Everyone starts somewhere. You don’t become a world-class chef overnight, just like you don’t amass a huge portfolio of wealth in just a few weeks. Good things come to those who have a goal and understand how to reach it. If your goal is long-term compounding wealth and a stable retirement, dividend investing 101 is the place to start.
Learning the fundamentals of dividends and dividend investing will lay the groundwork for a true understanding of how to build sustainable wealth over time. Applying this knowledge in your portfolio will help you tap into a long-term investing mindset and avoid the temptation (and fees) that come with growth investing, day trading, speculative investments and more.
What’s a Dividend?
The first step in dividend investing for beginners is understanding what a dividend is and why it’s paid.
When a company generates more revenue than it needs to fund its operations, it has several options for what to do with that money. Smart companies will reinvest it in themselves, in the form of research and development or paying down debt. However, large companies often have surplus profit even beyond this. So, they decide to distribute a portion of their excess revenue to shareholders, as a reward for their continued faith in the company.
How Does Dividend Investing Work?
Every shareholder of the company receives the same percentage of profits based on the shares they own. For example, if ABC Company has a share price of $20 and decides to pay a dividend of 1%, shareholders will receive $0.20 per share of ABC Company they hold.
Companies can pay dividends annually, quarterly, bi-monthly or any other time a company deems it necessary. And the dividend payments can add up fast. Using the same example above, if John holds 100 shares of ABC Company, he’ll receive $20 every time the dividend is paid. And, if it’s a quarterly dividend, that means John is bringing in $80 extra per year, just for being a shareholder.
The true power of dividend investing is about more than just collecting the dividend payment—it’s about reinvestment. If John takes the $20 in dividends he earns and automatically reinvests it, he’ll have enough to buy another share of ABC Company every quarter (4 per year). Each of those shares also pays a dividend, which means John continues to collect more and more as time goes on, just by being a shareholder.
To see the power for reinvesting, check out this free and powerful Dividend Calculator.
What’s a Growth Dividend?
There’s a sub-strategy of dividend investing that focuses on growth dividends. Dividend growth investing 101 is all about finding dividend-paying companies that have a history of increasing their dividend—or those likely to increase their dividend based on key financial metrics.
For example, XYZ Company has paid a dividend for 50 years. But, every 5 years they increase that dividend by 0.1%, and have done so since they first proposed their dividend. Today their dividend is 1.9%, but in 5 years, you can reasonably expect that it’ll be 2%; and in 20 years it’ll be at 2.3%.
These seem like small increases, but given a proper time horizon and continued investment, they’ll add significant wealth to your portfolio—simply by holding these stocks long-term.
What are the Benefits?
No introduction to dividend investing is complete without a quick breakdown of the benefits! Aside from the compounding wealth we’ve already talked about above, dividend investing has some core benefits that growth investing and speculative investing just can’t match:
- Reinvested dividends can be turned into passive income later in life.
- Dividend-paying companies are less volatile than growth stocks.
- There are fewer taxes and fees, since investments are held long-term.
- Unless cut, dividends offer stability during times of economic downturn.
It all boils down to better stability and more predictability. Dividend investing—especially with a diversified portfolio—will hedge investors against much of the volatility other investing philosophies encounter.
What are the Drawbacks?
No investing strategy is foolproof. Well-allocated dividend investors still face potential issues that could leave their portfolios at risk. Here are just a few potential drawbacks to the dividend investing strategy:
- If a dividend is cut or completely dissolved, it invalidates your strategy.
- Dividend investing takes decades to pay off, making it a long-term strategy.
- If a stock doesn’t pace the major indices, its dividend may not be worth it.
- High dividends can be a trap—especially if the company’s balance sheet is poor.
In the stock market, nothing is a sure thing. And while dividends represent lower volatility and more security, their success hinges on the health of the company. It takes research and patience to find a company worth investing in for decades to come.
Who Should Invest in Dividend Stocks?
Dividend investing is a strategy anyone can deploy with the right time horizon. The longer you’re able to invest in quality dividend-paying stocks, the better your returns will be. It also takes someone with confidence in their strategy and the discipline to not be tempted by market trends and fluctuations.
If you can commit to a dividend investing strategy for several decades, you’ve got a better shot than most at generating real wealth.