Dividend investing is a popular way to build passive income and expand your investment portfolio. Read on if you want to learn how to build a dividend portfolio if you're a new investor.
Building a dividend portfolio is great because it generates passive income for you, even while you’re asleep.
It’s also a popular way to generate your retirement income, and many investors prefer having a dividend portfolio because it’s less volatile than investing in growth stocks.
Sounds interesting? If you're looking to build a dividend portfolio, this article provides a rough guideline for finding reliable stocks.
Disclaimer: This article on SingSaver serves as an educational piece and is not intended to be personalised advice. When investing, readers should do their own research and understand the associated risks.
What is a dividend portfolio?
A dividend portfolio consists of various different dividend stocks. These companies pay their shareholders dividends based on their profits in the year.
These are usually established companies with a history of solid earnings. Examples are REITs and blue-chip stocks.
How does dividend investing work?
The dividend yield is the percentage a company pays out annually based on how much you invest per share.
For instance, say that a company pays S$0.20 a year per share of its stock, and one share is S$10.
If you own 1000 shares of the company, your total investment value in the company is S$10,000 (S$10 X 1,000).
By the end of the year, you’ll receive a dividend payout of S$200 (S$0.20 X 1,000). If the company’s share remains the same, it means that the dividend yield is 2%.
As you can probably tell, the more shares that you own, the higher your dividend payout.
How many stocks should you own?
As the saying goes: “don’t put all your eggs in one basket”. Suppose you place all your investments in one or two stocks, your entire portfolio would tank badly if the company goes bankrupt or if the market crashes.
Hence, it's important that you diversify your portfolio to reduce the volatility of owning individual stocks. The more stocks that you own, the more you’re able to spread your risk.
That said, don’t go overboard and buy more stocks than necessary or you risk over-diversifying your portfolio. Over-diversification reduces your portfolio returns without necessarily reducing its risk.
Furthermore, owning too many stocks makes it harder for you to keep track of your portfolio’s performance, which in turn also makes it more difficult to rebalance your portfolio.
So, what is the perfect number of stocks to own?
While there is no optimal number, most experts recommend having 20 to 30 stocks.
According to a study, it was found that a portfolio of 20 stocks helped to reduce its risk by nearly 22%. Meanwhile, owning 30 to 1,000 stocks only reduced the portfolio’s risk by 2.5%. In fact, a portfolio with 1,000 stocks only saw the risk reduced by 19.2%.
The moral of the story: don't over-diversify your portfolio.
Don’t concentrate too heavily on any sector
Aside from owning different stocks, you should also own stocks in different sectors and industries. E.g. tech, healthcare, and energy sectors.
The reason why you should be diversifying across sectors and industries is that if the stocks in your portfolio are too closely correlated, they’re prone to the same market factors. For instance, if oil prices fall, your portfolio of energy stocks will underperform as a result.
Therefore, you should mix things up to own different stocks that overlap each other. This way, you’re less likely to experience a huge drop if one of the sectors performs poorly.
That said, don’t diversify for the sake of it. For example, just because the tech sector consists of the biggest companies in the world, it doesn’t mean that you should invest in the sector, especially if you’re unfamiliar with the companies and their business models.
As legendary investor Peter Lynch famously once said: “never invest in any idea you can’t illustrate with a crayon."
The bottom line is that you should invest in what you’re comfortable with.
Invest in companies with a safe dividend payout
While it’s tempting to invest in companies that offer the highest dividend yields, it’s not a good strategy because there could be several underlying risk factors.
For example, if a company is paying unusually high dividends, it could be a sign that it's in financial trouble.
To mask its financial struggles, however, the company offers a high dividend payout to attract more investors to buy its shares. However, this isn’t sustainable and the company may run into cash flow problems, especially if it doesn't have a strong financial backbone.
Therefore, it’s important to understand how to evaluate a company’s financial health.
Some of the ways to do this are to look at key metrics, including the price-to-earnings (P/E) ratio, dividend payout ratio, earnings per share (EPS), dividend per share (DPS), debt-to-equity (D/E) ratio, net income, and cash flow. Here’s a brief explanation of each:
P/E ratio: helps you to evaluate the price of a company’s stock to its earnings per share. It’s derived by dividing the price of a stock by the stock’s earnings.
EPS: indicates how much money a company has for each share of its stock. The higher a company’s EPS, the more it’s considered to be profitable. EPS is calculated by dividing a company’s profit by its outstanding shares.
Dividend payout ratio: a percentage of a company’s earnings that it pays out to shareholders as dividends.
A low payout ratio indicates that it’s reinvesting the money back into the company to grow its business, while a high payout ratio means that the company is paying more dividends to shareholders, which could be unsustainable.
A good payout ratio can range from 75% to 50%, depending on the industry. However, according to a study, a safe payout ratio is about 41%.
DPS: total dividend payout by a company for each share of stock in a quarter.
D/E ratio: used to evaluate a company’s ability to cover its debt. It’s calculated by diving a company’s total debt by its total shareholders’ equity.
The higher a company’s D/E ratio, the harder it is for a company to cover its liabilities. In other words, it means that a company’s debt is high.
Net income: shows a company’s ability to make a profit.
Cash flow: the amount of cash that comes in and out. Positive cash flow indicates a company’s ability to pay dividends.
In summary, don’t just look at a company’s dividend yield; look at a company’s profit, debt, and ability to increase dividends consistently.
Ready to build your own dividend portfolio?
Open a brokerage account with SingSaver and start investing now.
Read these next:
A Complete Guide To Dividend Investing (And The Best Singapore Stocks To Start With)
How To Build A Dividend Portfolio For Consistent Returns
5 Of The Best Things You Could Do With Your Investment Dividends