Investing in dividend paying stocks is popular, but not without it’s disadvantages. In this article you’ll learn everything you need to know about dividend investing. You’ll find out what dividends are, where they come from, dividend stock myths, pros and cons. Finally, you’ll discover how and where to invest in dividend paying stocks.
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What are Stock Dividends?
The stock market offers profits in two unique ways. The first is via buying a stock at a low price and selling at a higher price, for a capital gain. The second is via cash dividend payments.
A dividend-paying stock typically pays investors dividends quarterly, four times per year. Dividend investors are essentially collecting some of the revenue and/or profit of the company throughout the year. A growth stock, in contrast, typically seeks to enhance earnings growth by reinvesting its revenue and profit instead of paying shareholders, and thus dividend payers are usually mature companies as opposed to the hot, new tech startups.
In theory, a firm will pay a dividend only if the company’s balance sheet is healthy and if dividends offer a better risk/reward profile for the shareholders than reinvesting capital into growth activities. Depending on a company’s financial goals, the dividend can change over time. For example, some dividend stocks are considered dividend aristocrats and are known for increasing their dividends annually, while other stocks cut or maintain their dividends to maintain a healthy balance sheet.
Where do Dividends Come From?
When a company has profits, they have several choices regarding those profits.
1. The company can pay the cash to the investor in the form of dividends. Then the investor can spend that money in any way she chooses. That option leaves the company with no funds to reinvest in the growth of the company. If the firm doesn’t reinvest in their growth, the company might find it difficult to prosper.
2. The corporation can take all of their profits and reinvest them in growth opportunities and acquisitions. If the company invests its capital wisely, the company will grow and it’s stock price will increase. This benefits the stockholder with a higher value stock. When the investor sells this growing company, he receives a higher price for the stock. This profit is called a capital gain.
3. The company can combine options one and two. The company can take part of its profits and give them back to the investor in the form of a dividend and reinvest the rest in the growth of the company. The percent of the company’s earnings, paid to investors is called it’s dividend payout ratio.
So you see, whether a company pays a dividend or not has little to do with your long term return. You either receive the company profit along the way as a dividend, at the end of your holding period, as a capital gain, or a little of both. The important point for investors is to invest in growing companies while paying a fair price.
The only difference between dividends and capital gains is in the timing of payments and tax treatment.
What is Dividend Yield?
The dividend yield is simply the amount paid as a dividend divided by the stock or fund price. If a $20.00 stock pays $1.00 in dividends per year, then the dividend yield is $1.00/$20.00 or 5.0%. Dividend yields are used to evaluate the potential dividend income from a stock or fund. No matter how often the dividend payments are made to shareholders, dividend yield is stated as an annualized figure.
Because a dividend payment is a specific dollar amount per share, the dividend yield varies with the stock price. If a stock price runs up over the year and the dividend amount stays constant, then the yield shrinks. Thus, in dividend stock investing, timing your purchase translates directly to getting better and/or worse yields. Paying less for shares will translate into a higher dividend yield.
In dividend investing, yields are also used as a guide to the stability of the company. A high dividend yield, above 10%, is often associated with greater risk. Lower dividend yields, below 5%, are usually associated with stability.
Dividend Stock Myths and Misconceptions
There’s a lot of dividend stock and fund misinformation and we’re here to separate the facts from fiction.
- Myth: Established companies pay bigger dividend yields. Truth: Maybe and maybe not. Companies set their dividend payment according to many factors, including other growth opportunities for the firm. If a company’s dividend yield is excessively high (like over 6%+), the company might have some sort of trouble. High dividend yields can be a result of investors selling off the stock and declining stock prices, not a result of annual dividend increases.
- Myth: Dividend stocks outperform growth stocks. Truth: Since 2014, growth stocks have handily beat dividend stocks. In the above chart, which reflects the comparison of the NOBL dividend aristocrat fund and SPX S&P 500 benchmark, you’ll notice that the S&P 500 handily outperformed NOBL since 2014. If your investing strategy employs dividend stocks, ensure it is for the right reason; outperformance is not a good reason.
- Myth: Dividend payers are the only stocks to return cash to shareholders. Truth: Stocks that don’t pay a dividend can also return equity to shareholders via buybacks. In some sense, a buyback plan is just a fancy dividend. Also, capital appreciation increases value to investors as well and growth stocks can be sold to create cash flow.
- Myth: Stocks that have cut their dividends are not worth investing in. Truth: Dividend stocks that cut their dividends might decide to improve their balance sheet at the expense of the dividend. The company might also have growth or acquisition opportunties that will ultimately lead to greater stock price appreciation. Evaluate the company before discarding it due to a decreased dividend payment.
- Myth: Dividend investing is only for older investors, those nearing retirement. Truth: While dividend income is seen as safer and desired by those who wish to receive stable cash payments in retirement, young investors can also benefit from dividend investments. If you hold a stock paying dividends over several decades, your dividend on the initial capital will likely be very high, while the on-paper yield is low. For example, your annual dividend payout could be 20% of your initial capital, while the dividend yield for current investors is a mere 5%.
- Myth: Dividends are a large tax burden. Truth: While ordinary dividends are taxed at a higher rate than capital appreciation, qualified dividends can reduce that tax burden. In addition, if you are single and making a low five-figure income or married and making a mid five-figure income, dividends might not even be a tax issue at all.
Dividend Stocks vs Growth Stocks
Adding dividend stocks to your portfolio can increase cash flow. Growth stocks, in contrast, sacrifice that cash flow for the potential for capital or wealth accumulation. Dividend paying companies can provide cash flow but typically don’t provide the large price gains that are achievable with growth stocks.
Many investors opt for the income that comes with dividend investing, but doing so limits your selection of stocks. For example, tech stocks tend to be growth stocks, and so seeking only stocks that pay dividends limits your portfolio exposure to this sector. However, a dividend investing strategy tends to lower portfolio volatility more than a growth stock strategy. So, a dividend portfolio lowers risk at the expense of higher returns.
Growth stocks are all about capital appreciation during the growth phase of a company. In a way, an investment in a growth stock can be more of a gamble than investing in a steady dividend payer. Dividend investing is a stable investment strategy, and a dividend investor can continue to generate income even during a market crash, such as that of 2008 or 2022.
Keep in mind that dividend stocks may over or underperform the total stock market or growth stocks during a specific period. From 2014 to 2022 growth stocks returned more than dividend stocks. Yet, from Jan 1, 2022 to April 19, 2022 the NOBL Dividend Aristocrat ETF declined -1.8%, while the S&P 500 and IWY a growth ETF each declined -6.8%, and -12.7% respectively. So, during this recent stock market drop, dividend payers held up better than the overall market and growth stocks.
Pros and Cons of Dividend Paying Stocks
You might be surprised to hear that in the investing community, the subject of dividend stocks is actually a divisive one. In any case, just be aware of the pros and cons of this investing strategy before you go all-in. Ultimately, you don’t have to completely subscribe to one school of thought or the other.
Here are important pros and cons of dividend investing.
- Passive income is a major pro here, especially when you are investing in companies growing their dividends. Dividend growth stocks epitomize the benefit of dividend investments. You can hold a stock and receive increasingly large quarterly payments without the need to actually sell the stock.
- Dividends provide regular income to investors during sideways markets. Thus, dividend investors are profiting despite the share price not moving, an impossibility for growth stock investors.
- Dividends can be reinvested, reducing the cost basis and increasing the amount of shares held. This also increases the opportunity for compound growth. Between 1930 and 2019, dividend growth added roughly 1.8% annually to the S&P 500 returns, according to a study by Hartford Funds, and shown in the chart above.
- Dividend stocks come with tax disadvantages for some investors. While “qualified dividends” are taxed at low rates, “ordinary dividends” are taxed at your marginal income tax rate. In contrast, capital growth isn’t taxed until the stock or fund is sold, and enjoys lower tax rates.
- Dividends are not guaranteed. Dividend aristocrats and other dividend payers can cut dividends at will.
- Investing in only dividend-paying stocks excludes a large swath of the global investment market. Investors who only invest in dividend stocks and funds are hurting their portfolio’s diversification.
The tax rate on qualified dividends is 15% for most taxpayers. (It’s zero for single taxpayers with incomes under $40,000 and 20% for single taxpayers with incomes over $441,451.) However, “ordinary dividends” (or “nonqualified dividends”) are taxed at your normal marginal tax rate.
How to Invest In Dividend Stocks?
If you’re comfortable using a stock screener and researching individual stocks, then you can invest in individual dividend paying equities through your investment brokerage account. Mutual funds and ETFs, in contrast, are good for those who do not want to perform the research necessary to select individual stocks and for those who prefer automatic diversification. The list of dividend funds is vast with choices dedicated to riskier high yield funds, dividend growing aristocrat funds and more.
When investing in individual stocks or funds, consider using a screener to narrow down your dividend investment choices. Useful screening criteria include:
- Dividend yield. Be careful with 10%+ yields, as those companies typically have underlying fundamental and financial problems. For high quality companies or funds, stick to a yield range of 2% to 6%.
- Type of investment. You can select from individual stocks, stock and bond ETFs, and REITs (real estate investment trusts, which offer monthly dividends).
- Sectors. High dividend paying sectors include utilities, financials, energy and others.
- Expense ratio. For cost conscious investors, lower expense ratio funds can be correlated with higher overall returns.
You can find decent screeners at most investment brokerage firms. For those that prefer pre-made dividend investment solutions, M1 Finance offers several dividend stock, and bond portfolios. Following are images of the pre-made dividend portfolios at M1 Finance.
How to Invest in Dividend Stocks With Little Money?
Want to build a portfolio that will pay dividends but don’t have the capital just yet? No worries. These days, you have several workarounds:
- Partial share investing. Partial – or fractional – shares allow you to buy a fraction of a share of a stock. If that stock pays dividends, you’ll get the equivalent amount of dividend payments. For example, if you invest $50 in a $100 stock that pays $4 per share in dividends, you’ll receive $2 in dividends.
- Robinhood. Robinhood was initially set up for novice investors who could not afford the industry standard commissions at the time. Now, the app still offers low-capital investors many tools, such as automatic recurring investments, dividend reinvestment plans (DRIP), and Roth IRA options. Robinhood also offers partial share investing and low minimums.
- SoFi. SoFi used to offer fractional shares per price (e.g., spend XXX amount on a certain stock to get the appropriate amount of shares). As of 2021, though, you can now state your purchase in terms of the fraction itself (e.g., 3/4 of a share). You can start with as little as $5.
- Schwab. Schwab is a bit behind its competitors in the fractional share game. For example, you cannot purchase partial shares on exchange-traded funds (ETFs) such as the SPY or QQQ. You can, however, buy fractional shares for any stock in the S&P 500 for over $5. So, if you’re not interested in purchasing partial shares of ETFs, Schwab is still a good option.
Is investing in dividend stocks a good idea?
With dividend stocks, you get three benefits: dividend growth, if the company raises its dividend; capital appreciation, from the stock prices rising; and income, from the dividend itself. Compounding, should you reinvest earnings, also is in play. Overall, dividend stocks can be a valuable part of a balanced portfolio.
What is the downside to dividend stocks?
Some investors consider dividend stocks to be inferior to other stocks in the broader market. Taxes tend to be a drawback for dividend stocks as well. You also have the fact that the dividend tends to be priced into the stock, which is why dividend stocks drop by the dividend amount on the ex-dividend date. Dividend stocks might not experience the price appreciation of growth stocks.
Can you get rich from dividend stocks?
If you get started early enough, focus on yields that are moderate-to-high, and choose companies that are growing their dividends, you can, over time, grow a small amount of capital into a large one. Compound returns is the name of the game. If dividends is your method, one reliable option is to open a Roth IRA as early as you can, invest in high-yield real estate investment trusts that pay at least 10% annually, all tax-free, as compounding that 10% will grow your account much faster than most would expect.
Is it smart to invest in high-dividend stocks?
If you have a lot of capital to begin with, investing in safe dividend payers could bring in enough income to support your lifestyle. For everyone else, chasing high-yield dividend stocks seems to be the alternative option. While high-yield dividend stocks can bring you some significant ROI on your investment – perhaps even enough income to pay for your lifestyle – they also come with risk. The stock market is essentially a balance of risk and rewards, and high-dividend stocks find themselves on the somewhat more risky side. You might find yourself with a high dividend payer who’s price sinks 50 to 75%. Then the high dividend isn’t enough to offset the return. When investing in high dividend stocks, understand the underlying fundamentals of the company and the risk of loss of principal.
Should I Invest in Dividend Paying Stocks? Wrap Up
Whether you should invest in dividend-paying stocks is a personal question that relies on your financial goals and risk tolerance. Perhaps a better question is whether a particular dividend-paying stock is worth your money. If a company is high quality with positive growth prospects then investors are generally rewarded, whether the firm pays dividends or not. Ultimately, examining at a company’s earnings, price, growth opportunities and financial health can be more important than the dividend. In strong growing companies, if earnings increase, dividends tend to rise, and the stock price rallies. So, choosing the right company in which to invest is the ultimate strategy here. Dividends are just a bonus from this perspective.
You also need to consider the current interest rates, as dividends yields become less attractive when interest rates are high. To some extent, the macro environment should also be considered when dividend investing. Dividend growth, for example, should outpace the interest rates.
In the end, the most important piece of advice for investing, whether you choose to go the dividends route or not, is to start early and begin earning compound returns, which is the real driver of long-term wealth.
For More Great Articles From Barbara Friedberg, read these:
- How To Invest A Million Dollars For Income
- Is Passive Income Real? Myths vs Reality
- SoFi Weekly Dividend ETF Review
- Which Investment Type Carries The Least Risk?
- Speculative Investments – How Much Should I Invest?
Disclosure: Please note that this article may contain affiliate links which means that – at zero cost to you – I might earn a commission if you sign up or buy through the affiliate link. That said, I never recommend anything I don’t personally believe is valuable.
Barbara A. Friedberg, MBA, MS, former portfolio manager, is committed to investment and money education across multiple platforms. Her work has been featured on US News and World Report, Yahoo!Finance, Investors.com and more. Friedberg owns Robo Advisor Pros.com, a non-biased, comprehensive and trusted resource for all of the latest robo and technology enhanced investing platforms. She owns Barbara Friedberg Personal Finance.com which is dedicated to improving investment knowledge and wealth. Friedberg consults for a select group of fintech companies and writes for many popular online media outlets. Her books can be found on Amazon.