Blue Chip Dividend Stock Investing

This approach is generally going to be a suboptimal investing strategy compared to indexing or stock picking based on long term business expectations.  However, this strategy has two major qualities that will make it appealing to many investors.

• Passive income;

• Scale allowing for it to be a sole income source;

• A gateway into more sophisticated investing;

This strategy can be used to generate very close to actual passive income.  This approach requires very little ongoing effort and when done well can generate reasonable ongoing returns.  This can help investors psychologically in that returns will keep generating under most conditions, even when overall markets are lackluster.  It also helps investors with volatility in that returns keep coming in regardless of current lower or higher value of the underlying stocks.

At scale this approach can easily result in enough funds to live off of.  Other strategies require more attention and moves to enable an individual to live off them.  Eventually, in most cases the goal is to be able to live off your investments without needing other sources of income and this strategy naturally lends itself to that outcome.

This strategy is, for many investors, a good intermediary step to more sophisticated investing approaches.  It is simple to follow, and the individual investments are typically stable and high-quality companies that have been around for a long time; which can also mean that they will experience lower volatility.  The ongoing returns also help investors deal with downturns in less emotional ways as they can see their investments continuing to generating returns.

This approach is not without drawbacks, primarily as mentioned it is likely to be suboptimal and over the long run generate lower returns.  Dividends in general are less tax efficient that capital gains in most cases.  The types of companies that are invested in using this strategy are in most cases less risky, but also normally offer lower long run returns as a result.  They typically have low growth prospects, which is why they pay sizable dividends to investors.  This strategy could be somewhat risky for particularly young investors in that limiting exposure to growth investments could have significant long run detriments to total returns of a large magnitude.

In short this is a relatively safer way to own individual stocks and generate an easy to observe return.  Because of these qualities it is often a good way for individual unfamiliar with buying individual stocks to start out and overtime become comfortable with the process.  It also has an advantage in that it is relatively easy way to live off investments.  A side note, using advance techniques that involved leverage can supercharge this strategy, essentially take a lower risk approach and making it higher risk, to generate additional returns, but that is only for individuals who have considerable time in the market and understand how to manage themselves in relation to the market.

The mechanics of the approach are relatively simple.  The idea is to identify a number of large stable businesses (“Blue Chip”) that pay a dividend and buy a number of them to achieve a reasonable level of diversification.  These can generally be found in certain sectors such as utilities, finance and infrastructure.  Filtering for a large market cap, with reasonable dividend sizes will often provide a good place to start.

Depending on funds available for investment selecting between 10-20 of these types of companies will provide reasonable diversification.  Note that there does tend to be some sector risk as this type of approach will tend to be more weighted to certain sectors such as utilities and finance.  It is a good idea to look out for businesses from other sectors that have similar qualities, solid dividend and sufficient large market cap, if you can find them, to reduce sector exposure.

A key consideration for this exercise is not favor the highest dividend paying stocks.  These generally come with significant risk, which is why they are paying a higher dividend.  So avoid the top 25% highest dividend payers.  Also, too small of dividend is not likely to be satisfying so avoiding stocks that pay a miniscule dividend is best.  So avoid the bottom 25% lowest dividend payers.  Seek out the middle 50% of dividend payers, favoring the top middle quartile over the bottom middle quartile for solid long run returns.  Use the bottom middle quartile if you have a need to reduce sector risk, or you discover a compelling opportunity in the bottom middle.  The third quartile (top of half of the 50% middle dividend payers) have been shown to provide solid, sometimes market beating returns in the long run.

You can choose to cash out your dividends, or reinvest them.  If you choose to reinvest dividends you can reinvest into the same company paying the dividend, or different companies.  Great long run returns can be earned reinvesting dividends.  If you choose to reinvest, consider a dividend reinvesting program where the dividends are automatically reinvested in a stock, as in some jurisdictions that can have tax advantages, depending on the program.

In terms of expected return of this strategy, it will probably be lower than an indexing approach, if for no other reason than it is less tax efficient.  However, if you stick to solid companies, paying solid dividends, it is possible to achieve to achieve around a 10% long run return considering dividends, capital gains, and reinvesting dividends.  In some cases returns will be even higher.