Although all investing strategies are designed to increase your earnings potential, different strategies take different approaches to achieve that goal. The strategies you use should be chosen carefully based on your appetite for risk, investing goals, and knowledge of the market.
Some investing strategies are designed for investors who have a healthy appetite for risk and a drive to live on the wild side. Others are for the risk-averse investor whose interest is making money in the stock market over the long-term. The dividend investing strategy is one of the latter.
What Is a Dividend?
Dividends are a form of passive income paid to investors who own shares in dividend-paying stocks. Publicly traded companies have three options when they generate a profit from operations: They can invest profits back into themselves, buy back shares from the market to increase the value of the remaining shares, or pay their shareholders directly in the form of dividends. Dividends are a predetermined percentage of a company’s earnings that are divided by the total number of shares of stock and paid out to shareholders according to the number of the company’s shares they own.
Not all stocks pay dividends. Unless a dividend is declared, or announced to the public by the issuer, there is no requirement for any publicly traded company to pay dividends.
Nonetheless, it is a common occurrence — so common, in fact, that many income investors follow a strategy centered around investing in stable stocks that pay the highest dividends. That strategy is known as dividend investing.
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What Is Dividend Investing?
Dividend investing is an investing strategy that is centered around purchasing high-quality dividend stocks. Ultimately, dividend investing provides investors with three primary points of value:
- Dividend Income. Dividends are what dividend investing is all about. Good dividend stocks will consistently return profits to investors with high dividend yields that grow consistently over time. As a result, dividend stocks are a favorite among retirement investors due to the income the investments provide. This dividend income can either be spent as regular income or used as dividend reinvestments in order to take advantage of compounding gains.
- Steady Growth. Stocks that pay high dividends are generally blue-chip stocks known for minimal volatility. This means dividend investors not only enjoy income, but they also enjoy slow, steady share price growth, rather than rapid swings of value seen in other areas of the stock market. As a result, dividend-paying stocks are generally safer investment options, scratching the itch for the risk-averse investing community.
- Tax Advantages. Dividend stocks are tax-advantaged investments. Therefore, dividend investors pay lower tax rates than investors in other forms of securities. This is for two reasons. First, dividend stocks are long-term investments, and capital gains from the sale of investments held for longer than one year are taxed at a lower rate. Second, qualified dividends paid by most dividend stocks are also taxed at a lower rate than ordinary income.
The dividend investing trading strategy provides these benefits by focusing heavily on the financial stability of the companies that are invested in and the dividends paid to investors by these companies.
How to Find the Best Dividend Stocks
Any time you make an investment, it’s important to do your normal due diligence by looking into the historic growth of the company, its stock price, the management team, profitability, market size, and a host of other factors. However, if you want to maintain a portfolio with high dividends, it’s important that you also pay attention to dividend-focused aspects of any company’s stock on your watch list. The three dividend-focused statistics that you should pay attention to include:
Dividend yield is a term used to describe the dividend-to-price ratio. A higher dividend yield means that you will earn more dividends per dollar spent when you make an investment, while a lower dividend yield means that you will earn a smaller percentage of your investment dollars as dividend payments.
A stock’s dividend yield can be calculated in two ways, but the result will always be the same:
- Per-Share Calculation. If you divide the total dividend per share paid over the course of a year by the price of the stock, you will come to the dividend yield. Therefore, if a $10 stock pays $0.50 per year in dividends, the dividend yield on the stock is 5%.
- Total Dividend Calculation. You can also calculate the dividend yield by looking at the total of dividends paid. For example, if a company worth $100 million pays $5 million in total dividends to its investors per year, it’s dividend yield is also 5%.
Paying attention to dividend yield is important because it tells you how much value you can expect in terms of income for every dollar spent when you make an investment. Dividend yields range from 0% to 5% on average, with few companies exceeding a 6% dividend yield. Although, there is no limit on the amount of dividends a company can pay back to investors.
Dividend Payout Ratio
The dividend payout ratio looks at the strength of dividend payments from a completely different perspective. Instead of looking at value per share like the dividend yield, the dividend payout ratio looks at what percentage of a company’s earnings are returned to shareholders as dividends.
To calculate the dividend payout ratio, simply divide the total dividend paid by the company’s earnings. So, if a company pays $5 million in dividends annually and generates $10 million in annual net income, it has a dividend payout ratio of 50%.
The higher the dividend payout ratio the better, in most cases. However, some profits need to be held back so the company can increase infrastructure and maintain growth. So, if a stock has a dividend payout ratio of 75% or higher, it could be a sign that it is overextending in terms of dividend payments and will soon have to reduce quarterly or annual dividends.
Tracking the dividend payout ratio is important, and there are benefits and pain points for both high- and low-dividend-payout-ratio investments. Low dividend payout ratios mean that you don’t get as big of a share in profits, but usually mean the company is reinvesting more of its earnings into innovation to drive sales growth leading to valuation growth. High dividend payout ratios are fun because you get a higher percentage of profits, but that leaves less capital in the company’s coffers for innovation.
Pro tip: If you’re going to add dividend stocks to your portfolio, make sure you choose the best possible companies. Stock screeners can help you narrow down the choices to companies that meet your requirements. Learn more about our favorite stock screeners.
Historic Dividend Growth Rate
In theory, as a company’s stock price increases, its dividend payments should grow as well. After all, as a company’s value grows, it’s a sign that it is generating strong revenue and earnings growth, so your cut of those profits should continue on the upward trend.
Street Insider offers up the perfect tool for digging into a stock’s dividend history, giving you a clear picture of historic dividend growth, or lack thereof. Simply type the ticker you’re interested in into the search box, and the site will show you the complete history of that company’s dividend payments, including how much the company paid to investors on what dates as well as the stock’s dividend yield history. Good dividend stocks will have a strong track record of relatively consistent dividend increases over several consecutive years.
Combine the 3
When looking for the best dividend stock, you’re ultimately looking for a stock with a dividend yield of 4% or higher, a dividend payout ratio between 50% and 70%, and a strong history of dividend growth. If you hit these three nails on the head, there’s a strong chance that an investment in the stock will provide an appreciable level of dividend income.
General Due Diligence
Finally, a strong dividend yield and track record of dividend growth is great, but it’s important to make sure that the valuation of any stock you buy makes sense as well. As with any other investment, do your research by diving into the company’s price-to-earnings (P/E) ratio, price-to-sales (P/S) ratio, debt-to-equity ratio, and other valuation metrics to make sure that you don’t find yourself investing in an overvalued stock.
Beyond valuation, it’s important to look into other fundamental factors including management, innovation, and plan for continued growth. A good dividend stock isn’t just any dividend-paying stock, but one that has the potential to achieve valuation growth in the long run.
Where to Find the Best Dividend Stocks
Publicly traded companies are not required to pay dividends, and many do not. However, there are a few sectors that are known for returning a large amount of value to their investors through dividend payments.
The sectors known for paying the highest dividend yields include:
- Utilities. In the old days, the adage “if you build it, they will come” lived strong. Today, that’s not always the case, but in the utilities sector, it often is. When utilities companies build infrastructure that ties into homes and businesses, offering water, electricity, and other necessities, they know the resources will be used. As a result, utilities companies have the ability to mindfully improve infrastructure while paying some of the highest dividends seen in the stock market today.
- Energy. The energy sector is also known for high dividend payments. However, these stocks tend to be the more risky of dividend-paying stocks, as they ebb and flow with the value of oil, a commodity that has seen tremendous pressure in recent years.
- Consumer Staples. Consumer staples companies enjoy steady demand from mass-market consumers. Therefore, it is easier for management to predict future growth trends and make sensible investments in infrastructure while returning value to shareholders through dividend payments.
- Dividend Funds. If you’re not comfortable with analyzing the market and making your own investment decisions, you have the option to take a heavily diversified approach by investing in funds that focus on dividends. In fact, there are plenty of exchange-traded funds (ETFs) and mutual funds that focus specifically on dividend income while providing the safety associated with heavy diversification.
How Much of Your Portfolio Should Be Geared Toward Dividend Income?
Most experts will say that high-dividend stocks should be part of just about every investor’s investment strategy. These stocks offer a way to break up some of the risk in any investment portfolio while providing stable dividend income. Even at smaller allocations, the benefits involved in dividend-paying stocks can make a significant difference, making them a valuable part of a well-diversified portfolio.
So, the question here isn’t who should invest in high-dividend-paying stocks, because the answer to that question is “everyone.” The real question is how much of your investment portfolio should be allocated to high-dividend stocks.
Determining how much of your investment portfolio should be allocated to dividend-paying stocks is an intimate process that requires detailed knowledge about you. The good news is that nobody knows you better than you. To determine how much of your portfolio should be invested in high-dividend stocks, consider the following:
Your Appetite for Risk
Risk is a crucially important factor to consider when making any investment. If you invest in stocks that are riskier than you’re comfortable with, emotions will drive you to make mistakes. Conversely, if you invest in stocks with low levels of risk that don’t provide the momentous growth you’re looking for, you’re not meeting your goals either.
Dividend-paying stocks are also generally known for relatively slow, steady growth. These are considered to be lower-risk stocks. As a result, if risk makes you queasy, a larger portion of your portfolio should be focused on dividend investments. On the other hand, if your motto is “bring it on baby,” a smaller percentage of your investment portfolio should be allocated to dividend-paying stocks.
Age is an important factor when investing. As you get closer to your golden years, it becomes more crucial to focus on stability and income, whether it be dividend income, coupon rates on bonds, or another form of income investment. Investing is just like anything else — as you age, you become less likely to take risks because risks become more painful.
Investing in high-risk stocks is a lot like skydiving. It’s fine when you’re young, but as you age, the potential consequences become more devastating, and the high-flying activity loses some of its appeal.
Moreover, as you near and enter your golden years, steady income is going to become more important than investment portfolio value growth. This only adds to the argument that your age should be considered when determining how much of your investing funds will be allocated to dividend-paying stocks.
Your Investing Goals
Finally, although everyone wants to make money when they make an investment, each investor’s goals and the time horizons are unique. Most overall portfolio goals can be grouped into three general buckets:
- Momentum. If you’re into stock trading in an attempt to make money off of short-term price movements in the stock market, you’re looking for momentum plays. Taking this to the extreme makes you a day trader. If you’re looking for momentous movements that have the potential to generate large gains but come with comparable risk, you won’t find it with stocks that pay high dividends. Although you should still have dividends somewhere in your portfolio, they should be far from the main focus.
- Growth. Some dividend stocks are also relatively strong growth stocks. That’s especially the case if you take the time to find stocks that are generally undervalued but pay high dividends. So, if you’re looking for growth and want to ice the cake with strong dividends, you may want to load up on well-researched dividend stocks.
- Income. Finally, if your goal is to generate income through your investments, dividend plays are the way to go. Stocks with a high dividend yield offer you more income per dollar than most other investments, both inside and outside of the stock market.
Are Dividends a Substitute for Bonds?
With dividend stocks providing slow and steady growth as well as dividend payments, they are often compared to bonds, which also grow at a slow and steady rate and provide coupon payments based on interest rates. However, high-dividend stocks — even the best of the best dividend stocks — are still stocks and should not be confused with bonds. Doing so may prove to be quite costly.
Bonds are the typical safe-haven instrument used to protect an investment portfolio from the risk of significant losses should the stock market as a whole take a nosedive. Bonds provide extremely stable income through predetermined interest rates, and a near-guaranteed return on investment if purchased from inception and held to maturity — that is, as long as the company or government municipality that issues them doesn’t become financially insolvent. Bonds are far safer than stocks, even when it comes to the best dividend stocks.
Sure, high-dividend stocks represent generally well-established companies that provide a great return of value for investors as well as dividend income. However, they provide nowhere near the investment portfolio protection provided by bonds and other, more stable safe-haven investments. As such, if you ditch bonds for dividend-paying stocks and the market takes a dive, your dividend investments aren’t going to protect your investment portfolio much.
Due Diligence Is Important Even When Investing for Dividends
Due to the relatively stable nature of dividend-paying stocks, many look at these stocks as low-risk investments, and they are. But that doesn’t mean that you should blindly pick a stock just because of its high dividend payments.
There have been points in time when the whole energy sector had a dividend yield of more than 7% on average. This happened when the floor fell out of the sector and stock prices dropped dramatically, but dividend money had not yet run out. In this case, a high dividend yield may have tempted you to invest in a sector that was diving — and would have led to significant losses.
The fact of the matter is that an educated investment has far better odds of producing profits than an invzestment made on a whim. The time it takes to research your investments before risking the first dollar is well worth the outcome in the long run.
Dividend investing is a tried and true strategy for building wealth and preparing for a comfortable retirement. In fact, it’s likely the strategy employed by your grandparents and possibly your parents.
These stocks provide a level of safety in a heavily diversified portfolio and stable income in retirement accounts. While dividend-paying stocks are compelling investment vehicles, the dividend investing strategy should be employed at different levels depending on the goals of the investor.
Investors in their golden years or those who aren’t comfortable with risk will benefit greatly from focusing on this class of stock. On the other hand, those with a healthy appetite for risk and an eagerness to see momentous movement in their portfolio may prefer to have less exposure to dividend-paying stocks.
As is always the case, regardless of allocation to dividend-paying stocks, you should make sure to do adequate research before making an investment. Educated investments tend to be the most rewarding.