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Investing in dividend stocks to create an income stream sounds easy. However, in reality, it has its challenges and novice investors often make mistakes that end up costing them money.
Here, I’m going to highlight three key mistakes that dividend investors often make when starting out. Avoiding these mistakes could potentially lead to much better long-term returns.
Focusing too much on yield
Probably the biggest mistake income investors make is focusing too much on a company’s dividend yield and not looking closely enough at the underlying company itself. This is kind of like buying a used car based only on a fresh coat of paint without checking the engine, transmission, or brakes.
Even if a company has a really high yield, it can end up being a bad investment overall if the company lacks consistent revenues and earnings (i.e., ‘quality’). For example, a lower-quality stock might suddenly fall 30% or more, wiping out any gains from dividends (for several years).
A good example here is housebuilder Taylor Wimpey (LSE: TW.), which is a really cyclical company. It has been sporting a high yield for several years now. However, over the last year, its share price has fallen nearly 40% due to challenging conditions in the housebuilding industry.
So, anyone who bought the stock a year ago is now sitting on substantial losses overall. That’s not the result one wants as a dividend investor.
When assessing a company, some good questions to ask include:
- How stable are revenues and profits?
- Is it vulnerable to an economic meltdown (i.e., is it cyclical)?
- Does the company have long-term growth prospects?
- What are its competitive advantages?
- Is it highly profitable?
- Does it have a consistent dividend track record?
Asking these kinds of questions can save a lot of pain in the long run.
Not looking at dividend coverage
Not looking at a stock’s dividend coverage ratio is another key mistake that novice investors often make. This is the ratio of earnings per share to dividends per share and it can provide clues in relation to how sustainable a company’s payout is.
Ideally, a company should have a ratio of two or more. This indicates that earnings could halve and the company could still afford to pay its dividend.
If the ratio is near one, it’s typically a red flag. Because this can indicate that a dividend cut is coming.
And one doesn’t want to experience that as a dividend investor, because dividend cuts can lead to both lower-than-expected income and share price losses.
Going back to Taylor Wimpey, it currently sports a dividend coverage ratio of about 0.90 for this year. That tells us that earnings are not expected to cover the dividend payout.
Given this low level of coverage, I’d be cautious with this stock today. Its yield is high at 8.7% but there’s no guarantee that the company will continue to pay such attractive dividends.
Not diversifying
Finally, not diversifying enough is another major mistake that new investors often make. Often, novice investors only own a handful of stocks and this hurts their overall performance.
For example, if one only owns three stocks and one falls 40%, the chances are, their overall returns will be lousy. If they own 20 stocks and one falls 40% though, it probably won’t be the end of the world – they may not even notice it.
