Please, Tell Me. How Do You Pick Your Investments?

Charlie Bowers Finance 101, Income Planning, Income Planning, Insight Investing Articles, Investing, Investing & Planning

When push comes to shove, there can be a great deal of complexity in selecting the “right” investments for your retirement portfolio.  With so many investment choices and so much “noise” from the media, is there any way to come away with an inkling of confidence that you made the right picks?

Well a good place to start would be to understand what your investments “need” to do in your retirement portfolio, and in light of your “need,” what investments have the best chances of creating your successful future.

At Insight Folios the vast majority of the people we talk with have a need for income, and the need for that income to grow year after year due to inflation.  This being the case, the question of what the “best” investments for this scenario are, must be answered.

For this discussion, we’re going to assume that dividend paying stocks, in general, fit the bill.  But with selecting a dividend paying stock strategy comes the question of how to identify the right securities for your portfolio.

Let’s Take a Look at Some Important Characteristics of the “Right” Companies

1. Dividend Yield
We’re back to needs again.  If your strategy for generating income is dividend paying stocks, then you better make sure your total portfolio of dividend paying stocks creates all the income you need. For instance, if you need your portfolio to generate a yield of 4%, then your selection of stocks, as a whole, needs to yield 4% or more as your minimum threshold.

If you aren’t in retirement yet and can only estimate your minimum yield needed, an unscientific rule of thumb we lean toward is a 3% yield threshold, with the expectation that the positions held will offer plenty of quality dividend and total growth opportunities.

2. Dividend Safety
For our “income through dividends” strategy to work, we need to be pretty certain that the companies we invest in will continue to pay their dividends, and even raise those dividends on a regular basis.  For dividend safety, several characteristics should be considered:

  • A payout ratio under 90% - and the lower the better1
  • Dividends were not reduced or eliminated during The Great Recession
  • The company can easily service its debt
  • The dividend is more than covered by the company’s cash flows and earnings


3. Dividend Growth
Remember how most of the people we talk with need income, and that they need this income to increase due to the effects of inflation?  Declining purchasing power is not your friend. Any security in which you invest should be expected to grow its dividend at least at the rate of inflation going forward, and preferably significantly faster.

A long history of steadily rising dividends, along with earnings stability, especially through recessions, are good indicators that a company’s future dividend growth is likely. 

4. Company Fit
Although we are looking at dividends and a company’s ability to pay, it doesn’t make good sense to overload your portfolio with companies from a particular sector.  Too much of a good thing may turn out to be not such a good thing.

5. Company Understanding
If you don’t understand how a company makes money, then you may worry about holding on to it during downturns.  Better to avoid this uncertainty and potential emotional selling decision and stick to companies you better understand.

6. Company Value
Where is the company trading compared to its historical fair market value?  Is it trading above, or is it trading below? There is a risk to your money based on the likelihood of a security reverting back to its historical fair value.  In general it is preferable to invest in securities that are trading at or below their long term historical average price-to-earnings ratio.

7. Expected Total Returns
Finally, wouldn’t it be nice if the companies in which we invest were expected to grow on a per share basis as well as offering relatively secure and higher paying dividends?  The market has historically averaged total returns on the order of about 10% per year2.  Investing in securities with expected total returns less that the market’s historical average makes little sense.  We would certainly like to achieve market growth returns while enjoying our dividends, and we especially appreciate those dividends through market downturns where we still will be needing our income stream.

Bottom Line

Electing to invest in an income creation strategy through companies that pay dividends can be a great way to create your successful future.  However, not just any dividend paying security will do.

References:

1 What is a Good Payout Ratio?  Ani G, Apr 26, 2016   https://www.dividend.com/dividend-education/what-is-an-ideal-payout-ratio/

2 What Is the Average Stock Market Return? JAMES ROYAL, PH.D. & ARIELLE O'SHEA, Sept. 3, 2019   https://www.nerdwallet.com/blog/investing/average-stock-market-return/