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Five Expert Steps for Investing in Dividend Stocks

By:Tom Preston

Dividend stock investing requires more than just buying stocks with the highest dividend payments. See the video for a passive income primer.

Interest rates offered by bank CDs are the highest they’ve been in 15 years. But as high as they are, dividend yields on certain stocks are even higher.

If you’re willing to take more risk in exchange for potentially higher returns, there are lots of resources that can point you to stocks with high yields. But there’s more to it than just buying stocks with the highest dividend payments. Here are five tips to start building a portfolio of dividend-paying stocks.

1) A simple way to look for stability of dividend payments

You generally want to buy stocks in companies that are financially sound and that have enough cash flow to continue to pay the dividend in the future. But a quick way to evaluate a stock’s dividends is to look at the payment history over the past four years. Why four years? That covers the COVID-19 economy, the recovery and the rise of inflation. 

A company that has maintained its dividend without any cuts over that time is likely strong enough to keep doing that for the next year or so regardless of the economy.

2) Diversify across industry sectors

Some industries, like banks and telecoms, for example, have stocks with among the highest dividend yields. That’s because their stock prices are lower. And for a given dividend payment, a lower stock price can mean a higher dividend yield. 

But don’t put all your money into stocks in the same market sector just because they have the highest yields. Specific industries can get hit with selloffs even if the broader stock market is strong. 

To insulate your dividend portfolio from that, try to find stocks in four or five industry sectors at a minimum, and make equal investments in each of them to balance the risk.

3) Balance risk within industry sectors

In each industry sector, there will likely be one stock that has the highest dividend yield. But you might not want to put all your capital allocated to that sector in that one stock. The reason is that even within a sector, one stock has risks others might not have. 

If other stocks have approximately the same, reliable dividend yield, you can reduce company-specific risk through diversification. Take the capital you want to allocate to that sector and divide it evenly between two or three stocks that meet your dividend criteria.

4) Look for stocks that have options to add covered calls to enhance returns

I thought this article was about dividends! Well, it is. But in the context of generating returns on your investments, a covered call can do that, too. Selling an out-of-the-money call, which has a strike price higher than the current stock price, generates a credit to your account. 

That does a couple of things for your dividend-paying stock. First, the credit from the short call can partially offset the risk of the stock price dropping, just like a dividend can. And second, it can increase the return on capital of the stock investment, just like a dividend can. 

Now, a short call on the long stock limits its upside potential. But that can mean that the stock price has risen to a point where the return on the investment is significant. It can be a first-class problem to have

5) It’s not a short-term strategy

Dividends have several dates involved: the ex-dividend date, the record date, and the payment date. Most stocks pay dividends quarterly to people who own shares. Who owns those shares is determined on the ex-dividend date. 

If you don’t buy or own the shares before that “ex-date," you won’t be considered eligible to receive the dividend. And if you buy the stock after the ex- date and sell it before the next quarter’s ex-date, you won’t be eligible to receive the next dividend, either. 

Also, the price of a stock could drop by the dividend amount on the ex-date. So, buying the stock right before the ex-date to get the dividend may not actually be profitable. That’s why for a dividend portfolio, consider holding the stocks for at least one quarter or longer.

Because it’s possible to buy single shares of stock, and even one share of stock can receive a dividend, an investor can experiment with building a dividend portfolio with relatively low risk and a smaller amount of capital. That’s why it can be a good strategy for novice investors.

Tom Preston is chief market strategist at tastylive. He is responsible for overall trading strategy, client-facing trading software, and futures trading products. He is also an author for Luckbox magazine and tastylive's Cherry Bomb newsletter. 

For live daily programming, market news and commentary, visit tastylive or the YouTube channels tastylive (for options traders), and tastyliveTrending for stocks, futures, forex & macro.

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