Dividend Investing: Pros, Cons and Rules to Follow

Dividend investing is an excellent and proven way to grow your wealth over time.

So, what is dividend investing?

When someone says they're a dividend investor, it means they buy common and preferred stocks of public corporations that share earnings with their stakeholders, or dividend stocks.

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There are several great advantages to dividend investing, especially compared to other types of investing such as buying growth stocks or REIT stocks.

At the same time, dividend investors should avoid some common pitfalls. The first thing is to understand how a dividend yield works.

Basically, you want to avoid buying stocks with the highest dividend yields because that high yield can often indicate a future dip in both the dividend payment and the stock price.

There are other issues successful dividend investors must navigate.

Let's take a look at these pitfalls as well as the advantages of dividend investing.

Why dividend investing is a good idea

The chief advantage of buying and holding dividend stocks is that, over time, consistently profitable companies tend to raise their dividends as their earnings grow.

This allows their shareholders to earn more income as time goes on. Moreover, it helps push the underlying stock price higher.

For example, let's say a dividend stock pays a $1.00 per-share dividend and the stock price is $33.33. That gives it a 3.0% dividend yield.

So if the company hikes the dividend to $1.20, the investor will make 20% more income. The stock will often but not always rise to bring the dividend yield back to what it was before.

In this case, the share price would have to increase by $6.67 to $40 to hit that 3.0% yield.

Another more subtle advantage of dividend investing is that the best dividend stocks are often less volatile. This is because stocks that pay dividends tend to be more stable over time.

For example, the market often rewards companies it believes have the earnings power and cash flow strength to maintain their dividends. Often the stock price will trade within a well-defined historical dividend-yield range.

As a result, the share prices of dividend stocks tend to display more stability than growth stocks, which can gyrate wildly based on their own momentum and other non-fundamental traits.

Finally, dividend investing, especially with profitable companies, can directly benefit from companies that buy back their stock.

For example, let's take a dividend-paying company that buys back 3% of its shares each year.

As a result, the company might raise its per-share dividend by 3%. The same dividend cost is spread over fewer shares outstanding.

Growth stocks that don't pay dividends don't gain this advantage.

Is dividend investing a bad idea?

Dividend investing is not a "bad idea." But there are several pitfalls to avoid when you deploy the strategy.

One of the most common is avoiding high-yield dividend stocks. The market tends to have a good sense of when a company can't afford to maintain its present dividend.

As the stock falls, the dividend yield rises. That's because the market sees a dividend cut coming and reacts by lowering the price to maintain the yield after the cut.

Don't be tempted to buy these high-yield stocks before the dividend cut actually occurs.

Another pitfall is excessive trading. This can prevent you from getting favorable tax treatment on your dividends.

For example, to earn qualified dividend tax treatment, investors need to hold the dividend stocks for longer periods.

The exact qualified dividend rules are complicated, but it essentially involves holding a dividend stock for at least 60 days.

It also depends on the exact date when an investor buys the dividend stock and when the next dividend record date is set.

Just keep in mind that favorable tax treatment of dividend income accrues to long-term investors.

And note that distributions from REITs and MLPs (master limited partnerships) do not have this qualified tax treatment. The basic explanation is that these public companies are not structured as corporations.

To avoid this tax treatment pitfall, successful dividend investing means not day trading dividend stocks and constantly buying and selling shares.

Three rules for dividend investing

Investors who follow three simple rules can enjoy the benefits and avoid the pitfalls of dividend investing.

First, stick with dividend stocks that have at least a 10-year record of growing their dividend payments on an annual basis.

One way to do this is to screen for stocks using Seeking Alpha, Yahoo! Finance or even Value Line.

Second, avoid small-cap stocks, even if they have a good dividend track record.

Many of these companies have less cash flow available, or debt or revenue issues that make dividend investing difficult.

Third, target stocks with dividend yields no higher than 4.0% to 5.0% (and, rarely, 6.0%, unless the company has a very healthy financial condition).

This will allow the investor to avoid the high-yield dividend investing pitfall mentioned earlier.

And don't forget: You must always monitor your portfolio to be a successful dividend investor.

Just like pulling weeds is critical to the gardening process, keeping a clean portfolio is important for growing wealth through dividend investing.

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