n54)How to Build a Large Dividend Portfolio

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In This Video, We Will Talk About How to Build a Large Dividend Portfolio

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In investing, knowledge is power. To paraphrase Ben Graham's investment advice, you should strive to know what you are doing and why. If you don't understand the game, don't play it. Stay away until you do.

If you are considering building a portfolio for income, this article will help guide you toward success. This means accumulating portfolio income that provides for your financial needs long after you stop working. This isn't a get-rich-quick scheme, though. In fact, we're saying the best investments come with patience and common sense.

The Scourge of Inflation

Inflation and market risk are two of the main risks that must be weighed against each other in investing. Investors are always subjecting themselves to both, in varying amounts, depending on their portfolio's asset mix. This is at the heart of the dilemma faced by income investors: finding income without excessive risk.

At 5% interest, a $1 million bond portfolio provides an investor with a $50,000 annual income stream and will protect the investor from market risk. In 12 years, however, the investor will only have about $35,000 of buying power in today's dollars assuming a 3% inflation rate. Add in a 30% tax rate, and that $50,000 of pre-tax and pre-inflation adjusted income turns into just under $25,000.

The question becomes: Is that enough for you to live on?

The Basics of Dividends

Dividends are very popular among investors, especially those who want a steady stream of income from their investments. Some companies choose to share their profits with shareholders. These distributions are called dividends. The amount, method, and time of the dividend payment are determined by the company's board of directors. They are generally issued in cash or in additional shares of the company. Dividends can be made even if a company doesn't make a profit, and do so to keep their record of making regular payments to shareholders. Most companies that pay dividends do so on a monthly, quarterly, or annual basis.

Dividends come in two different forms—regular and special. Regular dividends are paid out at regular intervals. Companies pay these dividends knowing they will be able to maintain them or, eventually, increase them. Regular dividends are the distributions that are paid out through the company's earnings. Special dividends, on the other hand, are paid out after certain milestones and are normally a one-time occurrence. Companies may choose to reward their shareholders with these payments if they surpass earnings expectations or sell off a business unit.

Why Dividends?

Many investors choose to include dividend-paying stocks in their portfolios for a number of reasons. First, they provide investors with regular income monthly, quarterly, or annually. Secondly, they offer a sense of safety. Stock prices are subject to volatility—whether that's company-specific or industry-specific news or factors that affect the overall economy—so investors want to be sure they have some stability as well. Many companies that pay dividends already have an established track record of profits and profit-sharing.

An equity portfolio has its own set of risks: Non-guaranteed dividends and economic risks. Suppose instead of investing in a portfolio of bonds, as in the previous example, you invest in healthy dividend-paying equities with a 4% yield. These equities should grow their dividend payout at least 3% annually, which would cover the inflation rate and would likely grow at 5% annually through those same 12 years.

If the latter happens, the $50,000-income stream would grow to almost $90,000 annually. In today's dollars, that same $90,000 would be worth around $63,000, at the same 3% inflation rate. After the 15% tax on dividends—also not guaranteed in the future—that $63,000 would be worth about $53,000 in today's dollars. That's more than double the return provided by our interest-bearing portfolio of certificates of deposit (CDs) and bonds.

A portfolio that combines the two methods has both the ability to withstand inflation and the ability to withstand market fluctuations. The time-tested method of putting half of your portfolio into stocks and the other half into bonds has merit and should be considered. As an investor grows older, the time horizon shortens and the need to beat inflation diminishes. For retirees, a heavier bond weighting is acceptable, but for a younger investor with another 30 or 40 years before retirement, inflation risk must be confronted. If that's not done, it will eat away earning power.

A great income portfolio—or any portfolio for that matter—takes time to build. Therefore, unless you find stocks at the bottom of a bear market, there is probably only a handful of worthy income stocks to buy at any given time. If it takes five years of shopping to find these winners, that's okay. So what's better than having your retirement paid for with dividends from a blue-chip stock with great dividend yields? Owning 10 of those companies or, even better, owning 30 blue-chip companies with high dividend yields.

Safety First

Remember how your mom told you to look both ways before crossing the street? The same principle applies here: The easiest time to avoid risk in investing is before you start.

Before you even start buying into investments, set your criteria. Next, do your homework on potential companies and wait until the price is right. If in doubt, wait some more. More trouble has been avoided in this world by saying "no" than by diving right in. Wait until you find nice blue chips with bulletproof balance sheets yielding 4 to 5%, or even more. Not all risks can be avoided, but you can certainly avoid the unnecessary ones if you choose your investments with care.

Also, beware of the yield trap. Like the value trap, the high yield trap looks good at first. Usually, you see companies with high current yields, but little in the way of fundamental health. Although these companies can tempt investors, they don't provide the stability of income that you should be seeking. A 10% current yield might look good now, but it could leave you in grave danger of a dividend cut.

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