follow a regular schedule to evaluate your holdings. Over time, you may experience diversification drift and become too heavily invested in a particular company or sector. This drift is more likely to happen in a DRIP where you are automatically reinvesting your dividends.
Fees
You should also carefully consider potential fees when selecting your investments, as they can be a drag on your portfolio performance. For each investment you have, make sure you are aware of any fees involved with acquiring, holding, or liquidating it.
Taxes
When it comes to dividend-paying stocks, qualified dividends are more tax-efficient than ordinary dividends. Because qualified dividends are taxed at the lower capital gains rate, they allow you to keep significantly more of your income than a similar ordinary dividend. Many investors also assume all “dividend” payments are the same. Make sure you understand non-dividend payments.
TrackYourDividends
TrackYourDividends is a great place to review, search, and select the companies you would like to invest in. Our Diversification tab allows you to see your existing portfolio and identify missing sectors and overweight stocks.
Our individual stock research page includes all the critical fundamental data necessary to analyze a stock. With a focus on dividends, you also have easy access to payment history, yield measures, and growth rates.
Once you’ve identified what is missing from your portfolio, our Dividend Screener allows you to filter all stocks by a ton of different factors. Yield and sector are common screens, but we include payout frequency, as well as P/E.
We also allow Premium members to set minimum levels for our Proprietary Scoring Systems. Our Premium members find the most value in our Dividend Safety Score, which combines many of the most common data points for dividend investors into one number from 1 to 100 to evaluate the safety and potential for future dividend growth.
The Dividend Safety Score puts the greatest weight on dividend growth and consecutive payment increases. Nothing demonstrates the safety of future payments like a recent increase or a strong history of growing dividends. We view stocks with consistent growth and payments as better long-term investments than those that simply have a higher yield today. TrackYourDividends gives you the big picture of your portfolio, as well as the ability to drill down on the important ratios and details that matter to you as an investor.