Don't miss the benefits of dividend investing by making these common mistakes.
There are mounds of academic studies that speak to the benefits of owning dividend-paying shares.
Most recently, Ned Davis Research looked at the performance of US companies from 1972 through May 2010 and found that companies who consistently raised their dividend returned 9.3% annualised versus 7.1% for those that didn't consistently hike their payout. Non-dividend payers managed a feeble 1.4%.
Invesco Perpetual's Neil Woodford is living proof that high-yield, blue chip investing can be profitable and market-beating. Over the past ten years, his "High Income" and "Income" funds have posted greater than 8% ten year annualised returns versus the FTSE 100's 1% return.
Mr. Woodford is a master investor, but the shares that he's bought over the years -- his top current holdings include AstraZeneca (LSE: AZN), GlaxoSmithKline (LSE: GSK), and British American Tobacco (LSE: BATS) -- are available to us, as well.
But for every Mr. Woodford, there are many investors who have underperformed the market with dividend-paying blue chips. Here are three reasons why investors struggle with dividend-based strategies.
1. Paying too much for the shares
In a low-interest rate environment like we have today, it's easy to see why income-thirsty investors may singularly focus on a share's yield, but a 5% yield will do little to cushion the blow of a "permanent" 50% loss.
It's essential, then, to make sure you're paying at least a fair price for your shares. This can be achieved by running a valuation based on dividends or free cash flow.
The point of these exercises is not to value a share to the penny, but to reduce the odds that you'll overpay for the share. If spreadsheets aren't your thing, at least compare the company's multiples (price-to-earnings, price-to-book, etc.) to its five- and ten-year averages.
2. Missing or rationalizing key weaknesses
Investors -- myself included -- often fall into the trap of rationalizing a company's problems as temporary and bound to be corrected.
One of the reasons I created the dividend report card was to counterbalance this tendency and make sure that I approached each share on equal footing, based on a number of financial metrics that I considered important to a good dividend share.
In 2007 and 2008, for example, Marks & Spencer's (LSE: MKS) dividend would have failed my test for free cash flow coverage, which was a red flag that the dividend was in trouble (it was, of course, cut in 2009).
3. Lacking the requisite patience
On my desk sits a quote from Tolstoy: "The two most powerful warriors are patience and time." It's a perfect quote to remember as a dividend-focused investor because dividend success is built over years and decades of compounding, not weeks and months of price fluctuations.
When I was interviewed in Barron's last month for an article on dividend-based ETFs, I said investors should reinvest dividends whilst they wait for share prices to recover. This is easier said than done, however, as we're frequently distracted by Chicken Little-news headlines and short-term swings in the market.
When anxiety to trade your shares creeps up, investors should take a deep breath, remember Tolstoy's quote, and rationally assess the situation.
Foolish bottom line
The myriad benefits of dividends will be realized by investors who can avoid overpaying for shares, be honest with themselves, and maintain a long-term perspective. Having the proper temperament as a dividend-minded investor is just as important as proper share selection.
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> Todd does not own shares of any company mentioned.
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