Two Investment Risk Spectrum Strategies

In a dividend investing strategy, each stock purchase falls onto the investment risk spectrum continuum.

At one end of this spectrum are lower-yielding stocks that are generally considered less risky. At the other end of the spectrum are higher-yielding stocks that the market views as having more risk, thus, the dividend yield is higher.

It is an interesting topic for a dividend investor to consider, as each particular investment requires a trade-off between expected yield and price paid for a stock. 

Buying Dividend Stocks: Investment Risks

Investing in stocks that pay dividends is no different than any other type of investing, in that each time we deploy our hard-earned capital, we are being subjected to risks, both seen and unseen.

Each particular company that we choose to purchase carries with it a risk profile. This risk profile will tell how much an investor is getting in return on yield in return for investing in the particular stock.

The common rule of thumb is the higher the dividend yield, the higher the risk.

This is especially important for dividend investors as we need to find the sweet spot between buying companies that yield very little and those companies that pay too much.

Dividend Investing: The Conundrum

Each investor is then faced with two main issues:

  1. If we buy into conservative companies that yield too little, it will be tough to accumulate the type of share accumulation that we need to put our dividend portfolios on autopilot.
  2. However, if one goes to the opposite end of the spectrum and invests too much capital in stocks that have higher-risk profiles, then as investors, we are buying into companies that might cut or eliminate their dividend, or worst-case scenario, not survive over the long-haul.

The Spectrum: Managing Investment Risk

When I am investing in dividend stocks, I always consider the risk profile of the particular stock I am investing in.

This is important to me, as I do not want a portfolio that is completely conservative nor do I want a portfolio that is completely high-risk. To be at completely at one end of the spectrum would be to lack the type of risk diversification needed to make the types of gains we desire.

The strategy is simple: there are two main ends of the spectrum that I am looking at for investment potential.

1. Conservative Companies with Lower Yield (Low Risk Companies – LRCs)

The first main category of stocks in the dividend portfolio are solid, conservative, dividend-paying companies that which I expect to be around for many many years.

General Characteristics of these Conservative stocks:

  • They tend to be Dividend Aristocrats, Champions, or Contenders
  • These companies have been paying dividends for a long time
  • Continued solid financial results

The kicker with the more conservative, well-established companies is that you typically obtain a lower dividend yield so it is more challenging to accumulate shares through DRIP investing. Often times the entry purchase point is higher as well, which makes each DRIP purchase smaller in comparison.

2. Riskier Companies with Higher Yield (High-Risk Companies – HRCs)

On the opposite end of the spectrum are stocks that yield a higher dividend. While a higher dividend does not necessarily mean a higher risk, oftentimes the yield is higher because the market has pushed the stock price lower due to negative sentiment, which naturally pushes the dividend yield up.

General characteristics of higher-yielding dividend stocks:

  • Either stock price is lower due to general market decline or dividend has been increasing in an attempt to make the stock more lucrative in the eyes of investors.
  • Flat or declining revenues.
  • General industry outlook is negative or unknown.

Because of these above factors, the stock price can become depressed and trade off 52-week lows, mainly due to downswings in either the industry’s economic conditions or declines in the material operations of the company itself.

In either case, there is a reason why an investor is obtaining such a high yield; higher risk.

The Dividend Investment Strategy

So what do I look for? Typically, the majority of my stocks will be invested in solid, conservative dividend-paying stocks that are moderate-low risk.

This means that I look to invest most of my capital into stocks with a long history of payment dividends that happen to be trading at adequate valuations.

Many of these companies will be Dividend Aristocrats – that is companies with 25-plus years of increasing dividend payouts.

This doesn’t always mean that stocks that have been paying dividends for 25+ years are less risky; rather it means they’ve been able to survive for many years and, more often than not, they are in solid financial condition which has allowed them to weather previous storms.

However, I do allow myself to purchase more speculative dividend plays in companies that are currently undervalued and with share prices that are underpriced, which allow for massive share accumulation if the dividend and share price stay relatively intact.

Risk Capital Allocation Amounts

I change up how I invest in stocks based on their risk profiles. It all comes down to how I allocate my capital.

Lower-Risk Companies

In solid dividend-paying stocks (LRCs), I buy in larger increments. This means that for Dividend Aristocrats, I will typically invest anywhere from $3,000 to $5,000 at any one time. I could even increase that to my current maximum limit of $10,000 if a particular investment looks too good to pass up.

The reason for the relatively large amount of capital deployment represents the fact that I am comfortable with the lower risk profile of these companies. Overall, I believe that this investment is one that I will be holding for the long-term.

I never expect to have to sell any of these positions nor do I expect any of these companies to come upon hard times that they cannot find their way out of it.

Higher-Risk Companies

On the other end of the investment risk spectrum are higher-risk stocks. These are typically dividend-paying stocks that have been beaten up by the market for various reasons; perhaps their overall sales have been in decline, the dividend payout ratio is getting too high, or the company had a large goodwill impairment write-off recently.

Whatever the case may be, these companies are currently trading at a heavy discount, especially when compared to their peers and, more often than not, the firm’s historical PE ratio.

I am willing to invest in these companies, but at much lower price points and in much smaller increments. Typically, I will deploy up to $500 to $1,500 in these higher-risk, higher-yield stocks (HRCs), knowing that the share accumulation is at an overall faster pace through the accumulation of shares at a lower share price.

Eventually, I will be paid off handsomely for the risks that I am assuming. The end goal is that the company “rights the ship”, and eventually I will own many more shares through a much higher share accumulation (aka The Snowball Effect). This means I will have many more shares that will experience price appreciation for me.

Now, there are caveats here: investing in HRCs brings with it a more speculative nature than is assumed when investing in LRCs. What this means is that, while I am hopeful for the future growth potential of the HRCs, I am cognizant of the fact that the stock is much more volatile and the company’s future much more uncertain.

While I am fairly certain that the LRCs will continue operations well into the future, I am not always as confident with the higher-risk stocks.

Simply put, if one of the HRCs ends up cutting the dividend or failing down the road, I would not be surprised. Thus I keep my overall initial investment amount low so as not to over-expose myself to this scenario.

The Investment Risk Breakdown

In my own portfolio, I would classify the vast majority of the holdings as relatively conservative.

As of this writing, my current dividend portfolio has a yield of 3.5% with 35 different stock positions. I would classify my overall portfolio’s risk as low-medium with a few higher-risk stocks sprinkled in.

Even though there will be general market declines, I expect to have most of my stocks survive the long-term.

What are some examples of lower-risk stocks (LRCs) in my portfolio?

  • Procter & Gamble
  • Starbucks
  • Coke
  • 3M
  • Apple

What are some examples of high-risk stocks in my portfolio?

  • Newell Brands
  • CenturyLink
  • Ford
  • General Electric

Investment Risk Portfolio Comparision

With all else being equal, I can expect my portfolio to yield $6,000 on a $200,000 valuation. These metrics could go up, or they could go down with each new position added. However, since I am typically targeting 3%+ dividend aristocrats, I do not expect it to fluctuate much above the 3.5% level.

Overall, I view my portfolio at a low-moderate risk level. I’d like to contrast this to a fellow blogger’s portfolio, which I consider to be very high risk.

When viewing my Twitter feed, I read about a fellow dividend investor and his achievement of $20,000 in dividend income. I give him a ton of credit for reaching this point and commend him for having the diligence to stick at it.

However, curious as I always am, I wanted to know the dollar size of his portfolio to get an inclination of his overall risk. Upon further reading, I discovered that his portfolio value was at $150,000.

If we do the quick math, that means that his portfolio is currently yielding 13.3%. This tells me that he has invested in many high-risk stocks, which might payout handsomely in the short-term, but I question their long-term viability. I’m guessing that he has many REIT stocks and natural gas plays in his portfolio currently.

In my opinion, it is ok to invest in higher risk, so long as the investor knows what he is in for. This particular investor might do very well if he can recognize when to sell out of his high-yielding position should the stock price reach a point of being too low and the dividend no longer being supported by cash flow.

In the end, it is all about knowing and managing your risk.

Risk Diversification: The 60-30-10 Rule

Knowing all this, how should you diversify your dividend portfolio?

As in all things investing, I believe that a solid diversification strategy is the key to a great investment strategy. It would behoove us to have a good mixture of stocks at various risk levels.

I personally recommend practicing the 60-30-10 investment risk reduction rule. This means that:

  • 60% of your stocks should be in or conservative dividend payers (aka the Dividend Aristocrats).
  • 30% can be in moderate growth dividend players (aka the Dividend Challengers).
  • 10% can be invested in higher-risk, high-yield dividend stocks.

I believe that this ratio allows an investor to adequately benefit from the various yields and potential share accumulation offered by each risk class.

Keep in mind that these percentages will change with your age. The closer you are to retirement, the less risk you want your portfolio. The younger you are, the more you can absorb losses, although a caveat must be made here.

If an investor, no matter what your age, invests only in high-risk dividend stocks, and you deploy those dividends back into the stocks through a DRIP investing program, you are definitely doubling down on your risk.

I personally would recommend that on higher-risk positions, you look to take these dividends as cash as opposed to reinvested dividends, so that you can figure out where you want to deploy that capital.

While this is more leg work for investors, it will have massive future benefits into the future as you be able to manage and mitigate your risk position better. Keep in mind that you can always choose to deploy your capital back into a high-yielding, higher-risk dividend stock; now it would be by conscious design and not just automatic process.

Do you have a dividend portfolio? If so, what is your risk makeup? Do you agree with the 60-30-10 rule? Or do you see a different investment risk allocation in your portfolio?

Comment below and get the conversation started!


Disclaimer:(1) All the information above is not a recommendation for or against any investment vehicle or money management strategy. It should not be construed as advice and each individual that invests needs to take up any decision with the utmost care and diligence. Please seek the advice of a competent business professional before making any financial decision.

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