When I first started on my journey toward financial independence, one of the first things I became interested in was dividend investing. There’s nothing necessarily better about dividend stocks, but they do offer advantages for people who are looking to escape the 9 to 5 job much earlier than the conventional retirement age. The number one advantage is that they’re somewhat more predictable than non-dividend stocks. When the market is volatile, it’s hard to know what your investments are going to do. But if you hold stocks that pay dividends, you can be reasonably sure they will continue to pay you dividends, even if the stock price drops. This gives those of us looking to escape the rat race early a level of predictability that helps us plan our futures. We don’t know what the stock price is going to do, but we know that every year we’ll receive x dollars in dividends.
Dividends will also turn into a predictable cash flow once we achieve early retirement. While we’re building up our investments, we re-invest dividends, but once we’ve established a large enough nest egg so that our dividends are big enough to live on (or big enough to supplement a part time job), we may opt to start receiving dividend checks and living off of truly passive income.
But not all dividend stocks are created equal, and an investor can’t just look at the dividend yield of a stock to determine its quality. For instance, as the stock price drops, the dividend yield goes up, so a stock who’s price has plummeted will have a very high dividend yield. This could be an indication that the dividend is not sustainable and will soon be cut. If there’s one thing a dividend investor wants to avoid, it’s having our dividends cut. We want to look for companies that are likely to increase their dividends year after year. And because we’re not speculators (remember, we want predictability), the best indicator of likelihood to increase dividends in the future is a history of increasing dividends in the past.
Enter the Dividend Aristocrats. Dividend Aristocrats are S&P 500 companies that have increased their dividends every year for at least 25 years. If a Dividend Aristocrat fails to increase their dividend (or cuts it), they are dropped from the list and have to start back at square one building up 25 years of dividend increases to get back on the list. As you can likely guess, companies that are on the Dividend Aristocrat list don’t want to be dropped from it, so they are very likely to continue increasing their dividend each year.
There are currently 51 companies on the list of Dividend Aristocrats. You’ll notice they’re not the most exciting companies. There are no high profile tech companies, no companies whose stock price is likely to shoot through the roof, and you probably haven’t even heard of about half of them. But these companies share two very important attributes: a well-established commitment to reward their investors with a dividend that’s bigger every year than it was the previous year, and the financial success to allow them to do so.
That is not so say that you should blindly invest in the Dividend Aristocrats without doing additional research. For instance, the highest dividend yield on the list belongs to Pitney Bowes (PBI), but their stock price has been dropping since 2007. From 2009 to 2010 it remained roughly stable, and began falling again in 2011. While the stock price certainly could recover and the company could prove to be a great long-term investment, the severe drop in price over several years is enough to make me too wary of the company to invest any significant chunk of change in them.
The Dividend Aristocrats are merely a starting point. If you’re not versed enough in stock fundamentals to understand how to use a stock screener (though you should learn how to use them too!), the Dividend Aristocrats do a pretty good job of distilling a huge pool of companies down into a manageable list of companies that are likely to be decent long-term investments. It’s a lot easier to research 51 companies than thousands of them.
There are a couple ways you can invest in Dividend Aristocrats. First, you can do your research and hand pick a few companies to invest in. If you choose this route, you need to keep diversification in mind. A good rule of thumb is that you shouldn’t have more than 10% of your net worth invested in any one stock. So if you’re just getting started and your net worth is $7000, you shouldn’t invest more than $700 in an individual stock. You can see why investing in individual stocks is tricky when you don’t have a lot of money to work with. You should also diversify across industries. For example, I wouldn’t recommend holding Coca-Cola (KO), PepsiCo (PEP), Hormel (HRL), and McDonald’s (MCD) unless you also hold enough companies in other industries to balance them out. Imagine you only held those four stocks and Michelle Obama managed to convince the whole country we should stop eating crap. You’d be screwed!
I enjoy investing in individual stocks, but I maintain diversification by using the individual stocks to supplement index funds. Once my net worth grows to a point where I could achieve sufficient diversification with just individual stocks, I may choose to do that. We’ll just have to see how I feel when I get there.
The other way to invest in the Dividend Aristocrats is to choose an index fund or ETF. This is a great way for beginning investors who don’t have a lot of money to get a lot of diversification. It also means you don’t need to think about things like whether Pitney Bowes’ stock price will recover, or if their outlook isn’t so good. While there aren’t any funds that track specifically the Dividend Aristocrats, there are several that use similar criteria to pick the stocks they track. The SPDR S&P Dividend ETF (SDY) tracks companies with 25 years of dividend increases in the S&P Composite 1500 (so very similar to the Dividend Aristocrats). The Vanguard Dividend Appreciation Index Fund (VDAIX) tracks US companies with 10 years of dividend increases. It’s also available as an ETF (VIG).
However you choose to invest in the Dividend Aristocrats, remember that while these are large companies with a lot of momentum to continue doing well, there is still risk involved. Dividend investing is a great strategy that offers a bit more predictability than relying just on capital appreciation, but it’s not foolproof. Even big, blue chip companies can fail. It also means you might miss out on big capital gains elsewhere. You should always do plenty of research and/or work with a financial adviser before investing in individual stocks, whatever strategy you choose to employ.
Do you invest in dividend stocks? Do you invest in individual dividend stocks or an index fund or ETF? Why do you like/dislike dividend stocks?