How would you feel if you get a lifetime supply of your favourite Choco chip cookies? The one for which initially you have to bake a few, and then after a short while, someone automatically does the needful for you, and the cookie number count increases magically!
You can imagine yourself swimming in a pool of cookies. It feels awesome, right?
How would you feel if I tell you secrets to automatically apply the same magical effect to your portfolio?
Exciting isn’t it?
The answer to this is careful stock picking.
But what did I mean when I prefixed stock picking with ‘careful’?
This time you won’t just build any portfolio but a special one – Dividend portfolio.
A dividend portfolio consists dividend providing stocks that intern contributes to monthly income.
Dividends are the most passive source of income. If you want to build a consistent stream of dividend income, there are some best practices you’ll want to consider. You can implement them on your own or opt for equity advisory services. In this article, we will share thumb rules for building a dividend portfolio you can live on.
Select Companies with a History of Dividend
When building a dividend portfolio, it is easy to be tempted by “shiny object syndrome,” or in this case, “shiny dividend syndrome.”
As crazy as it sounds, there are stocks with dividend yields of 10%, 15%, or even more. However, dividends this high are often from companies in unstable financial positions. High dividend yields can happen as the result of dividends going up or share prices going down.
For example, let’s say a company has a share price of Rs 100 and a dividend yield of 5%. If the share price drops to Rs 50 and the dividend remains unchanged, the dividend yield goes to 10%.
What can you infer about a company whose stock price drops by 50%?
It probably has some significant challenges. Instead of investing in high-flyers that may or may not maintain their dividends, instead, choose to invest in dividend silver spoons – companies with a long history of maintaining or raising their dividends.
Diversify! Diversify! Diversify!
If you plan to someday sustain primarily on dividend income, then it is time to appropriately diversify – stock portfolio management comes in handy in this case also.
Failing to diversify adequately is one of the most common investing mistakes. This muddle is very common amongst investors because there are many great dividend stocks, but sometimes companies hit a snag, causing them to slash their dividends.
You could find yourself in trouble if you own just one or two dividend stocks.
One such example is BP. The company had a long history of paying high dividends to shareholders. Then, in 2010, the unthinkable happened. When the BP oil spill took place, the company ran into significant financial turmoil. As a result, the dividend dropped to zero for three full quarters. And, when the dividend did return, it was less than half of its pre-oil spill level.
While this is a frightening example, it makes it easy to understand why you can’t own just one or two dividend-paying stocks.
The basics of stock portfolio management recommend that you must have at least 10 or so stocks to reduce portfolio volatility and unsystematic risk.
And not only do you want to own a substantial number of stocks, but you’ll want to make sure to diversify across sectors and industries.
For example, oil companies have historically paid strong dividends. However, as the world evolves towards more green energy, these companies might struggle in the future. So, you’ll want to make sure you have diversification across other industries such as technology, consumer staples, etc.
Properly diversifying can reduce your risk both as you build your portfolio and once you leverage it as a primary stream of income.
Rupee-Cost Average
Spoiler alert: building a dividend portfolio is a slow get rich scam. You’ll need to invest consistently over a long period to create a large enough portfolio to allow you to live on passive income.
Apparently, one day, that one fine day in the far future you may swim in the pool of currencies.
Because of this, you’ll need to make share purchases at regular intervals.
The immediate question must be regarding the right time is to make these investments.
The answer is hypothetical– it simply isn’t possible to time your investments.
Instead, take up an approach called rupee-cost averaging. Using this approach, you’ll purchase shares at a regular interval (e.g., monthly). As a result, some of the shares you buy will cost more, and some will cost less.
In the long run, time in the market beats timing the market.
Plan for the Unplanned
While setting up your dividend portfolio, make sure you plan the know unknowns.
Let us imagine that you’re gearing up for retirement and have finally hit a little bit more than expected. Sadly, the economy takes a dive. Suppose your average portfolio yield gets cut to say 2%.
In that case, you’re now only bringing a little part of dividend income, leaving you with a shortfall where you may need to start cannibalizing your portfolio to maintain your income.
While it’s great to set a target number, you should build cushions so that you don’t end up in a bad position if the market crashes during your retirement.
Shielding against Inflation
Finally, making your money work for you is the best shield to defend your portfolio against inflation. Let’s assume you buy a dividend stock with a 3% dividend yield. If inflation rises to 3%, what is your real return?
Zero.
It’s essential to build a portfolio that keeps pace with inflation, that’s just the beginning. Because to live entirely off passive income, you’ll want to create a portfolio that continues to grow at a rate faster than inflation, even when you stop feeding it new investment dollars.To race against inflation, it is evident that one takes some risks with your portfolio.
For example, while utility companies have a long track record of solid dividends, there is limited upside in these stocks. It is because it is challenging for these companies to grow earnings substantially.
When companies find ways to increase the bottom line, the stock price usually follows suit, creating additional upside for shareholders beyond the dividend payment. And this upside is what can help you stay ahead of inflation.