How To Create Dividends For Life

Regardless of whether you are young or old, I believe you can make this Foolish strategy work for you.

I imagine that, for most of us — me included — we'd be very happy if we could comfortably live off our investments and other sources of income in retirement, and perhaps leave something behind for our loved ones. But you can forget about doing that using income from term deposits and interest on your bank account, given the low interest rates they currently pay.

Now it may be a simple goal, but self-funding your retirement is not exactly simple to achieve.

There are many strategies for building and maintaining wealth, and I'm going to look at a popular one for us Fools.

Dividend investing.

I'm not talking about chasing massive gains from speculative miners or blue-sky biotechs…

…but growing your money in the stock market by investing in a more straightforward way.

You see, successful income investing can be as simple as owning a handful of solid dividend-paying stocks that you can hold for decades…

…then, as your dividend payments roll in, you can use that cash to supplement your income and help realise your financial goals.

Dividend and conquer

Of course, the wonderful thing about having dividend-paying shares in your portfolio is that you have the choice of what to do with the cash you receive.

You could save it, or use it to pay bills, or perhaps reinvest it in the same share… or possibly reinvest it in another share altogether.

Sure, dividend shares can sometimes lack the excitement of many growth-oriented stocks, but income shares essentially allow you to tailor part of your portfolio to best suit your unique needs.

To illustrate, let's see how you could use dividends at different stages of your life:

It's important to note that, regardless of which category you fall into, everyone's situation is different and may differ from the generalised table above.

A pensioner, for example, may have other sources of income to support his or her lifestyle during retirement and may, therefore, have different goals with his or her portfolio.

The main point is that dividend-paying shares provide real returns when they pay out cash and give you the flexibility to decide how to best manage your portfolio.

So if you want more yield or you want more growth, you can tailor the dividend-based portion of your portfolio to meet those goals.

How dividends can provide the foundations for a more dependable portfolio

As I say, dividend shares can sometimes lack the excitement of many growth-oriented stocks.

But I want to show you a chart that I reckon underlines how dividends can provide the foundations for a more dependable portfolio.

Source: Google Finance

To me, the chart demonstrates how dividend-paying ASX 200 (INDEXASX: XJO) (ASX: XJO) companies have continued to reward long-time investors… even during times when the wider index has not provided much in the way of capital gains.

And here's a selection of companies, and their returns over the past 10 years. You can see the difference receiving dividends and reinvesting them makes – in some cases, more than doubling the long-term return.

Source: CapitalIQ

5 Golden Rules for Building a Dividend Portfolio

Now, before you run off and buy just any old dividend-payer, please remember there are pitfalls to avoid when investing for income. In fact, I have devised these five golden rules to bear in mind:

1) Do not chase the very highest yielder of the day

If a company is offering three times the yield of the market average, be careful — chances are this super income could be too good to be true. You see, the market's very highest yielders are often priced that way because the payout is likely to be cut. BC Iron Limited (ASX: BCI) currently sports a trailing dividend yield of 35%, but given the iron ore price crash, there's no way the miner will be paying anything near the 32 cents it paid last financial year, and very likely won't be paying any dividends this financial year.

2) Do not buy shares with a shoddy dividend track record

Look back through the archives and check dividend histories — in particular, compare the payouts made before and after the global financial crisis. And be wary of companies that have a haphazard record. Ideally you want companies that can deliver in bad times as well as good, like stalwarts Wesfarmers Ltd (ASX: WES) or Woolworths Limited (ASX: WOW).

3) Do not focus exclusively on high yields from smaller companies

True, smaller companies can offer more in the way of growth — in terms of rising share prices as well as rising dividend payments — but they tend to come with greater risk, too. Instead, blue-chip names frequently have the greater resources to ride out tough economies and rough markets. Should Australia head into a recession, the bigger dividend payers are more likely to keep paying out.

4) Do not forget to diversify your portfolio

Quite often, the most attractive yields can be concentrated in just a few industries. So be careful — you are not really diversifying if you invest in many different companies from the same sector. Hands up if you think you are diversified because you own shares in a number of the big four banks?

It's often best to invest in a variety of industries, even if you have to accept a lower initial yield.

5) Do not put your money in companies that simply can't afford the dividend

Such companies may be signalled by their very high yield (see my first rule). But sometimes they won't be and it will be up to you to spot trouble ahead. Is the company taking on too much debt to fund the dividend? Is the market ignoring potential profit problems in the future? You always need to answer such questions.

Foolish takeaway

Perhaps the best dividend portfolio to build will carry a number of large-cap companies spread across a range of industries and sectors, with a selection of smaller to medium-sized companies with the ability to grow their dividends.