Dividend investing is a strategy that appeals to investors young and old. One compelling aspect of a dividend-focused portfolio is that it should pay regular dividends regardless of what the market is doing. In a down market, dividend investors continue to get paid while they wait for their portfolio to recover. Another more glamorized notion is the idea of living off the dividends – building a portfolio that churns out enough income that you never have to touch the capital.

But is dividend investing a good idea? I dabbled in dividends when I first learned how to start investing. I learned the pros and cons of this approach, pitfalls to avoid, and some alternatives that may lead to better outcomes. So I’m going to share everything that I’ve learned about dividend investing with you.

My dividend stock strategy

I got into dividend investing after reading about an approach called the Dogs of the TSX. In this strategy, investors buy the 10 stocks with the highest dividend yield, hold them for one year, and then rebalance with next year’s top 10 dividend-yielding stocks.

This strategy claims to work because stocks with high dividend yields tend to be value stocks that have recently seen a large drop in price. Investors are buying 10 value stocks, collecting big dividends, and hopefully riding their eventual return to better prices.

As I read more about dividend investing I learned about dividend growth stocks. These stocks are commonly referred to as dividend aristocrats – companies that have a long history of increasing their dividends over time. One big proponent of this approach is an investor named Tom Connolly, who ran the Dividend Growth website and produced a popular newsletter for his subscribers.

Connolly said that a portfolio of Canadian dividend growth stocks, of which there were only 20 or so, should outperform the broader market while steadily paying rising dividends over time.

I opened a discount brokerage account and slowly built a portfolio of 24 Canadian dividend-paying stocks in my RRSP, which at the time was worth about $100,000. I tracked my returns and benchmarked them against the broader market and also against iShares’ Canadian Dividend Aristocrats ETF (CDZ).

Indeed, from August 2009 to December 2014 my portfolio trounced the market – returning 14.79% a year compared to 13.41% a year for CDZ and 7.88% for the TSX, as represented by the iShares ETF XIU.

Pros and cons of dividend investing

Dividends give investors an emotional benefit. Think of the stock market moving up and down like a roller coaster. Index investors need to accept that volatility and hope that prices continue to rise over the long term to help meet their investing goals. Along the way, these investors might panic and sell when markets correct or even crash. Dividend investors, on the other hand, draw comfort from the fact that every month or every quarter they continue to receive a dividend payment. They’re earning something from their investment, even when markets fall. Dividends help investors stay in the market for the long term.

On the downside, dividend investors may not be as diversified as they should be. Dividend investors miss out on the returns from growth stocks like Facebook, Amazon, Alphabet, and Netflix, among others. Canadian dividend investors are even less diversified, as our economy is driven by mostly banking and energy. This lack of diversification may lead to poorer long-term outcomes compared to simply buying a market-tracking index fund or ETF.

Regardless of whether you buy dividend stocks or ETFs, to get started, you’ll need to open a discount brokerage account online. View our ultimate guide to Canada’s discount brokerages.

More: What is a dividend reinvestment plan

Alternatives to dividend investing

In 2015, I made the switch from dividend investing to index investing. My portfolio is now made up of just one asset-allocation ETF – Vanguard’s VEQT – which I feel gives me maximum diversification across the globe for a very small fee.

Index investing is likely the biggest alternative for dividend investors. Today, Canadian investors have access to low-cost, broadly diversified ETFs and can build a retirement portfolio with just one or two index funds. That was the compelling draw for me, versus researching and keeping tabs on dozens of individual companies. Just buy the entire market cheaply and prosper.

Dividend investors can also get dividend exposure by purchasing a dividend-focused ETF like Vanguard’s VDY (High Dividend Yield Index), which charges an MER of 0.23% but pays a juicy yield of 4.19%.

Another option is to invest in stocks with the help of a robo-advisor. Robo advisors will automatically create a diversified, balanced portfolio based on your individual preferences, like time horizon and risk tolerance. Plus, they offer fees much lower than a bank or brokerage — saving you even more money in the long run. For a comprehensive comparison of robo-advisors in Canada, read our complete guide to the best robo-advisors in Canada.

The pitfalls of dividend investing approach

Despite five years of outperformance, cracks were beginning to form in my dividend investing approach. The core tenant of dividend growth investing was to buy dividend stocks when they are value-priced and hold them for the long term. Dividend investors should also stick with large, blue-chip companies with a long track record of paying dividends (BMO has paid a dividend since 1829).

Despite this knowledge, I fell into some classic pitfalls with my dividend approach:

  • Chasing high yield: Stocks with a high dividend yield are inherently risky. The yield is typically high because the stock price has been “beat up.” Perhaps the company hasn’t met its earnings per share estimates, or there’s something wrong with the business fundamentals. The company may not be able to sustain its high dividend for long. Cutting the dividend not only hurts an investor’s dividend income but also tends to drive share prices even lower as dividend investors flee to safety. I made this mistake when I bought Canadian Oil Sands stock. It had a high yield but no track record in growing its dividend. The price got cut in half during the oil recession and it finally had to reduce and then eliminate its dividend.
  • Sticking to the rules: Since there are only a handful of blue-chip dividend payers in Canada (mainly in the financial, telecom, and energy sectors), dividend investors might be inclined to add some smaller-cap stocks or fast-rising dividend growers who don’t have a lengthy track record. This was my biggest problem. I didn’t have the patience to stick to the rules. Once I added the 18-20 core blue-chip dividend stocks to my portfolio, I started buying smaller, more volatile stocks that ended up being money losers for me.

The bottom line

Is dividend investing right for you? It may be if you like the idea of building a cash-generating portfolio of stocks for the long term, or the emotional comfort of getting paid regularly while you build your portfolio, or the idea of living off your investment portfolio in retirement. It’s a fine strategy for investors who want to build a retirement portfolio, and for retirees who like the idea of receiving regular dividend cheques or who want to live off the dividends from their portfolio.

Dividend investing might not be right if you don’t have the time to research stocks, the patience to wait for stocks to be value-priced, and the ability to stick to your rules no matter what the market is doing.

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Robb Engen is a leading expert in the personal finance realm of Canada and is also the co-founder of Boomer & Echo, an award-winning personal finance blog.

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