How To Build a Dividend Portfolio for Passive Income

Dividend Investing, Income Investing
Dividend portfolio: A couple meets with a financial adviser

The stock market can pave the road for a comfortable retirement. But many investors don’t put in the work it takes to become informed, instead treating the stock market like a trip to Vegas. They’re not investing — they’re gambling.

The right strategy will not only help you secure a super-cushy nest egg, but it can deliver on something even better — passive income.

Passive income is just what it sounds like. Cash comes in while you sit and watch. Or sleep. Or sip a frosty drink on a white sandy beach. Not bad, right?

But before you can enjoy all the benefits of passive income, you’ll need a basic understanding of how to build a dividend portfolio with strategically selected stocks. We’ll show you what strategic dividend portfolios look like, how they work, how to assess dividend stocks for your portfolio, and why recurring dividend payments can be a game changer for your future.

What Is Dividend Investing?

A hand holding ripe grapes in a vineyard

Dividend investing is a strategy. You buy stocks that pay reliable dividends so you can generate regular income from your investments. You hope they appreciate in value, but whether the value goes up or down, you’re still collecting money either way.

Imagine a vineyard.

You’ve nestled these beautiful plants into the hillside, and the grapes are growing abundantly.

Do you cut down the vines? Of course not.

You harvest the grapes, make your wine, and go on your happy way.

And then, when the next harvest season rolls around, the grapes grow, and you pick them all over again. The vines live to see another day and continue to produce results.

It’s the same with dividend stocks.

Like we said before, you’re hoping that the stock appreciates in value over time. But the dividend income provides a cushion, so you’re in no rush to cut down the vines by selling your shares.

Dividend investing creates a stream of income in additionto the appreciation of the stock price itself. But when dividend stocks are strategically selected, the portfolio will have several dividend payouts during the year, rather than just one harvest season.

What Dividends Say About a Company

Dividends are an indicator of a company’s viability.

When the company is profitable, it is free to do a number of things with those profits. One option is to share profits with its stockholders.

Keep in mind that companies are not required to pay dividends and can stop doing so at any time. So naturally, when you see a company consistently paying out dividends or — even better — increasing their dividend payout, the company is signaling its confidence that it will continue to operate profitably.

Dividend Portfolios vs. Fixed Income Portfolios

The fact that companies aren’t required to pay a dividend means that dividend income is not fixed. It’s not 100% reliable. And that is how a dividend portfolio will differ from one that is heavy in bonds or CDs.

Perhaps you’ve heard before that risk and reward are a package deal. You’ve got to tolerate a bit of risk to have a chance at a greater reward. And, of course, the opposite is true.

Income from bonds and CDs — although not known for being particularly lucrative — is fixed. It’s safe.

Stocks that pay dividends can also be some of the safest stocks to own. But since a company is free to cancel its dividend program at any time, you can put yourself at risk if you don’t do your research.

The unfixed nature of dividend programs can be both good and bad.

  • The good: The flexible nature of the product means that there is more opportunity for income growth with dividends. Risk and reward, remember?
  • The bad: If a company finds itself needing to cut expenses, the dividend could be the first thing to go. So, it is important to build a portfolio with a margin of safety that is balanced and diversified for various risk factors.

You’ve surely heard that diversifying your investments is a good idea. It’s true for dividend portfolios as well.

By diversifying the dividend stocks you choose, you avoid putting all your eggs in one basket. This limits your risk exposure and minimizes the volatility in your dividend portfolio.

Dividend Portfolios: How Stable Are They?

There are a number of ways to determine the degree of stability in a dividend stock. Here are some of the things you should do when you’re assessing a possible investment.

Understand the Company

Understanding the company, its industry, and its current position in that industry is a good first step. Determine whether the company is likely to remain on its expected trajectory. Then, dig in to understand how stable the company’s income and dividend payouts have been over the years.

As mentioned earlier, a company doing well is likely to continue paying dividends at the current rate — or potentially increase the dividend over time.

Consider Market Volatility and Current Events

A number of factors impact market volatility, and those factors differ among industries. Competition, supply, demand, and potential disruptions should all be considered.

Think about current events and how the stock will perform in the near future as well as in the long term.

Take the COVID-19 pandemic, for example. REITs, health care, online retailers, and tech stocks flourished, while airlines, restaurants, and the travel industry were crushed.

Review Dividend Payout Ratios

There are also many resources you can find that rank stocks by dividend stability. The rankings are determined by a combination of qualitative and quantitative factors.

Comparing a company’s earnings to its dividend payout ratio is another common indicator of stability. A payout ratio is the total amount of dividends paid to shareholders in relation to the total net income of the company.

The payout ratio provides insight into how much money the company is paying to shareholders versus how much money the company is using to pay off debt or reinvest in the company.

In simple terms, the payout ratio tells investors about the company’s maturity. New growth-oriented companies are trying to expand and grow, so payout ratios are likely to be lower. A higher payout ratio indicates that the company has moved past the initial growth phase.

For example, let’s assume a company earned $10 million last year and paid out $4 million in dividends. The dividend payout ratio is 40%.

A healthy payout ratio is typically between 30% and 55%. Ratios higher than that are difficult for companies to maintain over the long term.

Look at Dividend Yields

Dividend yield tells investors the ratio of dividend payout per share to stock price per share.

For example, if a company’s annual dividend is $1.50 per share and the stock trades at $30 per share, you divide $1.50 by $30 to calculate the dividend yield. In this scenario, the dividend yield is 5%.

The best dividend stocks have yields of 4% or more. However, be wary of an unusually high dividend yield. If a dividend yield appears too good to be true, it usually is.

A high dividend yield could be a signal that:

  • The stock price has taken a nosedive.
  • The company might be stretching beyond its capacity and paying out dividends that don’t make sense in relation to its balance sheet and debt levels.

Investors typically view dividend yields between 2% and 6% as healthy. But of course, some dividend stocks with higher payouts are legitimate money makers.

Like with any investing strategy, you’ll want to look at a combination of the above factors when making decisions about how to invest your money and plan for your future.

How To Become a Strategic Dividend Investor

Dividend portfolio: Two hands pointing at graphs and charts

Strategic investors will take a holistic view when building their dividend portfolios.

You know who else likes a simple and holistic approach?

Warren Buffett.

In Buffett’s 2019 annual letter to shareholders, he advised “thought and principles, not robot-like ‘process’” should guide decisions.

He went on to say, “We constantly seek to buy new businesses that meet three criteria. First, they must earn good returns on the net tangible capital required in their operation. Second, they must be run by able and honest managers. Finally, they must be available at a sensible price.”

So, how can we follow his lead?

Build a Portfolio That Stands the Test of Time

A portfolio that stands the test of time will strategically combine income investing with equity investing. The goal of income investing is to earn recurring income, while equity investing focuses more on stock price appreciation.

By combining the two, you can improve the likelihood that your portfolio will withstand inflation and market volatility. This lets those vines continue to grow as you harvest your dividend income year after year.

Seek Out Consumer Staples

Industries that deal in consumer staples will be less sensitive to unpredictable external factors, making them more stable. Food, personal care items, and beverages are some examples of consumer staples. However, be sparing with more discretionary sectors, like entertainment and general retail.

And although industries like info tech and health care aren’t considered consumer staples, they continue to shape the economy and also merit consideration.

Assess the Markers of Confidence

Remember, a rising dividend is a sign that a company is feeling confident about its future performance. So, look for companies, mutual funds, or exchange-traded funds with a proven track record of raising their dividends each year. If management has confidence in the company’s growth potential, so should you.

Look for Dividend Aristocrats

Instead of trying to figure out some magical formula for building a dividend portfolio, simply focus on quality companies with a proven track record of dividend growth. These stocks are often referred to as “Dividend Aristocrats.”

Companies in the S&P 500 earn this title when they have paid and increased base dividends every year for at least 25 consecutive years. The S&P Dow Jones Indices reshuffles a list of companies who qualify every year.

3M (NYSE:MMM) currently tops the list with 57 years of consecutive dividend growth. You’re also going to find your blue-chip Wall Street darlings like Coca-Cola (NYSE:KO), Johnson & Johnson (NYSE:JNJ), and Colgate-Palmolive (NYSE:CL).

Time To Start Building a Dividend Portfolio

It really all comes down to how you think about your dividend portfolio. Think like an investor, not like a gambler.

With dividend stocks, you can leave your principal investment alone. After all, you’re building this portfolio to stand the test of time. And, if you do it right, you’ll provide an ongoing stream of income for your future.

Passive income can mean early retirement and financial freedom. Those are two pretty life-changing things — wouldn’t you say?

So harvest your grapes, sit back, and enjoy a glass of wine while you look out over your vineyard that might just be the start of intergenerational wealth for decades — or centuries — to come.

Now that you’re thinking about building an income stream with dividend stocks, you’re getting that much closer to financial freedom and the retirement plans you’ve always dreamed about. To keep that momentum going and learn about three dividend stocks we think you should buy and hold forever, subscribe to Investors Alley “Dividend Hunter” newsletter.