Updated on March 21, 2017 by Nicholas McCullum
When you start investing, you know the least about investing that you will ever know.
This can lead to poor initial results, and ultimately ‘quitting’ investing without ever benefitting from the prosperity creating effects of compound interest.
If you are starting from scratch, it pays to begin your investment journey with the knowledge necessary to succeed.
This article is your guide on how to invest well, from the start.
Investing can seem extremely complicated.
There is a staggering amount of industry-specific knowledge in investing. Case-in-point: here are 101 financial ratios and metrics that are important to investing.
Fortunately, you don’t need to know all 101 to do well in the stock market.
In fact, how to do well as an investor can be boiled down into the following sentence:
Invest in great businesses with strong competitive advantages and shareholder friendly managements trading at fair or better prices.
Buying high quality businesses has historically been a winning strategy, but please do not just take my word for it…
Claims without facts are just baseless opinions.
The bolded statement above covers all there is to know about successful dividend growth investing. Admittedly, it is missing some detail.
The rest of this article discusses in detail how to build a dividend growth portfolio, starting with $5,000 or less.
Choosing the Right Stock Broker and Funding Your Account
The way that we purchase stocks has changed dramatically over the decades.
It used to be very expensive to purchase stocks – a ‘broker’ was an individual, not an online platform. Buying stocks involved calling your stock broker and seeing if he knew anyone who was selling your desired security.
Today, there are a plethora of online stock brokers with low fees and easy-to-use trading platforms.
The purpose of this section is not to recommend a specific stock broker for Sure Dividend readers. Rather, certain positive characteristics will be identified to help you on your search for the right broker.
The biggest factor is fees. Investing fees can be a serious detriment to overall investor returns.
As a self-directed investor, the largest fees you will incur are when you trade. Most brokers charge a flat per-trade commission which can be as low as $1 (though often much higher).
When you start investing and your portfolio is small, these fees can really eat into returns. This is one reason to support long-term investing – long holding periods means less trading, which reduces fees.
Some investors will also elect to trade on margin as a way to increase returns (with a proportionate increase in risk). This means that an investor will borrow money from their stock broker to purchase more stocks, using existing investments as a collateral.
Different brokers will charge different interest rates on borrowed margin. The lowest I have seen is 2% for an entry-level portfolio. Typically, the interest rate will decrease as portfolio size increases.
For large portfolios that trade on margin, margin interest rates will be a larger factor than commission fees when determining which broker to use. This is because margin is calculated as a percentage of portfolio size, while trading commissions are a flat fee and generally do not change based on trade size.
A further consideration is a broker’s built-in research capabilities. For investors that are new to the markets, some brokers will have dedicated in-house stock screeners and investment seminars that will help flatten the learning curve as you build your dividend growth portfolio.
All of these factors should come into play when deciding which stock broker to use.
Once you have selected a stock broker, you must then ‘fund’ your account. If you do not fund it, there will be no money available to buy stocks.
There are many different mechanisms through which you can fund your investment account. Some brokers will accept checks delivered via mail. Others accept payments via a bill payment from your financial institutions. Arrangements can often be made to have money automatically withdrawn from your checkings account on a periodic basis (which is ideal for the systematic investor).
Instructions for funding your first investment account will be available on your broker’s website.
Should You Build Your Portfolio With Stocks or ETFs?
In the past, the only way to gain exposure to the financial markets was by investing in individual securities. Investors would buy stakes in companies like Wal Mart (WMT), Exxon Mobil (XOM), or Johnson & Johnson (JNJ) directly.
That changed with the introduction of the mutual fund and later the exchange-traded fund (ETF). These offerings are financial products where retail investors like you and I purchase units of a fund and our money is professionally managed by an expert investment manager.
While we oppose mutual funds because of their high fees, ETFs are a low-cost way for investors to gain diversification and access to the financial markets.
ETFs are traded through the same mechanism as shares on the stock exchange (which is not the case with mutual funds). You can purchase ETFs in your brokerage account and hold them for as long (or as short) as you like, just as with stocks.
There is much back-and-forth in the investing industry about what is better: ETFs or individual stocks.
The truth is that both options have pros and cons. I personally prefer to invest in individual stocks – systematically.
The 8 Rules of Dividend Investing systematically identify and rank high-quality dividend growth stocks using metrics that have historically either improved returns or reduced risk.
I say this so that you can understand my bias from the beginning. With that said, I will now present the pros and cons of ETFs versus individual stocks summarized from the article mentioned below.
Pro: Investing in dividend ETFs provides wide diversification.
This is helpful for investors with small portfolios as they can get the necessary diversification from owning multiple stocks without wasting money on many brokerage commission fees.
Evidence shows that most of the benefit of a diversified portfolio comes from owning ~20 stocks (more on that later). ETFs often hold hundreds of positions, so they might be overdoing it a bit.
With that being said, though, when diversification is needed, it is often really, really needed. ETFs are a simple way for investors to gain diversified market exposure.
Pro: Investing in dividend ETFs has a low time commitment.
Once purchased, investors can ‘sit and forget’ about their ETF. No additional research is required since the fund is being managed by talented a team of investment professionals.
This low time commitment is beneficial for two sorts of people: those who do not find stock market research interesting and those who are already too busy with other activities.
Pro: Dividend ETFs almost always have lower expense ratios than their mutual fund counterparts.
There are several dividend ETFs that have annual expense ratios below 0.1%. Most dividend mutual funds would have a fee of 1% or more (which amounts of $1,000 of annual fees on a $100,000 portfolio).
Related: 7 Tips to Grow Your Wealth Like the Best Dividend Investors (hint: one is to minimize fees)
Con: Dividend ETFs are always more expensive than owning individual stocks.
After the initial purchase is made, individual stocks will always have an expense ratio of 0.00%. There is no cost to hold a stock, regardless of the holding period.
You may be thinking – but what about brokerage commissions? Since ETFs trade in the same way that stocks do, most brokerages require a commission to be paid for both the purchase of ETFs and stocks. This means that stocks have no cost advantage over ETFs when it comes to trading them.
Con: You cannot hand-select which businesses you own with a dividend ETF.
Dividend ETFs give you no control over your portfolio. You cannot buy or sell individual stocks, which means you cannot fine-tune your strategy to match your specific needs.
There are many cases where you would want to tweak your portfolio to meet certain needs. For example:
- Only stocks with 5%+ dividend yields (the Sure Retirement criterion)
- No fossil fuel holdings
- Hold only stocks with high levels of insider ownership
The endless customization possibilities are one of the major advantages of buying individual stocks over ETFs.
Conclusion: There is nothing necessarily wrong with dividend ETFs.
For investors with minimal time or interest in investing, ETFs are an excellent alternative to high-fee mutual funds.
With that being said, I prefer to invest in individual businesses, not markets. The rest of this article will assume you do as well.
Where to Find Great Businesses
To invest in great businesses, you have to find them first.
Sure Dividend generally recommends two databases of stocks as a source of high-quality dividend-paying businesses. Both of them are based on consecutive streaks of dividend increases.
Consecutive dividend increases are important because they demonstrate two things:
- The business is doing well
- The management is shareholder-friendly
With regards to the first point, a company cannot raise its dividend if earnings are not also increasing.
While dividends may outpace earnings in the short-term, this is impossible over the long-term. A very long streak of constantly rising dividends means that a company has grown dividends (and earnings) through everything the market has thrown at it.
Secondly, shareholder-friendly management teams are a telltale sign of a great business. Exceptional people create exceptional companies, plain and simple.
The first source of great businesses we recommend is the Dividend Aristocrats Index. In order to be a Dividend Aristocrat, a company must:
- Be in the S&P 500
- Have 25+ consecutive years of dividend increases
- Meet certain minimum size & liquidity requirements
The Dividend Aristocrats have historically outperformed the overall stock market as measured by the S&P 500 Index.
Another great place to look for high-quality businesses is the Dividend Kings.
Like the Dividend Aristocrats, the Dividend Kings list is based on historical dividend increases – except it is even more exclusive. To be a Dividend King, a company must have 50+ years of consecutive dividend increases.
This group is a bit more inclusive as it allows a business to freeze its dividend (not raise it but continue to pay it) and still be on the list.
How To Know If A Great Business Is Trading At Fair Or Better Prices
Finding great businesses with shareholder-friendly management is the first step.
The second is to determine if these great businesses are trading at fair or better prices. Even the best company becomes a poor investment if an investor pays too high a price.
“For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.” – Warren Buffett
A very quick-and-easy rule of thumb is to look for great businesses trading at or blow the S&P 500’s price-to-earnings ratio. If a business is higher-than-average quality, you would think it would command a higher price-to-earnings ratio than the market average (as measured by the S&P 500).
Great businesses that trade below the S&P 500’s price-to-earnings ratio are a good place to look into value with more detail. The S&P 500’s price-to-earnings ratio is currently 26.6. The following Dividend Aristocrats are high-quality companies that are trading at substantial discounts to this valuation:
- Hormel Foods (HRL): 21.4 adjusted price-to-earnings ratio
- AbbVie (ABBV): 13.1 adjusted price-to-earnings ratio
- Abbott Labs (ABT): 20.6 adjusted price-to-earnings ratio
Beyond comparing stocks to the overall market, investors shuold compare a business’ price-to-earnings ratio to both:
- Its 10-year historical average price-to-earnings ratio
- Its competitors’ price-to-earnings ratio
It is important to remember to use adjusted earnings when comparing price-to-earnings multiples.
GAAP earnings can be reduced by one time effects such as acquisition costs or depreciation charges. Similarly, GAAP earnings can be artificially inflated if the company sells assets.
These charges are accounting based, not reality based, and may not truly communicate the long-term earnings power of a business.
One factor that will affect a company’s ability to be purchased at a discount to its intrinsic value is its volatility.
Volatility, generally measured by standard deviation, is the tendency of a stock price to ‘bounce around’. Some stocks have naturally high volatility, while others like Johnson & Johnson (JNJ) have notably low volatility.
Related: On Stock Price Volatility
Volatility tends to benefit the buyers of stock (as it creates opportunity) and harm the holders of stocks.
Buying Your First Stock
Once you have identified a high-quality business trading at an attractive valuation, it is time to buy.
Buying stocks can seem just as complicated as analyzing stocks. It is not as simple as just pushing ‘buy’ – there are a number of different order types that investors can use, depending on the circumstances.
For simplicity’s sake, the beginning investor should only be concerned with two types of orders:
- Market order
- Limit order
A market order is when you communicate to your broker ‘buy this stock at prevailing market prices’. Market orders are always the quickest way to execute a trade.
Market orders have downsides. If the stock price moves quickly after you place your order, you may end up buying the stock at a higher price than you wanted.
Limit orders are the solution to this problem. A limit order is when you communicate to your broker ‘buy this stock, but only at a price of X or below‘.
For example, if Target (TGT) was trading at $55 and you saw value at $50, you could place a limit order for $50 and the order might never be filled unless Target stock dropped to $50 (or below).
There are many other types of buy orders that are more complicated than the two mentioned above. There are also equivalent sell orders.
However, limit orders are generally the best way to ensure that you are getting a fair or better price on a trade.
More sophisticated investors can also take advantage of stock options to buy and sell stocks to increase income and avoid costly brokerage commissions.
However, these strategies are more advanced in nature and should not be pursued until investors have a firm grasp of the other investing fundamentals that are described in this article.
How Many Stocks Should You Hold?
There is a tradeoff with diversification.
The more stock you hold, the safer you are if any one of them implodes. On the other hand, you have less to gain from the stocks you hold that do well.
Professional investors also experience this divide. Warren Buffett, the CEO and Chairman of Berkshire Hathaway, manages a ~$150 billion common stock portfolio where his top 4 holdings make up 57% of his portfolio.
Buffett does not have a very diversified portfolio.
Peter Lynch, on the other hand, most certainly does (or did – he is now retired). As the manager of the Magellan Fund at Fidelity Investments between 1977 and 1990, Lynch’s portfolio averaged a 29.2% annual return – making him the best-performing mutual fund manager in the world.
Although managing much less than Buffett – around $14 billion at his peak – Lynch was known to hold more than 1,000 individual stock positions. Lynch had a very diversified portfolio.
Who is right? The empirical data suggests that a 1,000-position stock portfolio is unnecessary. According to studies cited by Morningstar:
“About 90% of the maximum benefit of diversification was derived from portfolios of 12 to 18 stocks.“
Holding a portfolio of ~20 stocks (to be on the safe side) gives 90% of the benefits of holding 100+ stocks. There are also numerous advantages to holding around 20 stocks.
First of all, holding 20 stocks means you get to invest in your best ideas. You can own the businesses you are most comfortable holding – the ones that you believe have the greatest total return potential.
Holding a large portfolio of 100 or 200 stocks also requires a large time commitment and is virtually impossible to keep up with. It’s hard to really know 100+ businesses. Keeping up with the quarterly earnings reports of this many businesses would be a huge endeavor – much less so for 20 businesses.
So investing in around 20 businesses is the ‘sweet spot’ between investing in only your best ideas while still benefitting from diversification.
You can’t just own any 20 stocks and be diversified, however.
As an example, if you owned 20 upstream oil corporations, you would not be well diversified. Similarly, owning 20 biotech companies does not a diversified portfolio make.
Dividend growth investors should look to invest in different sectors to gain exposure to different types of great businesses. For context, here is the breakdown of the Dividend Aristocrats by sector:
- Consumer Staples: 25.5%
- Industrials: 17.6%
- Health Care: 13.7%
- Consumer Discretionary: 11.8%
- Financials: 9.8%
- Materials: 9.8%
- Energy: 3.9%
- Information Technology: 2.0%
- Real Estate: 2.0%
- Telecommunication Services: 2.0%
- Utilities: 2.0%
Clearly, there exist high-quality business in basically every sector.
The next section discusses different portfolio building strategies.
Dividend Growth Portfolio Building Strategy
There are two types of ‘new’ dividend growth investors:
- Those that are starting from scratch
- Those with sizeable portfolios looking to transfer over to dividend growth investing
This article is about starting from scratch. That’s what will be covered in this section.
Building a high-quality dividend growth portfolio is a process. Diversified dividend income will not be created overnight. The process will take time, just like most important things in life.
Instead of thinking you will ‘never make it’ because you don’t have $100,000 or $1,000,000 to build your portfolio, focus on saving and investing the same amount each month.
Related: On Long-Term Systematic Investing
I recommend buying the highest ranked stock you own the least every month based on your specific criteria. Each criterion should be selected to either increase returns or reduce risk.
Further, each criterion should be supported by empirical evidence with logical underpinnings (not clearly unrelated relationships like ‘companies with CEOs named Jim have outperformed over the past X years’).
The longer you invest, the more money you have to invest, and the more diversified your portfolio will become.
No matter how selective you are when purchasing stocks for your dividend growth portfolio, you will eventually have to trim the ‘dead weight’. The composition of your portfolio will undoubtedly change over time.
The best investments are long-term in nature. Once a stock is purchased, investors should prefer to let it compound their wealth indefinitely.
A long-term orientation also provides individual investors with a competitive advantage over institutional investors like pension plans and mutual funds, whose performance is judged on a quarter-over-quarter basis.
“The single greatest edge an investor can have is a long term orientation” – Seth Klarman
With that being said, holding a stock for the long-term is not always possible. Things happen. Businesses that were great at one time lose their competitive advantage.
This can happen by management losing its way, technology changes, or by competitors finding a way to destroy or copy the company’s competitive advantage.
When a business loses its ability to compound your wealth through rising dividend payments, it is time to sell.
The primary sell criteria according to The 8 Rules of Dividend Investing is to sell when a business cuts or eliminates its dividend. This is a very clear sign from management that either:
- The dividend is not important (shareholders don’t matter)
- The business cannot sustain its dividend (business is in decline)
In either case, that is not the type of investment likely to generate long-term wealth. Of course, there are exceptions.
Sometimes businesses rebound after dividend cuts. However, the historical record shows that dividend cutters make poor investments, on average.
More specifically, dividend cutters have had a lower return and a higher standard deviation than all other classes of stocks, resulting in terrible performance on a risk-adjusted basis.
Source: Santa Barbara Asset Management
Fortunately, there are typically many more dividend growers & initiators than dividend cutters/eliminators at any given time.
This makes it easier (and less risky) for dividend growth investors to execute their investment strategy.
Source: Santa Barbara Asset Management
There is one other good reason to sell a dividend growth stock – if it becomes wildly and absurdly overvalued.
I will happily sell a business with an adjusted-price-to-earnings ratio over 40. At this level, ‘irrational exuberance’ has clearly taken hold.
It is better to profit from this overconfidence by selling than to participate in it. Profits can be reinvested into dividend growth stocks with sane valuations.
This benefits investors in a number of ways. Stocks with lower valuations have better total return potential, all else being equal.
Similarly, two companies that have the same earnings and payout ratios but with different valuations will also have different dividend yields – the lower-valued company will generate more dividend income for shareholders.
Discipline Is The Key
What sets apart those who will retire wealthy from the rest is the amount of discipline you have to stick with the plan you lay out.
If your investment strategy is sound, and you follow it diligently, you are likely to do well in the market over time.
The stock market does not go up in a straight line.
You can experience losses of 50% or more investing only in stocks. If you have the fortitude to persevere through market downturns, you can benefit from the compounding effect of owning fantastic businesses over long periods of time.
On the other hand, if you sell when things look their worst – like March, 2009 – you will likely underperform the market by a wide margin.
Staying fully invested throughout market cycles appears to be the best strategy. Missing a few key days over the long run can have a profound effect on investment performance.
Sadly, most individual investors tend to buy and sell far too often.
The study The Behaviour of Individual Investors by Brad Barber and Terrance Odean revealed the unfortunate truth about individual investors.
The authors analyzed data from 78,000 individual investors. They found that when individual investors sell a stock to buy another, the stock they sold outperforms the stock they purchased (on average).
This means we tend to buy and sell at the wrong times…What’s the solution?
Practice ‘do nothing’ investing. Don’t sell stocks without a very good reason. Price declines are not a good reason unless the underlying business has deteriorated.
Related: Do Nothing Investing
For a moment, compare investing to grocery shopping. If you bought steak for $10 and it went on sale for $8, would you go back and return the steak you had already purchased? No! You would buy more.
When a stock’s price declines, you can buy more for a better deal (assuming the underlying business has not significantly changed). This makes stock declines the right time to add to your positions, not sell them.
Final Thoughts: Why Investing Matters
Why is investing important?
Because the average retirement age in the United States is increasing. Both the age people expect to retire and the age at which they actually retire is trending upward.
This should not be the case.
People should be retiring earlier…The national GDP has marched upward over the last decade, yet people are not able to retire when they want.
Dividend growth investing will help you build a portfolio that pays growing dividend income during retirement. This can lead to retirement on time – or even early retirement.