Many people follow the dividend growth investing (DGI) philosophy to reach retirement. Like many, I can see why it is attractive. Dividend growth investing just means building a long-term portfolio of stocks with companies that have the ability to pay (and increase) dividends over a long period of time.

The hope is that the portfolio will get big enough so passive income from the dividends will be able to support your lifestyle in retirement.

Given that the strategy is popular with the personal finance community, I wanted to discuss common dividend growth investing mistakes you want to avoid. I’ve made some of these mistakes in the past, so hopefully others can learn from them.

Focusing Too Much On Yield

One thing I learned in school is that bond yields and risk are directly related. If a bond has a high yield, it is probably a very risky investment.

In fact, the borrower probably has a high rate of default so lenders must charge a much higher interest rate (or ‘yield’) in order to protect themselves. Conversely, a lower bond yield typically signals a safer investment all else equal.

The same analysis applies to investing in dividend stocks. DGI investors should always be skeptical of companies that pay very high dividends. In my experience, anything over a 5% yield should be heavily scrutinized.

Let’s go over a few reasons why:

1. First, companies in poor or secular declining industries often like to pay higher dividends (GameStop is one that comes to my mind). Their growth prospects are very bleak and revenue/cash flow will unlikely be much higher 5 or 10 years from now.

As a result, these companies like to pay higher dividends to attract investors. In my experience, these are very poor opportunities to invest in.

Many DGI investors focus on the yield, but forget that you can get burned by losing your principal (the amount of money you invested) due to share price declines. 

2. Second, high dividend yields may not always be sustainable. If the underlying business economics deteriorate, a dividend could be cut.

When a high paying dividend stock cuts its dividend, the result can be disastrous for shareholders. This is because investors who are primarily holding the stock for its dividend no longer have any reason to own it…so they dump it!

It’s not uncommon to see a 20%+ drop in share price when a dividend darling cuts its dividend.

Past Performance Does Not Guarantee Future Performance

When some dividend growth investors talk about their thesis they sometimes mention something like this:

“XYZ company has been in business for 200 years and has paid dividends for 30 years in a row.”

That’s great and everything, but past performance is no indicator of future performance. I always think of past performance like a resume. It tells me what you accomplished in the past. However, that means nothing to what you WILL do for me going forward.

Businesses change dramatically over short periods of time. In fact, the iPhone didn’t exist 10 years ago!

While a Company might have paid dividends for 30 straight years, the business back then might be completely different than it is today. As a result, it is not appropriate to extrapolate past data to justify any investment.

Cheap Does Not Equal Value

A lot of dividend growth investors like to focus on the numbers. This includes various valuation techniques such as price earnings or price-to-book.

They can tell you the history of a stock’s valuation multiple, but they don’t know too much about the underlying business.

In other words, they are not too familiar with the fundamentals of the business. If you ask them, they will not be able to tell you who the company’s largest customers are, what their most important products are, or even who the CEO is.

Don’t get too caught up in the numbers. More often than not, a stock is cheap for a specific reason…maybe the management team is inept or maybe the industry is in secular decline (i.e. a book store operator).

The point is, cheap does not equal value.

As Phil Fisher once said:

The stock market is filled with individuals who know the price of everything, but the value of nothing

Always remember: price is what you pay, value is what you get.

As an investor, you want the best VALUE for your buck, not absolute dirt cheap companies in the clearance bin. I’d rather pay up for a quality business than buy a crappy “cheap” business.

DGI Is Like Investing In Bonds

Some people confuse dividend growth investing with investing in bonds and other fixed income investments. The most obvious similarity is that both will both pay out periodic payments to investors.

However, investing in a dividend stock (or a portfolio of “dividend aristocrats”) is not even close to investing in U.S. government bonds.

The risks of losing money are far greater in dividend stocks than government bonds. A dividend can be cut and a company can go out of business. Dividend stocks cannot substitute a bond portfolio to act as a “safe” investment.

One other thing dividend growth investors focus far too much on is the actual dividend as I explained before. However, sometimes they forget they can lose money if the share price declines.

In certain scenarios, a big share price decline can even offset the annual dividend payment rate.

Don’t forget: dividends are not a replacement for bonds; they are merely an alternative.

Final Thoughts

Dividend growth investing is a great way to build a retirement nest egg. Like I always say, if you can avoid big mistakes you’ve already won the big battles. Hopefully this advice was helpful!

Readers, are any of you big dividend growth investors? Do you think I missed anything? Let me know in the comments!

P.S. If anyone is interested in learning more about investing or financial statement analysis, I have created a great course on Udemy on the subject. Click here to find out more!