If you are anything like me — conservative and low tolerance to risk, then becoming an active trader in the market can feel frightening, or even downright exhausting. You certainly don’t want to waste your hard earned money by going with the market flow or simply because your friend told you to buy or sell a particular stock. Sometimes you get lucky. But in most cases, this form of investing is often compared to mere speculation and it feels dangerously close to gambling.
Anyone knows that a great way to become an effective investor in the stock market is to diversify your portfolio, whether that be through ETFs, bonds, mutual funds, or thematic stocks. But what a few people may not understand is that equally important to building a portfolio strategy is adopting the right style to match the investor’s personality and financial goal. There are 3 major styles: growth, value, and income investments. Knowing the key difference among the 3 might give you that extra edge to differentiate yourself from a mere speculator to a serious investor.
Here is a quick overview of their definitions:
These stocks consist of smaller firms that have a huge growth potential in the near future. Their P/E ratio is usually high and investors expect returns in the form of stock price increases. Important to note, however, is that these type of stocks are extremely risky.
Value stocks are undervalued companies that have a high dividend yield and low price-to-earnings ratio. When stock prices become deflated due to market reactions from news, value investors view this situation as an opportunity to make large gains.
Investors who adopt this particular style aren’t looking for stellar growth potential. Instead, they prefer to have a steady stream of supplemental income that performs consistently well. For conservative investors like myself, income stock is a great consideration. And the rest of this article will primarily focus on this style of investing.
Getting the Basics Down
To understand income stocks in detail, you first need to know dividends. A dividend is a form of payment that companies give to their shareholders, paid usually on a quarterly basis. For example, if your company has a dividend of $8 dollars, you’ll get paid $2 dollars every quarter for 1 share. That’s a total of $800 dollars in 1 year if you own 100 shares. Income stocks tend to be the least volatile of all stocks, which means they are considered popular choice among conservative investors.
Many investors equate income stocks with defensive stocks. Defensive stocks are known for their stable earnings regardless of the outside economic conditions. Some examples include utilities like water, gas, and electricity, consumer staples, health care, and energy. Even during economic downturns, people still need these resources to perform their daily tasks. Thus, including defensive stocks in your portfolio can significantly reduce volatility and increase stable returns.
But before we dive straight into defensive stocks, we first need to consider some potential drawbacks. Investing in general guarantees no fixed returns and income stocks are no exception. Factors that affect the overall stock market — politics, trends, risks, etc. can and will affect income stocks as well.
If an investor is looking to make short-term profits, he won’t be able to find them through income stocks. That’s because defensive companies use their profits for dividends instead of reinvesting in their businesses for growth. Another major disadvantage is inflation. While some companies raise their dividends in regards to the rate of inflation, others simply don’t. This means that while your costs increase, your income will shrink in value over the coming years.
Who is This For?
Income stocks are well-suited for these 4 types of investors:
- Conservative — Investors who prefer to have a consistent approach to growing their money, all the while receiving a steady stream of dividend income on the side.
- Beginner — Anyone who wants to start investing, but feels too overwhelmed to study the market and actively invest through common stocks.
- Retirees — Retirees may want growth in their portfolios, but their main concerns usually consist of bringing in regular income that keeps pace with inflation. These type of investors usually don’t have much wiggle room to move their funds around.
- Dividend Reinvestment Plan (DRP) Investors — These particular investors look to reinvest their dividends for price appreciation or compounding without the burden of paying brokerage fees. Income stocks fit well with their goals.
How to Buy Dividend Stocks?
A key point to choosing an income stock is to find a company that has a good track record of paying consistent and uninterrupted dividends over numerous years. A healthy company should have a steady history of paying dividends in a 5-to-20 year timeframe. If a company has shown a rising dividend, it means that the company was able to deliver a promising growth in the past.
To go deeper, you’ll need to understand how to analyze the company’s financial statements and industry. In business, a financial statement acts similarly to a progress report, showing how much money a company has and how much debt is currently owed. The four main factors that go into a financial statement are balance sheets, income statements, cash flow statements, and shareholders’ equity statements. Knowing these valuable insights is extremely critical to choosing not just dividend stocks, but general stocks as well.
Perhaps the most important factor to consider when purchasing a dividend stock is the safety of its yield rate. In other words, you need to understand the company’s payout ratio. A payout ratio is the percentage of a company’s earnings that’s given to its shareholders. Anything above 80% is generally considered dangerous because it means that the company is paying more dividends than its earnings. The lower the rate, the better your chances will be at growing your stocks over long-term.
While investing is tough, there are several ways to get educated in this day and age. Income stock is a great way to get started for investors looking for a safer route. Not that dividend stock rules out all risk, it still manages to offer more stability than volatility compared to other types of investments. At the end of the day, whatever your reasons are for investing, the most important factor to consider is to understand your goals and know in great detail where you are putting your money in.