Regrets, I've had a few. Actually, when it comes to investing, I've had more than a few.
Making mistakes is part of the learning process for every investor.
Which brings us to today's topic: the most common mistakes dividend investors make. I'm something of an expert in this area because I've made many of them myself. I've also watched a lot of other people – friends, acquaintances, readers – make them, too.
Some mistakes are especially common among newbie investors, but even people with years of experience will occasionally lapse into bad habits.
As the legendary value investor Benjamin Graham once said: "The investor's chief problem – and even his worst enemy – is likely to be himself." These are the mistakes I see over and over. Learning to recognize them will make you a better investor.
Focusing solely on yield
Occasionally, I'll get an e-mail that goes like this: "I was wondering about [insert fund or stock name here]. It has a 10-per-cent yield, which is pretty good. Is there a catch?" Yes, if a yield is 8 per cent or 9 per cent or 10 per cent, there's definitely a catch: The fund might be distributing liberal amounts of return of capital, essentially shovelling your own money back to you; it might be selling covered call options, which generate current income at the expense of future capital gains; or, in the case of a stock, the company might be paying out more than 100 per cent of its earnings and dying a slow death. Yields that seem too good to be true usually are, and they scream out for further investigation. If you don't understand how the cash is being generated, stay away.
Selling too early
"You'll never go broke taking a profit," goes the old Wall Street adage. But if you're constantly selling your winners, you won't realize the full potential of your portfolio's returns, either. As a buy-and-hold investor, I try to identify great businesses whose sales, profits and dividends will continue to rise for years or even decades. The only time I consider selling is when the outlook for the business has changed fundamentally for the worse. If it hasn't, I hang on – and buy more if the price drops. Selling a perfectly good business to lock in a profit is short-term thinking at its worst, and it creates more stress because you then have to decide how and when to reinvest the proceeds – possibly as the stock you just sold continues to move higher. As Warren Buffett once said: "Our favourite holding period is forever."
Avoiding tax-sheltered accounts
You've probably heard "experts" say that dividend stocks should be kept in a non-registered account to take advantage of the dividend tax credit, and fixed-income securities – on which interest is fully taxed – should be kept in a registered account. This dogmatic advice ignores the fact that, with interest rates at historic lows, you just don't save much tax by parking guaranteed investment certificates or "high-yield" savings in a registered account. Depending on the yield and expected return of your dividend stocks, you could save far more tax by holding them in a registered account instead and leaving your low-yielding fixed-income investment outside (assuming you don't have room for everything in your registered accounts).
Maintaining a diversified portfolio is important regardless of the investment style you choose, but dividend investing brings its own special challenges. That's because certain sectors – banks, utilities and pipelines, for example – are overrepresented in the dividend space, potentially leading to unhealthy levels of portfolio concentration. For example, as extreme as this sounds, I've heard from several readers who own nothing but Canadian bank stocks. That's fine when banks are churning out record profits, but what happens if – or, more likely, when – they run into trouble? In addition to diversifying across industries, investors can benefit by owning a mix of higher-yielding and lower-yielding stocks. Some dividend stocks with only modest yields – Starbucks Corp. and CCL Industries Inc., for example – have produced spectacular returns in recent years. Their yields may be small, but their dividends – and share prices – have been growing fast.
Not reinvesting dividends
To make the most of compounding, you need to reinvest your dividends. There are different ways to do that: You can enroll in a dividend reinvestment plan (DRIP) through your broker or the company's transfer agent; if you own mutual funds, you can choose the (usually default) option to automatically reinvest your distributions in additional units; or you can let your cash accumulate and then decide what to buy. I use the third option because it provides greater control over the reinvestment process, but the downside is that, without automatic reinvestment, I sometimes forget about the cash or have trouble pulling the trigger on a purchase for one reason or another. As a result, cash sits around longer than it should. When paralysis sits in, it sometimes helps just to dump the cash into a dividend exchange-traded fund or low-cost index mutual fund and be done with it. It's not a perfect strategy, but it gets the job done.