It is never too late to learn how to invest in dividend stocks. Investors of any age can take advantage of the stock market. Wall Street has become synonymous with impressive returns for those who can exercise patience and diligence. While the market is susceptible to volatility, it has historically returned an average of 10.0% annually, according to NerdWallet.
Investors who exercise the ability to hold through volatility are more likely to realize market-beating returns. That said, there’s more than one way to realize profits on today’s major indices. In addition to trading, investors may also practice what is known as income investing.
Income investing is the practice of buying stocks with dividend yields and compounding returns for years, if not decades. If done correctly, it’s entirely possible to build a portfolio in which investors can supplement a large portion of their annual salary (if not all of it) with passive returns. Compounding returns have the power to grow income year-over-year without any additional effort, which begs the question: What are dividend stocks? More importantly, how will today’s investors take advantage of dividend stocks for a brighter tomorrow?
Learning how to invest in dividend stocks will show investors a powerful wealth-building tool they may have never even knew existed. Hopefully, the following will serve as a good place to start.
What Are Dividend Stocks?
Dividend stocks are equities traded on Wall Street; they are traded alongside “regular” stocks on all the major indices: the S&P 500, the Dow, the Nasdaq, and more. They share many similarities with their traditional counterparts. However, dividend stocks offer investors something their non-dividend counterparts can’t: a dividend yield.
Dividend stocks are typically purchased for their dividend yield. That’s not to say dividend stocks can’t offer growth, but rather that their dividend yield is usually what makes them attractive to investors. Income investors strive to build entire portfolios based on dividend yield, which begs the question: What is a dividend?
A dividend is a small payment on behalf of qualifying companies to shareholders. Traders will receive a small percentage of the stock’s value for each share they own. In return, the companies will typically receive tax breaks at the corporate level.
Dividend stocks reward their shareholders with two ways to increase their net worth: growth and dividend income. Let’s say, for example, an investor bought one share of Apple, Inc. (AAPL) 12 months ago. At the time, the share was worth $53.71. Since then, the stock’s value has increased by 109.42% and is now worth $112.82. The increase nets the investor a $59.11 profit. However, Apple investors were also the beneficiaries of modest dividend yield. For every share of Apple-owned, investors will receive 0.68% of the share’s value each year, or $0.76 per share.
While a single share may not result in significant dividend income, it is possible to build an entire portfolio around dividend stocks. A portfolio centered on high-yielding dividends can turn into a powerful wealth-building vehicle, one that can compound year after year with reinvestments. Traditional undervalued stocks, on the other hand, reward investors with growth potential, but neglect to include dividend income. The differences are subtle but worth considering.
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What Is Dividend Yield?
A dividend represents a payment made on behalf of a company to its shareholders (reflected as a percentage of the stock’s price). The dividend yield is the same concept extrapolated over an entire year. For example, if a $100 stock yields 5.0% once a year, a single share would net investors a dividend yield of $5.00 (5.0%) each year. When a stock only pays an annualized dividend (once a year), it is equal to the dividend yield.
However, it is worth noting that not all stocks pay dividends to their shareholders once a year. Some dividend stocks pay a dividend to their shareholders twice a year, quarterly, or even monthly. Investors can’t simply compare the dividends of separate stocks to determine the best returns. Comparing a stock that pays 12 dividends a year to one that only pays four could be misleading. Instead of using dividends to determine which stocks have the best returns, look at the dividend yield. That way, they will know how much to expect in return over a year.
A $100 stock that pays its shareholders two dividends of 2.5% each year, for example, still has a dividend yield of 5.0%. The only difference is that the dividend payment is distributed two times a year instead of one.
The dividend yield is essentially another stream of income. However, the dividend yield is about as passive as an income stream as investors will ever see. Outside of owning shares, all investors need to do is sit back and collect the dividend yield.
Dividend Stocks Vs. Dividend Funds
Dividend stocks are simply equities traded on all of the major indices, not unlike traditional stocks. Investors will invest in dividend stocks to capitalize on both growth and dividend yields. There are many dividend stocks traded on Wall Street, and it’s not easy to choose between them all.
Traders who know how to conduct their research and are comfortable making their own investment decisions are free to deploy their cash in whatever way they see fit. Investors who are less familiar with their dividend stock options have another opportunity: dividend funds.
Otherwise known as dividend mutual funds, dividend funds operate in the same way as their traditional mutual fund counterparts. Instead of investing in just any equities, dividend funds only invest in stocks that pay dividends. If investors aren’t comfortable picking their dividend stocks or prefer a more passive approach to investing, they can invest in a dividend mutual fund.
Dividend funds are run by professional money managers and tend to prioritize established stocks with high dividend yields. Anyone who pays into a dividend fund can expect someone else to distribute their capital amongst several dividend stocks. When all is said and done, these funds serve as a “middleman” for investors looking to invest in dividend stocks. Any dividends the shares earn will first be distributed to the fund, which will then return the dividends to the investors (after taking their fair share, of course).
According to Greg McBride at Bankrate, there’s no reason investor shouldn’t consider both individual stocks and funds. If for nothing else, investing in both is a great way to diversify holdings. “Mutual funds and exchange traded funds diversify your money over many companies – sometimes hundreds or even thousands – as a way to reduce risk. This can provide investors with a reliable income stream that isn’t sensitive to the fortunes of one company,” says McBride. Additionally, those who diversify well will reap long-term rewards if they reinvest their dividends. McBride is quick to point out that “reinvesting the dividends back into the fund is a great way to compound your wealth as you buy more shares, that in turn generate more dividends that can then be reinvested.”
How To Evaluate Dividend Stocks Before Investing
Dividend stocks share a lot of similarities with traditional (non-dividend) equities. As such, many of the same evaluation methods used to determine a good stock can also be applied to dividend stocks, with a few exceptions. Most notably, investors will want to pay special considerations to the stock’s dividend yield. The dividend yield will determine the income one can expect over a year. However, the dividend yield is only a fraction of the equation. In addition to income potential, investors should also look closely at the following:
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Consistency: Great dividend stocks have developed a track record of growing their dividends year after year. Whether it be in times of prosperity or downturn, growing a dividend is a sign of strength investors should pay close attention to. The Dividend Aristocrats, for example, have grown their own dividends for at least 25 consecutive years. Conversely, companies who have eliminated their dividends on more than one occasion may not be on solid financial ground and may not be the best place to deploy money for long periods.
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Financial Stability: Financial stability is second to none. For a dividend stock to even be considered by investors, it should have a good balance sheet. A company with little debt and a lot of extra cash on hand is always a good sign. Remember, there’s no reason for investing in a dividend stock that won’t be around next year, so put your money where you can set it and forget it.
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Profit Margins: Dividends are paid directly to shareholders from the companies themselves. As a result, it’s important to make sure the company is making enough to continue paying said dividends. Of course, company revenue can vary from quarter to quarter, but it’s important to make sure the business can keep its shareholders happy.
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The Moat A moat is another term for a company’s competitive advantage. Investors will want to see their dividend stocks boast a large moat, one that can keep risk to a minimum. A company that doesn’t face many exterior threats is more likely to succeed in the long run and pay dividends for years to come.
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Potential: Generally speaking, investors invest in dividend stocks for the yield, but there’s no reason a great stock can’t grow too. The best dividend stocks have a lot of growth potential in a promising industry and still pay dividends.
High Yield Vs. Low Yield Dividend Stocks
It is all too easy for inexperienced investors to allocate their cash into dividend stocks with the highest yields. High yields should suggest the investor will get more in return for their investment. However, a high-yielding dividend stock isn’t necessarily indicative of a good investment. Dividend stocks with yields much higher than their counterparts are most likely too good to be true. According to Jason Hall at the Motley Fool, “High yields can be the result of a stock that’s fallen because the dividend is at risk of being cut. That’s a dividend yield trap.”
A high dividend yield doesn’t mean the stock is a bad investment, but be wary when something seems too good to be true. Instead of blindly buying a stock for its yield, do the homework. Let decisions be based on the company’s fundamentals and track record and not subjective feelings. A good company with a lower dividend yield will almost always trump a virtually unknown entity with a high yield. “It’s better to buy a dividend stock with a lower yield that’s rock-solid than to chase a high yield that may prove illusory,” according to Hall.
How To Invest In Dividend Stocks In 5 Steps
With perhaps the lowest barrier of entry for any investment vehicle, investing in stocks for beginners is relatively easy. A brokerage, a mind for due diligence, and a little patience are all that’s needed for dividend stock investing. It can be broken down into five simple steps:
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Settle On A Goal
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Compile A Watchlist
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Screen Each Stock On Your Watchlist
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Decide How Much Of Your Portfolio You Want The Stock To Be
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Diversify
1. Settle On A Goal
The first thing aspiring dividend stock investors will want to do is settle on a goal. Determine exactly what you want out of the stock market and develop a plan around your endgame. There’s no way to gauge success or failure without the backdrop of a control. Determine how much money you want to make within a certain timeframe, and start looking for companies that might get you closer to your goal.
2. Compile A Watchlist
Once you know where you ultimately want to be, it is time to pick the road to take you there. Instead of a literal road, however, the path will be paved with dividend stocks. It is at this point you will want to compile a watchlist of potential investment candidates. It is always a good idea to invest in industries you are acutely familiar with. Stick with what you know, and investing will be a lot easier. However, it’s never a bad idea to listen to successful investors, too. Find out what today’s most successful investors are talking about and add the companies to a watchlist.
3. Screen Each Stock On Your Watchlist
This is the step that separates good investors from bad ones. If, for nothing else, it’s not enough to simply like a dividend stock—investors need to know why they like a stock. Build a thesis as to why you should invest in a company. Look at everything from its previous performance to the people managing the business. Pay close attention to the price-to-earnings ratio and the debt. There are countless things to look at before making a decision, so don’t act impulsively. Only once you like everything you see should you even consider adding a stock to your portfolio.
4. Decide How Much Of Your Portfolio You Want The Stock To Be
Starting a position in a new dividend stock isn’t as simple as putting all of your free cash into it. Instead, it’s always a good idea to start a small position and build up to a larger percentage of your portfolio. Typically investors will want to keep each holding to around 5.0% of their portfolio, but there’s nothing wrong with opening a smaller holding and building it up over time. That way, investors are less susceptible to buying at peak prices and may average down over time.
5. Diversify
No investment is guaranteed. The best investors are right slightly more than half the time. However, it only takes a few good calls to cancel out all the poor ones. As a result, investors will want to diversify their holdings. It is not wise to put all your money in a single stock. Instead, spread your capital out over somewhere between 10 to 20 stocks. That way, a single bad call won’t tank your entire portfolio.
Now that you know how to invest in dividend stocks, take a look at our picks for the best high-yield dividend stocks of 2022.
Are Dividend Stocks Worth It?
Far too many investors don’t appreciate dividend stocks for what they are: wealth-compounding machines. Instead, many investors are quick to write off dividend stocks as boring, low-return equities. It’s true: most dividend stocks don’t have the same allure as today’s best growth companies. Admittedly, dividend stocks don’t look as exciting as small-cap companies with unlimited growth potential, which begs the question: Are dividend stocks worth it?.
Dividend stocks are worth the investment for those looking to capitalize on compounding returns and passive income. Truly great dividend stocks can simultaneously provide shareholders with decades of growth and annual income. Even a small investment in a dividend stock now can compound over the years and improve returns without investors lifting a finger. Executing a DRIP (dividend reinvestment plan) strategy will have investors reinvesting their dividends back into growing companies and creating intrinsic value with little to no effort.
In their simplest form, “DRIPs are a type of dollar-cost averaging,” according to Robert R. Johnson, Professor of Finance, Heider College of Business, Creighton University, Omaha, Nebraska. “Instead of accepting a cash dividend, the dividend is reinvested at the then-prevailing price. For the investor, the most basic advantage relates to cash planning. Why should an investor accept dividends if he doesn’t need the income for many years? By reducing costly transaction fees and commissions, the investor can put more of his investment dollars to work over the long run and earn more. For plans that allow discounted purchases or other perquisites for shareholders, the advantage can be even greater,” said Johnson.
The greatest benefit of dividend investing occurs when share values rise. Even if the dividend remains the same, the company’s growth (and the value of its shares) will increase the dividend yield. Or, as Investopedia so eloquently puts it, “if a company keeps a dividend payout ratio constant, say at 4%, but the company grows, that 4% begins to represent a larger and larger amount. (For instance, 4% of $40, which is $1.60, is higher than 4% of $20, which is 80 cents).”
It is important to note that the same dividends investors covet also limit their respective shares’ upside. While dividends can be a great source of income, the simple fact that the company is distributing dividends means the growth of the respective stock is limited. In other words, money that could be spent on growing the company is instead returned to shareholders. When all is said and done, investors shouldn’t be asking themselves, “are dividend stocks worth it,” but rather, are they worth it for where I am at in my investing career?
Summary
Learning how to invest in dividend stocks doesn’t carry the same level of excitement as some of today’s most promising growth stocks. After all, growth stocks are the ones making all the headlines at the closing bell. Nonetheless, there’s absolutely no reason to ignore the highest paying dividend stocks with proven track records. While they may not be as exciting as tomorrow’s newest tech IPO (initial public offering) or a game-changer in the electric vehicle industry, dividend stocks are mostly dependable and entirely capable of serving as the foundation for any portfolio. Learn how to invest in dividend stocks today, and years of compounding reinvestments will most likely make your future self a lot more financially secure.
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