“The only thing that gives me pleasure is to see my dividend coming in.” –John D. Rockefeller.
I’ve been taking a look at dividend stocks lately, if recent post about how dividend stocks rock  is any indication, because of how dividends are taxed. To help me make sure I’m not going off track, or falling too much in love with them, I asked The Dividend Guy to write a guest post on where these types of stocks fit in your portfolio.
Dividends have been helpful in my portfolio. However, I have not simply used dividends for the sake of using dividends because I like the income. Instead, I have a very specific strategy that has worked well for me. Perhaps this strategy may work for you, or you can adjust it to fit your own needs. Either way, I would love to hear your comments so that we all can learn a little bit more about this game we call investing.
What Are Dividends
Before we get into it, let’s quickly discuss what dividends are. Dividends are essentially cash payments to shareholders that are paid out from a company’s earnings. It is as simple as that.
In slightly more detail, companies use dividends to pass on their profits directly to shareholders. The most common method of dividend payment is in the form of cash: a company will pay a small percentage of its profits to the owner of each share of stock. Sometime dividends can be paid as more shares, however that is not nearly as common.
People invest for dividends for a number of reasons, however the primary one is that they are looking for income from those shares. Income aside, there are really two other reasons investors use dividends as part of an investment strategy:
1. Compound Growth
Dividends provide an investor with cash they can use. One option is simply spending that money on that new TV. However, as we are all dedicated investors that is not what we are doing right? Instead, we are funneling those dividends back into our portfolio. Investing these dividends into more investments provides us with a compounding effect in our portfolios. I will talk about this later.
2. A Big Part of Historical Returns
Dividends have been a huge contributor to stock market returns in the past. Have a look at the following chart from Plexus Asset Management:
As it is clear to see, dividends have been a huge component of stock market returns and I don’t think can be ignored as part of a well built portfolio.
The Most Powerful Dividends
The real crux of a dividend investor’s strategy often lies in one real important concept: dividend growth. Dividend growth stocks are the creme de la creme of dividend stocks. In essence, dividend growth stocks are stocks that increase their dividends year after year for many years.
If you look at the following chart, from fellow dividend investor Dividend Growth Investor , you can see how dividend growers have done compared to other components of the market. These are the stocks that we are interested in.
How to Use Dividend Growth in Your Portfolio
Now let’s get into how to use dividend growth in a portfolio. Here are three ways that I like to suggest people go about it.
1. Build a core portfolio of index funds
As a dividend investor, people are usually surprised when I say that the first step in build a dividend portfolio is building a core portfolio of index funds. The market is hard to beat, and in this day and age any investor who lags the performance of the market is missing out.
As such, the first step I suggest is to determine an asset allocation that meets your needs, and then populate that asset allocation with low cost index funds or index ETFs.
2. Supplement with Dividend Growth Stocks
Once that core portfolio is build up, then an investor can move on to dividend growth stocks. There are two alternatives to do that:
Alt 1: Find Index Funds that Track Dividend Growth
The easiest and most diversified way to add a dividend growth component to your portfolio is to use index funds that track dividend growth stocks. These funds buy a basket of securities that are known to be dividend growth stocks.
One option for these types of funds include the The PowerShares Dividend Achievers Portfolio (PFM), which is based on the Mergent Broad Dividend Achievers Index. These companies are U.S. equities with at least 10 consecutive years of dividend growth.
Another example is the SPDR S&P Dividend ETF (SDY), which tracks the S&P High Yield Dividend Aristocrats Index. This index is comprised of companies that have increased dividends for at least 25 years.
Research these funds and see how they can be incorporated into your overall asset allocation.
Alt 2: Buy Your Own – Start with Dividend Aristocrats
The other alternative for dividend growth investing is buying individual stocks on their own. This can be a good alternative if you have the time, inclination for intensive stock research, and money available to buy a number of dividend growth stocks to ensure proper diversification. If you do meet these prerequisites, then the best place to start your research is with the Dividend Aristocrat index. As mentioned, these are stocks that have a 25 year track record of increasing dividends and typically represent fundamentally strong and stable companies.
Keep in mind, individual stock selection is tricky so you need to really do your homework because any stock can tank quickly (remember Bank of America). The full stock selection process is obviously beyond the scope of this article so if you are interest in this do some digging around the internet for how to research stocks.
3. Reinvest Those Dividends
This is an important step, because it is where the real gains come from. As I mentioned earlier, investors use dividends for the compounded growth that can provide. To get that growth, it is important to take those dividends received, and funnel them back into additional investment assets. That can mean buying more of the company that was paying you the dividends, or using the dividends to buy shares in one of your core index funds or other dividend shares. Either way, you are putting that money back to work for you.
A dividend growth strategy is a very powerful tool in a portfolio. The compounded growth and high portion of stock market returns that come from dividends cannot be ignored. If this is of interest to you, then consider the suggestions for how to use dividend growth in your own portfolio and start to make some changes.
The Dividend Guy writes about dividend growth investing. His posts cover many aspects of the investing process including dividend growth stock selection, asset allocation, and stock market research. Visit him at TheDividendGuyBlog.com .
(Photo: epitti )