This article is intended for the young investors whom I have classified as those people between the ages of 19 and 25 years.
Does It Pay to Be Risky?
One of my biggest pet peeves is hearing people say "You are young, you can afford to take risk," or "You are supposed to be risky when you're young." I never really understood this concept, and I believe young investors should be taking exactly the opposite approach to investing. Although the young investor would have time to recover any losses, losing on one investment would be a larger portion of one's portfolio when compared with the older investor.
I would encourage young people to use the power of compounding over a longer period of time, rather than going for the "home run" with high-risk investments. By investing in dividend (growth) companies, investors have the option of either re-investing shares through a DRIP program, or taking the dividend as cash and then purchasing stocks in another company. The power of compounding dividends can generate great returns given the longer time frame.
Most investors agree that it is a wise strategy to diversify within one's investment portfolio, and there are different approaches in order to reduce risk. Some investors like ETFs/mutual funds, while others prefer to invest in a variety of stocks across various sectors. I agree that it is important for investors to diversify, but I would like to offer a different perspective for young people as they begin to develop their portfolios.
It is hard for young people to save money on a starting salary because they have limited funds, and often they are dealing with a financial commitments for housing, food, transportation costs, and repayment of student loans. As a result, I do not think diversification is as important in the beginning stages. I also believe that young investors should buy individual stocks to grow their portfolios, rather than purchasing ETF's and paying annual fees. Therefore, young investors might not achieve much diversification, but as they are able to save more money, they can initiate positions in core holdings which will allow the portfolio to grow. Since young people are not relying on the funds to cover daily expenses, the lack of diversification is reasonable at this time.
Why Dividend Stocks
As previously mentioned, dividend stocks offer investors the opportunity to continue to compound their money without depleting the initial investment. Although it is not ideal, it is possible for investors to use the dividend income for payment of bills and/or to repay loans. If the interest rate on the borrowed money is less than the yield of the dividend, then it allows the person to pay off the interest, and continue to accumulate wealth. This is compared to owning a stock strictly for capital appreciation and being forced to cut spending or to take on more debt.
High Dividend Growth Please
Now that it has been established that I prefer dividend-paying companies, I would like to suggest that young investors should focus on stocks that have large dividend growth potential. Mature companies such as The Coca-Cola Company (NYSE:KO), Exxon Mobil (NYSE:XOM), and AT&T (NYSE:T) offer investors great dividends. I think that young investors can choose companies that are still in the growth stage, as these companies were many years ago. This gives young investors the opportunity to purchase stocks with a dividend of $0.20/share, with the potential for dividend growth to $0.80/share over the long term. The goal is that the share price will continue to rise with the increase in distributions similar to the KO chart below.
As one can see in the graph for KO over the past 10 years, the dividends paid and the share price tend to coincide. Therefore, with higher dividend growth, and lower current yield, the possibilities of more capital appreciation is present.
Result of High Dividend Growth
Take KO for example, if they increased their dividend today by 20% with their pedigree, investors would rush to own the stock and would believe that there is growth in the company. Therefore, it can be said that if companies like Visa (NYSE:V), MasterCard (NYSE:MA), Starbucks (NASDAQ:SBUX), and Tim Hortons (THI) continue to grow their dividends at current rates, with big dividend growth prospects ahead of them, one can expect share appreciation. I am not recommending purchasing these companies although I did write an article about Tim Hortons and its dividend growth potential, but they are simply examples of the types of companies that I believe young investors should consider owning as part of their portfolios.
I think that the blue chip, mature companies are still good choices. However, I also believe that investing in companies that have the ability to join (or continue to stay on) David Fish's CCC list, and become the next dividend challengers, contenders, and champions, offer young investors greater opportunity to increase their wealth.
Overall, this article was meant to give young people a path to become successful investors. In my opinion, it gives them the framework to increase wealth by using time to their advantage. It enables young investors to compound their money and hold stocks for the long term. Over time, young investors will be able to add holdings to their portfolio to diversify further and increase its value.
Disclosure: The author is long KO, THI. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.