Here are four tips in buying dividend stocks:
Tip 1: The Lindy Effect
What is a very important principle in choosing dividend stocks? In Matthew Kratter’s Book, Dividend Investing Made Easy, he shares a powerful shortcut called “the Lindy Effect.”
It came from a cafe in New York where actors used to gather after broadway shows. They noticed that if a show lasted for 100 days, it has a probability to last for another 100 days. It means that the probability to last longer comes with age.
Basically, the probability for living organisms to die increases with age. For example, plants, animals, and humans, have a higher probability of dying as they get older.
But this has an opposite effect with non-organic entities such as works of art, shows, and corporations. For example, people have been listening to the masterpieces of Beethoven since the 1800s. Meaning, that for the next 200 years, it is more probable that people will still be listening to them. On the other hand, people have been listening to Justin Bieber since around 2009, and it is also probable that his music may also last for the next years.
But comparing Justin Bieber and Beethoven’s music, which do you think will probably last for the next 200 years? Justin Bieber or Beethoven? Again, this is only a probability. No one knows about our tomorrow. But it is most likely that since Beethoven’s music survived for more than 200 years, it is probable to survive in the next 200.
So applying this principle to dividend stocks, which company has a higher probability to keep releasing dividends? Coke which was incorporated in 1919 or a company that was only incorporated in 2004? Of course, it’s Coke. Unless of course along the way, something really revolutionary happens to an industry, or a great breakthrough happens like what happened to Kodak and Blackberry and after the introduction of the iPhone.
In dividend investing, the Lindy Effect is useful. We want to own dividend-paying stocks that will be around for a long time because it won’t be good if we own a company now but after a few years it will go bankrupt.
Hence, companies that have been paying dividends regularly for a very long time are likely to continue doing so.
These stocks are also called “Dividend Aristocrats.” So if your purpose is long-term dividends, buying Dividend Aristrocrat stocks is the best decision. Check out with your broker to know which stocks have been paying dividends for the longest time. In the Philippines, you can check it out on the Philippine Stocks Exchange website.
So one of the best ways to build passive income is to purchase high-paying and regular-paying stocks in the stock exchange.
Tip 2: Cost-Averaging
Sometimes we have a tendency to buy stocks lumpsome, or one-time big time. Let’s say investing Php 10,000 PHP in full today, but next month all stocks started going down. To avoid this scenario and to avoid the so-called “analysis paralysis”, divide your P10,000 into 4 weeks. So you invest P2,500 per week for 4 weeks. By doing this, you have invested in a certain stock at its average price for 1 month. If it goes down next week, you will be happy that you can buy it at a lower price. If it goes up next week, you will be happy that you already bought it a lower price. This is called Cost-Averaging because the price you paid is the average price.
Tip 3: Diversification
In the stock market, it’s best if you invest in several companies that produce products and services that people use every day. Concentrating all your money in one industry, for example, is not ideal because if that industry will go down, your losses will not be mitigated.
For example, if you invest in a coal company, what happens if one day, the government decides to aggressively regulate coal? Of course, your investment will go down. But if you also have invested in a solar and wind energy company as well, your losses will be mitigated or cushioned because your investments are spread out. This is called diversification.
As a famous line from the novel Don Quixote says, “Don’t put all your eggs in one basket.”
Check out Matthew’s book for more strategies. Link in the description below.
Tip 4: Not Just Dividend Per Share
You may be tempted to only select a company that has a high dividend rate. For example, Company X declares a P3/share dividend, while Company Y declares a P1/share. So you will automatically choose Company X. But be careful.
Remember that once a company distributes dividends to the shareholders, they take the money from the profits that could have been reinvested back into the company or pay off their debts. A high dividend rate does not always mean a highly ideal company for the long-term.
Also remember that dividend distribution is purely dependent on the discretion of the Board of Directors. So a company’s quality is also measured by who sits in their Board of Directors.
You should also look at the company’s history, income, profits, asset growth, and how consistently they distribute dividends. If a company declares a high dividend this year but did not do so in the last 10 years, you should assess its other metrics to know about its health. You don’t want to invest in a company that won’t stay long after some time, or else you lose all your invested capital.