It is almost a cornerstone of my investment philosophy, at least for now and over the past few years: I virtually never touch a stock that doesn’t pay a dividend. In fact, not just any dividend—it has to be a good one, with a yield of at least 4% to 6%. This approach has worked well for me, helping me build a significant passive income stream that will, hopefully, one day replace my salary and allow me to achieve financial independence.
But there’s one big problem: among these high-yield stocks, I’ve bought into a few bad apples—ones that, over time, have proven to be dividend value traps. These assets initially generated high yields, but the moment they faced challenges, whether from inflation or high debt, they slashed their dividends by half, or even two-thirds. Overnight, what had been a reliable income source became a burden. Worse still, the stock price often plummeted, as investors lost trust in the company, further compounded by the sudden sharp decline in yield.
What is the magic formula?
If dividends are a cornerstone of your investment philosophy, focusing on value stocks with moderate yields can be a wise strategy. These stocks are typically issued by companies with relatively large market capitalizations, known for consistently paying dividends over years—sometimes even decades or centuries.
However, the yield is a critical factor. While there’s no universal threshold, yields below 6% are generally considered safe. Conversely, when yields begin to rise sharply—often a result of a significant price decline—it’s a red flag. Such a scenario may indicate underlying issues with the company’s fundamentals, signaling it’s time to proceed with caution or even consider selling.
To guide my own investment decisions, I’ve developed a yield benchmark that I aim for when buying stocks: approximately 5.75%. This figure comes from a long and personal backstory, but what’s most important is that it works for me. It strikes a balance—high enough to generate meaningful passive income but not so high that it exposes me to the risk of a dividend cut.
When determining your own investment objectives, think about the yield you aim to achieve. Once you’ve set a target, use it as a guide when evaluating companies. However, don’t treat this number as rigid; instead, remain flexible. For instance, if you come across a solid company with strong growth potential but a lower yield, it may still warrant consideration. Flexibility can help you balance your long-term goals with opportunities for diversification and growth.
Dividend paying stocks are great to have, as it acts as accelerant for your journey towards financial independence. But it can also end up harming your portfolio if high yield is all your care about, as a lot of these stocks that have a high yield, end up being value dividend trap; slashing their dividend significantly to pay debt etc. Do your homework and have an average yield in mind to guide you.