If you’re new to the stock market, you may have come across the term “dividend investing” before. There are many investing philosophies and dividend investing is one of them. It’s a strategy that’s simple enough to understand, but takes some time to fully play out.
For those looking for a low-risk way to invest their money, dividend investing is a tried-and-true approach. This strategy is all about reaping the benefits of dividends—whether you reinvest them automatically or have reached the point where you can live off of the cash flow. Let’s break down the basics…
What is Dividend Investing?
Dividend investing is the strategy of creating a portfolio primarily comprised of dividend-paying stocks. As opposed to a growth investing strategy—which focuses on up-and-coming companies with a rising share price—dividend investing focuses on long-established companies with an excellent track record of financial health.
Dividend investing, at its core, is a strategy with two parts and requires a long time horizon to truly be effective. The longer you can play out a dividend investing strategy, the more fruitful it’ll be!
For the first part of the strategy, a person will spend the majority of their investing career diligently investing money in dividend-paying stocks, opting to reinvest any dividends paid back into more shares. Over time, through the magic of compounding reinvestments, the number of shares owned will increase at a dramatic rate.
To see the impact of reinvesting, check out our free Dividend Reinvestment Calculator.
The second part of the strategy simply involves turning off dividend reinvesting when a person reaches retirement age. Instead of going towards the cost of new shares, dividends paid will go directly to the stock owner as a form of income. This is why a focus on dividend investing is also called passive income dividend investing.
Here’s an example of how the entire model works, with assumed fixed variables:
John buys $10,000 in shares of Company X, with plans to invest another $200 every month. Company X has an annual dividend growth rate of 8% and a dividend yield of 3.25%. John plans to reinvest the dividends on his shares for the next 30 years. Assuming the share price of Company X matches the historical average annual increase in the S&P 500, In just over 23 years, John will receive annual income that is more than his original investment. After 30 years, he will receive more than $24,000 in annual income and his nest egg will be worth $726,598.
As a person gets older, a third benefit of dividend investing also becomes apparent. Because dividend-paying companies tend to be bellwether stocks, they’re likely to remain stable in value over time. A person can begin to liquidate their shares in old age if they don’t plan to pass along their portfolio. This is great for obtaining large cash sums right away, but it will instantly reduce total dividend income for the investor, since dividends will be paid on fewer shares.
What is the Idea behind Dividend Investing?
One idea behind a dividend investing strategy is to double down on companies that maintain success. Some call it “gambling with house money,” but compared to other forms of stock investing, dividend investing is far less of a gamble and more of a safe play.
Let’s look at dividend investing through the eyes of a conservative investor. Which of these companies sounds more appealing over a time horizon of 10 years?
- Company A, which has an annual growth rate of 2.8% and a quarterly dividend of 2.1%. It has paid its dividend for 52 consecutive years.
- Company B, which has only been public for 3 years, but has experienced surging growth of 34% over that time. This company doesn’t pay a dividend.
Both stocks are viable investments, but demand two different risk tolerances. Let’s take a look at the factors in favor of Company A and the dividend investing approach.
History of Stability
Choosing high yield dividend stocks really comes down to time horizon for most investors. A lot can happen in 10 years. In this scenario, Company A is much less likely to cut its dividend (52 years strong) than Company B is to experience sudden downturn, bringing volatility to the share price.
Many investors will see the 34% growth of Company B as a huge opportunity to get in at the ground floor of a booming company. But this level of growth is unsustainable. Wild swings aren’t uncommon for stocks. Couple this with short sellers and naysayers and you’ve got a recipe for volatility. All the while, Company A will quietly take its 2.8% growth, fluctuating just fractions of a percent, if at all.
Company A pays a dividend, which means shareholders can buy more stock with no out-of-pocket capital by reinvesting that dividend. Each new share purchased through reinvestment will pay its own dividend, creating a continuum of “free” money (still subject to taxation). Company B has no dividend, meaning the only way to obtain shares is to purchase them out-of-pocket.
These factors and more paint a low-risk picture of investing in the proven stability of Company A. In this way, dividend investing is a moderate-risk, moderate-reward approach, as opposed to a more boom-and-bust gamble on up-and-coming growth stocks.
Three Types of Dividends
What exactly is a dividend? Why do some public companies offer them, while others don’t? It all comes down to cash flow for the company in question.
Companies with stable cash flow or the ability to generate enough equity internally to finance their many ventures will often use a dividend to raise shareholder confidence and reward them for continued investment in the company. There are three chief types of dividend offered by a company:
- Cash: Cash dividends are the most common type of dividend. Cash is paid out of the company’s earnings or profits, directly to the shareholder (usually through their brokerage account).
- Stock: Stock dividends are paid through the issuance of common stock to a shareholder. A point of clarification on stock dividends—the new issuance of common stock must not exceed 25% of current shares, otherwise it’s considered a stock split.
- Property: Instead of issuing cash or stock to stakeholders, a company may choose to pay a property dividend. This is simply the issuance of a tangible asset—like sending products to shareholders, in lieu of cash.
Generally, dividends are only paid by established companies with a long track record of positive cash flow, a healthy balance sheet, and exceeding returns. In some cases, a company may also issue a scrip dividend—a promissory note that serves as an IOU if they’re unable to pay their established dividend on a set date.
It should also be noted, that just as any company can offer a dividend to shareholders, companies can also cut their dividend in times of financial hardship. In this way, dividends are a good indicator of a company’s financial health and outlook. If it’s increasing, the company is generating reliable positive returns; if it’s decreasing, the company is weathering financial burdens.
Different Dividend Policies
In addition to different types of dividends, there are also different rates at which a dividend may be paid to shareholders. The most common issuances are quarterly and annually, however monthly and special dividends are also applicable. It all depends on the dividend policy of the company:
- Residual: Companies have the ability to internally generate equity to finance new projects and ventures. Leftover equity from those investments is paid in dividends to shareholders.
- Stability: Dividends are represented as a fraction of quarterly earnings. The dividend is paid to shareholders as a form of certainty, showing the company’s stable cash flow.
- Hybrid: This model generally pays regular quarterly dividends, however special dividends may be offered with residual equity, as a bonus to shareholders.
Companies may follow one or more of these policies when choosing to issue a dividend. Shareholders are notified of the company’s dividend policy (or changes to it) when they make an investment. Dividend policies are also public knowledge via the business’ financial filings with the SEC.
The Benefits and Drawbacks to a Dividend Investment Approach
There are many benefits to a dividend investing strategy, with several key drawbacks that must be understood. Before putting your money in high-yield stocks, get familiar with these pros and cons:
- Passive income can be reinvested to increase share ownership or collected as supplemental income.
- Ability to purchase more shares without any out-of-pocket capital expenses or borrowing from brokers (margin).
- More stability and less volatility in your portfolio, as dividend-paying companies are usually “blue chip” bellwethers.
- Reduced risk by investing in companies that are able to generate self-sustaining capital from their operations.
- The prospect of rising dividends, which will reward stock owners for being long-term shareholders.
- Fewer taxes paid as opposed to frequent trading, which incurs fees and capital gains payments on profits.
- Because of their stability, investment in dividend-paying stocks can be a hedge against inflation that may drive the general stock market down.
- High yield dividend investors will continue to see a profit from their portfolio even in a bear market, so long as dividends aren’t cut.
- Dividends aren’t a sure thing. They can be raised, but they can also be lowered or completely cut at any time.
- It can be hard to diversify a portfolio around dividend stocks, since many high yield companies are based in a small pool of industries.
- There’s lower growth potential from dividend stocks, meaning they’re unlikely to appreciate much faster than inflation.
- Stocks are riskier than bonds, which can prove to be a more stable alternative to a dividend investing strategy.
- High dividends by themselves can be misleading. Some companies pay an unsustainable dividend and will eventually need to cut the dividend or perform a reverse split.
- Most dividends are taxed at the long term capital gains rate, so be sure to set aside some of the money you receive to pay taxes. If the stock is held in a tax deferred account like an IRA, you will not have to pay taxes in the year the dividends are received.
- A dividend investment strategy requires a long time horizon to be effective. Investors starting later in life won’t be able to maximize their returns.
- Selling off any dividend-yielding stock eliminates any dividend income you may have been receiving from them.
A dividend investment strategy relies heavily on time horizon and risk aversion, however it’s one that lacks a lot of outright growth potential.
How to Start Investing in Dividend Stocks
Investing in dividend stocks starts by identifying high-yield stocks and researching the companies behind them. Never invest in a company outright for its dividend. Instead, understand the nature of the company and observe some of the key variables that dictate the reliability of its dividend.
For example, a company may have an appealing 6.5% dividend yield. But, its balance sheet may be littered with convertible notes and asset debt. Or, it might have concerning share dilution in its history or low float. Low float can lead to high volatility and as a result, swings in the stock price that impact the dividend payout. Looking beyond the dividend yield at these factors can save you from making an investment that’ll eventually backfire.
Look for stocks with attractive dividend yield. Then, take the time to investigate the company a little more thoroughly. If you can read a balance sheet, look up a company’s 10-Q filing with the SEC to get a better understanding of their financial picture. If you can’t read a balance sheet, get familiar with some of the chief variables affecting dividends:
- Yield: How much of a dividend is the company paying out? Be suspicious of dividends above ~6% (with the exception of REITs). Remember that while a high dividend is nice, it’s also an obligation for the company to pay out. Dividends that are too burdensome may be slashed in favor of a healthy balance sheet.
- Payout: How often is the dividend paid out? Most companies will pay quarterly dividends, however there are also monthly, semi-annual and annual dividends to consider. Special dividends are also issued periodically, but shouldn’t be counted on unless a company has a track record for issuing them with some regularity.
- Consistency: How long has the company been issuing a dividend? The longer a company’s dividend track record, the more reliable they are in honoring it moving forward. A company with a 30-year history of dividends will likely have the balance sheet stability to continue offering it. Conversely, a company with a 2-year dividend history may need to cut it if they encounter a rocky financial situation.
Beyond these pillars of dividend investing, take a little bit of time to get to know the company you’re thinking about investing in. How long have they been in business? What do they do? Are they in a high-margin or low-margin business? Are there any bankruptcies or sharp downturns in their history? How long has their management team been in place? These are all simple questions that yield a lot of insight!
Once you’ve got a few companies narrowed down as quality dividend investments, you’ll need to consider the right approach for investing in them.
Dividend Investment Strategies to Consider
There are several strategies for dividend stock investing, all with the same core concept: You want to start investing as soon as possible in quality dividend-paying companies. That said, there are different strategies available to diversify your investments, mitigate risk or even take on more risk for a higher return on your investment. Here are the best strategies to consider:
Some people like to focus on 1-3 specific high dividend stocks. This approach can help boost dividend cash flow early. For example, if you invest $250 per month across 3 stocks, you’ll be able to secure more dividend-yielding shares faster than if that money was spread-out among 10-12 stocks. Instead of purchasing 2-3 shares for a large basket, you’ll purchase more shares across just 3 stocks. More shares mean more dividends, which manifest as even more shares when reinvested!
The downfall of this method? Lack of diversity. If something catastrophic happens to one of your 1-3 stocks and the share price tumbles or the dividend is cut, you’ll effectively lose a major part of your strategy—not to mention taking the portfolio hit.
Baskets of Stocks
Baskets of dividend yielding stocks are the solution to diversification. By investing in 10-12 steady dividend stocks, you’ll be insulated against unforeseen troubles with one or more of these companies. This approach also offers diversification across industries. You might select dividend-paying stocks across several sectors, further protecting you from hardship in certain aspects of the market. If tech stocks are only falling and 18% of your portfolio is tech stocks, it means 82% of your dividend stocks are safe.
The problem with the basket approach is not always having sufficient investment capital. Trying to invest $250 per month across 10 stocks only works if each stock is valued at less than $25 per share. This is unlikely, which means having to cycle investments between 3-4 every month. This means building your dividend portfolio incrementally, which takes time.
ETFs combine the positives of the basket approach with the benefits of the individual stock approach to provide a convenient middle ground. ETFs are pre-made baskets of stocks, giving ETF owners exposure to every stock in the basket, while consolidating dividends. For example, the iShares Core High Dividend ETF (NYSEARCA: HDV) contains 75 different companies and pays a dividend of just over 3%. It effectively diversifies your portfolio, while consolidating that diversity into one asset.
The downfall of ETF investing is fees. Most ETFs—especially dividend-focused ones—come with a management fee, which can eat into profits. If the ETF charges a management fee of 1.5%, your total return will be 1.5% lower than the total return of the assets held by the ETF. You pay for the convenience and risk mitigation of an ETF by giving up some of the dividend yield to fees. Keep this in mind when looking at ETFs and other managed investment vehicles.
On the higher end of the risk spectrum (though not as inherently risky as growth investing), is a dividend stock investing strategy involving Real Estate Investment Trusts (REITs). REITs focus specifically on companies that own and manage real estate. Due to the way they’re structured, however, companies in this industry have to pay out a substantial portion of their profits (90%) back to shareholders. As a result, REITs usually have dividends ranging from 4% to a whopping 12% or more! Additionally, REITs are known for paying more frequent dividends.
REITs may sound like a foolproof strategy for dividend investing, but they carry a fair amount of risk with them. First, the companies within REITs have very levered balance sheets, usually piled with debt from owning and leasing real estate. This means they’re hugely impacted by economic factors. Second, dividend income from REITs is taxed differently from stock dividends. REIT shareholders are taxed on dividends as if they were pure income, which could be as high as 37%, depending on the tax bracket.
Get Familiar with Dividend Aristocrats
If you’re going to focus on individual stock investing or put together a basket of stocks, it’s important to get familiar with a group of companies nicknamed the “dividend aristocrats.” This title is earned by companies that have paid a dividend for 25 consecutive years or more. It represents “blue chip” stocks for investors seeking the ultimate in stability and reliability. For anyone new to investing in high dividend stocks, this group is the place to start.
More than sharing a common history of paying dividends, the companies within this group general ascribe to better overall performance, even in bear markets. For example, the S&P 500 Dividend Aristocrat Index—which tracks only dividend aristocrats against the broader S&P 500—shows these companies to be historically less volatile when it comes to share price, as well as better compounding dividend prospects as opposed to other, younger dividend-paying companies.
The only real downfall to investing in the dividend aristocrats is exposure. Because there are just over 50 companies in this exclusive group, their sector exposure in the stock market is limited. Moreover, dividend aristocrats are weighted heavily across just a few sectors. Here’s a complete breakdown of exposure (as of January 2019):
- Consumer Staples: 24%,
- Industrials: 21%,
- Health Care: 12%,
- Materials: 11%,
- Consumer Discretionary: 11%,
- Financials: 10%,
- Energy: 3%,
- Technology: 2%,
- Real Estate: 2%,
- Utilities: 2%,
- Telecommunications: 2%
Lastly, it’s important to recognize that not even dividend aristocrats are immune to market forces. Even these bellwethers can suffer a downturn. For example, several companies including Bank of America (NYSE: BAC) abruptly lost dividend aristocrat status in 2008 due to the Great Recession, while the likes of General Electric (NYSE: GE) suffered steady decline until falling out of the club in 2010.
That said, of all the investing options a person has, picking dividend aristocrats is far and away the safest bet on wealth generation.
Don’t Forget to Diversify
Investing in dividend stocks for retirement is a superb strategy—especially if you get an early start in your 20s, 30s or even early 40s. But, it shouldn’t necessarily be your only strategy. If you’re a conservative investor, consider bonds when economic downturn looms, to supplement your dividend stock portfolio. If you can stomach the risk, dedicate a small portion of your portfolio to a couple of growth stocks. Or, dedicate a Roth IRA or 401k to aggressive stock investments while you cultivate a personal portfolio of dividend stocks on the side.
Dividend investing is the epitome of “slow and steady wins the race.” And, it also follows another wise adage about personal investing: “Time in the market is better than timing the market.” If you’re the type of person who wants to build wealth assuredly over time, who enjoys stability and who intends to maintain a long-term strategy, there’s no better investment than high-yield dividend stocks.