In a second example, if interest rates increase dramatically to say over 6%, and your portfolio is yielding say only 4%, there is no room for concern as long as the business fundamentals of your holdings are still sound on aggregate. You should not be worried, because your portfolio will generate a growing stream of income to compensate you for the faster increase in inflation. Therefore, if your portfolio is worth $500,000 and generates $20,000 in annual dividend income to cover all of your expenses, rising interest rates should not mean anything to you.
It is true that you can sell your dividend stocks, and earn $30,000 in annual interest income. However, this stream of income will be certain to lose purchasing power in the inflationary world that produces yields of 6%. In addition, if rates increase further to say 8%, your bonds yielding 6% would surely lose value and you would still only earn 6% on your cost. However, if you didn’t do anything in the first place other than hold on to your sound businesses, your dividend portfolio would have likely delivered the growing stream of income that would have ensured purchasing power even as interest rates kept increasing.
A third way to mitigate certain risks is through diversification. Diversification gets a lot of bad rep, but it could protect your assets in the case things take an unexpected turn of events. Let’s face it, no one can predict the future. Therefore, even if you know everything there is about a company, you can still lose money on this investment if an unexpected turn of events occurs.
If you hold less than 10 – 15 individual dividend paying stocks in your portfolio, you are likely asking for trouble. This is because just a bad apple or two could seriously derail your dividend earning potential for a few years, thus potentially causing you to dip into principal. You should also try not to concentrate your portfolio in companies that are in similar industries.
If you owned ten oil and gas companies, and five pipeline MLPs, you are not diversified adequately. Many investors have been betting heavily on major energy companies in 2013, but they might be ignoring the fact that they have no pricing power. If commodity prices drop, those earnings could cause dividend freezes across the board. In addition, having a slight 20-25% allocation of US Government bonds could help you avoid losing sleep in case deflation happens. Unfortunately, since 2010 it has been difficult to get decent returns with Treasuries and Agencies in terms of yields.
During any of the scenarios above, and probably others that I cannot even conceivably forecast today, you would likely get a pretty negative sentiment towards dividend investing. This is actually fine, because as a true contrarian investor, you should be happy when everyone hates your strategy. This is because when the fans of your investment style are few, security prices are usually lower as there is less competition from others. So, anytime you hear about the death of dividend investing, rejoice a little. This is because lower entry prices for the quality companies we discuss on this site would translate into better entry yields for you. This could potentially help you reach your financial goals much sooner.
In conclusion, dividend investors can expect some temporary short-term discomfort when holding dividend paying stocks, due to some of the reasons above.
However if the dividend investor did their homework in stock selection and bought shares at reasonable prices, they can afford to simply sit down and watch their capital compound over time. This is because on aggregate, their portfolio of quality businesses will keep earning more, and showering him or her with more cash each year. This rising stream of dividend payments coming to his bank or brokerage account will provide this investor with the strength to keep holding, even during the most turbulent times.
Full Disclosure: Long PG and KO