CREATING A DIVIDEND
INVESTING STRATEGY

This article will explore various dividend investing strategies, and guide investors on how to create one that suits their goals, and is  in line with their own appetite to risk.

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Once you start building a dividend investment strategy, you will soon realise how the regular drip feed of dividend payments has the potential to support your overall returns through passive contributions and compounding. 

To some extent, dividend stocks will take care of themselves, but that doesn’t mean that there aren’t approaches you can take to optimise your returns and better align your dividend strategy with your overall investment goals. For instance, choosing diverse ways to receive dividends and employing portfolio management techniques can keep your investments on the right track towards helping you to achieve your financial goals. 

Types of dividend investing strategy

Developing a clear strategy which factors in your personal financial goals is one of the golden rules of investing. If you’re including dividend stocks in your overall investment plan, it’s important to tailor your approach accordingly. This might involve adjusting how you receive dividends to suit a long-term or short-term perspective. In addition, understanding how various stocks support an adjusted approach like this remains key. For example, some dividend stocks provide options such as reinvestment plans that others might not offer.

Dividend reinvestment plan (DRIP)

A dividend reinvestment plan (DRIP) is one where investors opt to take dividends in the form of additional stock, rather than as a cash payment. If you opt in or sign up for a DRIP scheme, shares will be credited to your account, commission-free, each time the company pays a dividend.

Signing up for a DRIP scheme allows you to tap into one of the biggest secrets of successful investing: compounding. Compounding explains how over time, the size of your holding will increase exponentially. As the size of dividends is determined by how much stock you hold, each upcoming dividend will also be greater in size as a result. If that process is given time to develop, a passive “snowballing” effect can occur and boost your overall returns.

Diversification

Diversification is another crucial component of a dividend investing strategy. There are many reasons why spreading capital across different types of assets is a good idea. A diversified portfolio has less exposure to single-stock risk, reducing the chance that one position will drag down your overall performance.

Macroeconomic cycles which cause the financial markets to rise and fall in value are unavoidable, and portfolio diversification will make it easier to navigate the natural ups and downs of the economy. Moreover, diversification can help you to mitigate losses in the case of an individual company missing targets, having a poor earnings season, depreciating in stock value or experiencing situations such as bankruptcy.

Your portfolio being overexposed in any one position will not only impact your bottom line, but could result in panic-inspired decision-making. Constructing and implementing diversification strategies to avoid overexposure will help you to stick with a carefully thought-out investment strategy. 

Dividend investing is about taking the long-term view and aiming to track (rather than beat) the market, while receiving a passive income along the way.

Holding a large number of individual stocks (both dividend-paying and not) is the first part of the diversification process, but there are additional factors to consider. Avoiding being overexposed to any particular sector or industry, or not having all of your capital invested in one particular region are also good ways to maintain a diversified portfolio. Diversification can also extend to including a mix of small-, medium- and large-cap stocks in your portfolio.

Dividend capture strategy

Adopting a dividend capture strategy can take your dividend payouts to an extreme level. This rather specialist strategy focuses on generating dividend income by buying stocks just before their ex-dividend date (or “ex-date”).

Investors who are holding stock on ex-date will be eligible to receive a dividend, regardless of when they purchased the stock and whether they then sell the position straight away.

Some investors who use this strategy will hold positions for only a few days before moving their capital into another stock.

A dividend capture strategy certainly has the potential to boost the percentage of your returns received in the form of dividend income, but it is important to be aware that there are reasons it might not actually improve your overall returns. 

For example, rotating in and out of positions will incur trading costs which can impact performance. The time taken to research and monitor different positions also needs to be factored in as a “cost” of some sort. What’s more, if you hold positions for a short period of time, you may not receive any of the beneficial tax treatment which is reserved for longer-term investments. 

The main factor working against the dividend capture strategy, however, is that dividends are factored into stock valuations in the run up to ex-date. After the dividend ex-date comes around, the stock can be expected to fall in price, as buying the stock no longer includes an element of dividend income. It is possible that the price reduction will be less than the size of the dividend payment, but it could also be greater and, thus, result in a capital loss.

Which dividend strategy is right for me? 

Your personal investment aims should always determine which dividend strategy you adopt. Younger investors or those with the potential to maximise their time in the market may sign up for a DRIP, which offers greater long-term potential. Conversely, retirees with more free time and a desire to maximise short-term cash flow may opt to follow a dividend capture approach.

Tools which will help your decision-making include the dividend yield metric, which shows what kind of income returns stocks offer, and a Dividend Calendar to show the frequency with which stocks make payouts to shareholders.

Final thoughts

The good news is: there is a dividend strategy that exists to suit most objectives. Establishing your investment aims is one element of investing which is within your own control, as is factoring rebalancing opportunities and ensuring to monitor your portfolio. Designing a plan that you can stick to, but that is flexible enough to accommodate changes relating to your personal circumstances or market conditions, is also key. 

Use the eToro Academy to learn more about investing.

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FAQs

What is a value trap stock?

A value trap stock is one which appears cheap according to standard valuation metrics but is not a good buy because of some other factors. In the case of dividend stocks, a high dividend yield might make a stock look attractive, but it could be that the stock price has fallen because the firm’s management has signalled that future dividends are going to be lower than expected.

Should I look for high dividends or growing dividends?

This will depend on your investment aims. If receiving short-term income is your priority, then high-dividend stocks or the iShares Core High Dividend ETF would generate a more immediate cash flow. A stock with smaller but growing dividends signals that a company’s underlying business is improving and that it could be a better long-term bet.

Do unrealistically high dividend payouts threaten the future of dividend investing?

Yes. Some firms pay dividends partly because their shareholders expect them to. Not doing so could cause the stock price to crash as dividend investors exit positions. If your research identifies that a dividend is being paid despite that not being supported by the business fundamentals, then the stock price and dividend payouts could both fall as more investors draw the same conclusion.