5 Rules For Building A Dividend Portfolio You Can Live On

This is a guest contribution from After School Finance

If you’re looking to build a dividend portfolio that provides consistent monthly income, you’re not alone. Dividends are the most passive stream of income there is – they truly are “mailbox money.” If you want to build a consistent stream of dividend income, there are some best practices you’ll want to consider. Today, I’m sharing with you five rules for building a dividend portfolio you can live on.

Rule #1: Diversify Your Portfolio

First, if you plan to someday live primarily on dividend income, the number one rule is that you must appropriately diversify. Failing to diversify adequately is one of the most common investing mistakes.

Here’s why: there are many great dividend stocks, but sometimes companies hit a snag, causing them to slash their dividend. If you own just one or two dividend stocks, you could find yourself in trouble.

One such example is BP. The company had a long history of paying high dividends to shareholders. Then, in 2010, the unthinkable happened. When the BP oil spill took place, the company ran into significant financial turmoil. As a result, the dividend dropped to zero for three full quarters. And, when the dividend did return, it was less than half of its pre-oil spill level.

While this is a frightening example, it makes it easy to understand why you can’t own just one or two dividend-paying stocks.

Modern portfolio theory indicates that you’ll want at least 30 or so stocks to reduce portfolio volatility and unsystematic risk. And not only do you want to own a substantial number of stocks, but you’ll want to make sure to diversify across industries.

For example, oil companies have historically paid strong dividends. However, as the world evolves towards more green energy, these companies may struggle. So, you’ll want to make sure you have diversification across other industries such as technology, consumer staples, etc.

Properly diversifying can reduce your risk both as you build your portfolio and once you leverage it as a primary stream of income.

Rule #2: Select Companies with a History of Dividend Increases

When building a dividend portfolio, it is easy to be tempted by “shiny object syndrome,” or in this case, “shiny dividend syndrome.”

As crazy as it sounds, there are stocks with dividend yields of 10%, 15%, or even more. However, dividends this high are often from companies in unstable financial positions.

High dividend yields can happen as the result of dividends going up or share prices going down. For example, let’s say a company has a share price of $100 and a dividend yield of 5%. If the share price drops to $50 and the dividend remains unchanged, the dividend yield goes to 10%. What can you infer about a company whose stock price drops by 50%? It probably has some significant challenges.

Instead of investing in high-flyers that may or may not maintain their dividends, instead choose to invest in Dividend Aristocrats who have a long history of maintaining or raising their dividends.

Want to take this one step further? You can achieve one-stop diversification amongst dividend aristocrats through ETFs or mutual funds. For example, the Vanguard Dividend Appreciation ETF holds over 200 stocks that have a consistent track record of dividend increases – allowing you to invest in a broad basket of Dividend Aristocrats at a very low cost.

Rule #3: Dollar-Cost Average

Spoiler alert: building a dividend portfolio you can live on is a get-rich slowly kind of game. You’ll need to invest consistently over a long period to create a large enough portfolio to allow you to live on passive income.

Because of this, you’ll need to make share purchases at regular intervals. You may be wondering what the right time is to make these investments. The answer is that it’s impossible to know – it simply isn’t possible to time your investments.

Instead, take up an approach called dollar-cost averaging. Using this approach, you’ll purchase shares at a regular interval (e.g., monthly). As a result, some of the shares you buy will cost more, and some will cost less. And that’s okay! Because in the long run, time in the market beats timing the market.

Rule #4: Protect Against Inflation

The next rule of making your money work for you is to defend against inflation. Let’s assume you buy a dividend stock with a 3% dividend yield. If inflation rises to 3%, what is your real return? Zero.

While it’s essential to build a portfolio that keeps pace with inflation, that’s just the beginning. Because to live entirely off passive income, you’ll want to create a portfolio that continues to grow at a rate faster than inflation, even when you stop feeding it new investment dollars.

To stay ahead of inflation, you’ll need to take some risks with your portfolio. For example, while utility companies have a long track record of solid dividends, there is limited upside in these stocks. Why? Because it is challenging for these companies to grow earnings substantially.

Compare this to a Dividend Aristocrat like Walmart (WMT). Walmart has ways to increase its earnings power. For example, in recent years, Walmart has ramped up its eCommerce business to try to take share from folks like Amazon (AMZN).

When companies find ways to increase the bottom line, the stock price usually follows suit, creating additional upside for shareholders beyond the dividend payment. And this upside is what can help you stay ahead of inflation.

Rule #5: Plan for the Downturn

Finally, when setting up your dividend portfolio, make sure you plan for the downturn. Here’s what I mean. Let’s say you need $50,000 per year of dividend income to live off of your investments. If your stocks have an average yield of 3%, this means you’d need approximately $1.67 million invested to generate $50,000 of passive income.

So, imagine that you’re gearing up for retirement and have finally hit the $1.67 million mark. Are you finally in the clear to retire? Personally, I vote no.

Let’s say you hit this marker, retire, and then the economy takes a dive. Suppose your average portfolio yield gets cut to say 2%. In that case, you’re now only bringing in $33,400 of dividend income, leaving you with a shortfall where you may need to start cannibalizing your portfolio to maintain your income.

While it’s great to set a target number, you should build in a cushion so that you don’t end up in a bad position if the stock market takes a dip during your retirement.