When you live on dividends, you generally need to continue holding shares of the underlying companies to maintain your income stream. That can mean holding a stock even when its valuation looks stretched. A current example is Royal Bank of Canada (TSX:RY).
Royal Bank is a high-quality Canadian bank with a history of dividend growth and strong long-term earnings potential. Its recent earnings growth has been stronger than usual, and expectations remain positive. As a result, the stock is trading near its highest valuation in roughly 20 years, according to the F.A.S.T. Graphs chart below.
That does not necessarily make Royal Bank an immediate sell. Trying to avoid every market correction is neither realistic nor necessary for a long-term investor. However, corrections eventually occur, and when one arrives, an expensive stock can fall toward a more normalized valuation — or potentially overshoot to the downside.
Based on a roughly 10-year historical perspective, a normalized valuation could imply a fair price of around $195. That doesn’t mean the stock must fall to that level, but it illustrates why valuation still matters, even for an excellent dividend-paying company.
Manage Portfolio Concentration
Investors should periodically review their portfolio allocation, ideally at least once a year, and rebalance when necessary. If a single stock or sector has grown to represent a substantial portion of the portfolio, reducing that position can help manage concentration risk.
Many professional fund managers impose limits on individual holdings, often keeping a single stock within a range of roughly 5% to 10% of the portfolio. For individual investors, the appropriate limit will depend on their objectives, risk tolerance and overall diversification. Core holdings can collectively represent a large portion of a portfolio, say up to 80%, but diversification remains important.
Dividend investors should also consider a second form of concentration risk: dividend income concentration.
A stock might represent a relatively modest percentage of a portfolio but account for a disproportionately large share of its dividend income. That creates additional risk because dividends are not guaranteed. Public companies are generally only obligated to pay dividends that their Board of Directors have declared. So, dividends could always be reduced or even eliminated when the operating environment gets bad enough.
There is More Than One Way to Manage Winners
There are also practical, real-world considerations. Some investors prefer a traditional buy-and-hold strategy, allowing successful investments to keep compounding. This approach recognizes that today’s expensive stock can continue producing strong returns if the underlying business keeps growing. Over the long run, a few major winners can potentially compensate for investments that disappoint.
Other investors prefer to periodically take some money off the table. For example, suppose an investor puts $10,000 into Royal Bank and the investment eventually doubles to $20,000. They could sell half the position, recover their original $10,000 and leave the remaining $10,000 invested.
This approach can reduce risk while allowing the investor to maintain exposure to a successful company. If Royal Bank later becomes attractively valued again, the investor could choose to add to their position.
Ultimately, living on dividends is not simply about finding stocks with high yields. It is about balancing income, valuation, diversification, and risk while ensuring the portfolio can continue supporting your financial needs through different market cycles.
Summary
Living on dividend income can provide investors with a reliable source of cash flow, but it also creates a unique challenge: you may need to continue holding dividend stocks even when they appear expensive. Investors need to think about their portfolio allocation, stock valuation, and concentration risk.