Learning how to invest in dividend stocks is essential for investors looking for investments that offer regular income. Dividend stocks disperse part of a corporation’s earnings to investors consistently. Many American dividend stocks pay a set amount to investors quarterly, with top dividend stocks, increasing their payout amounts over time. While some investors elect to reinvest their dividends, others build a cash stream similar to an annuity. Either way, it’s essential to understand what dividend stocks are, the pros and cons associated with them, and how to invest in dividend stocks successfully.
How to invest in dividend stocks:
- Locate a dividend ETF or individual dividend stock
- Analyze the dividend ETF or company of stock you are considering
- Analyze the safety of the dividend ETF or individual dividend stock
- Purchase the dividend ETF or individual dividend stock
What Are Dividend Stocks?
Dividend stocks are corporations that regularly pay out dividends to investors. Dividend stocks are typically well-established businesses with a solid history of dispersing earnings back to investors. They are usually less volatile than growth stocks making them an excellent way to diversify your investment portfolio and reducing your risk level.
Pros and Cons of Investing in Dividend Stocks
There are several advantages associated with dividend stocks, including immediate cash flow, reinvestment opportunities, and special tax considerations. It’s important for investors to understand the favorable aspects of having dividend stocks as part of their portfolio and how they can boost their financial strategy.
- Investment income. While CDs and bonds are more common types of investment income, dividend stocks can also provide this. This is especially helpful when stock markets appear to be at a standstill. Investors can wait for stocks to increase in value while still earning passive income.
- Relative stability. Usually, companies are only able to pay regular dividends when they have consistent earning streams. This means companies with long dividend histories are viewed as “blue-chip” or reliable stocks that have a predictable cash flow. Top dividend stocks typically have less volatility than the market overall and are in constant demand, which supports long-term increases in stock prices.
- Capital appreciation. Companies that pay dividends offer investors two ways to make a profit. Along with a quarterly paycheck, investors can also benefit from any increases to the stock’s price. Finally, blue-chip stocks that have a long dividend-paying history may also increase their dividend amount over time, which increases an investor’s income stream.
- Reinvesting dividends. Many companies provide dividend reinvestment options where investors can elect to reinvest their cash dividends into more shares of stock instead of getting cash distributions. By reinvesting dividends, investors will compound interest, which makes their investment grow faster over time.
- Special dividend tax rate. Investors may qualify for the “qualified dividend” rate, a special tax rate most stocks that pay dividends benefit from. Instead of paying their ordinary income tax rate on their dividend income as they would with investment coming from CDs and bonds, investors will pay a special 0%, 15%, or 20% rate depending on their tax rate.
While dividend stocks may provide a reliable stream of income, they’re also susceptible to double taxation, business costs, and decreasing stock prices. Finally, depending on the investment needs and style of individual investors, slow, steady growth may not be considered attractive.
- Getting taxed twice. First, any income the company earns is taxed at its tax rate. Then investors will pay tax on dividends when they file their tax return.
- Reinvesting instead of distributing. Sometimes investors think a business can grow faster by reinvesting its cash flow to finance its operations instead of distributing profits to investors. Many companies growing rapidly elect to use their profits to fund business expansion instead of paying profits out in dividends.
- Low growth resulting in low income. Top dividend stocks are generally larger, established companies viewed as more reliable instead of explosive in terms of earnings. While a consistent income stream can be attractive, many growth investors shy away from these companies. Instead, they favor more cutting-edge, aggressive companies offering higher reward and risk.
- Risk of a dividend cut. While high payout ratios may be initially attractive, an abnormally high dividend per share may not be sustainable in the long term. When dividends get cut, the price of that stock can suffer tremendously.
How to Invest in Dividend Stocks
There are two basic ways to invest in dividend stocks, either by purchasing individual dividend stocks or via exchange-traded funds (ETFs) that house these stocks. Dividend ETFs offer an easier entry option, especially for new investors, and include hundreds of dividend stock options. This instantly provides investors with diversification and increases the safety of their payout. Even if some of the stocks in the fund decrease or eliminate their dividends, the effect will have a minimal impact on the overall dividend for the fund.
Building a portfolio of individual dividend stocks is more complicated than buying a dividend ETF and requires a great deal of time and effort on the part of the investor. However, investors choosing to pick their dividend stocks have the opportunity to personalize their portfolio and locate higher dividends than found in an ETF. A consistent payout and one with minimal risk should be a top consideration for any investor purchasing a dividend-paying investment.
How to Invest in Dividend Stocks via ETFs
Dividend ETFs provide a straightforward and simple way to gain exposure, knowledge, and experience in the investing niche of dividend stocks. Buying a dividend stock ETF is easy if you following these simple steps:
- Locate a broadly diversified dividend ETF. Searching a broker’s website for a dividend ETF is one easy way to start. A low-cost EFT that selects dividend stocks from the S&P 500 stock index is a relatively safe option. Investors may also want to restrict their search to commission-free options eliminating the requirement of paying a commission every time they buy or sell the ETF.
- Analyze the dividend ETF. Confirm the dividend ETF is invested in equities or stock and not bonds.
- Analyze the safety of the dividend ETF. Check the dividend yield, or how much the company pays out in dividends annually compared to the share price. This is typically shown as a percentage, and usually, the higher the percentage, the better. However, they should examine anything higher than 3.5% to assess the safety of their investment. Also, take note of the ETF’s five-year returns where higher is better, and it’s expense ratio or the ETF’s annual fee where lower is better but definitely under 0.5%.
Finally, look at the stock size. Dividend ETFs can invest in companies with small, medium, or large capitalizations where small caps generally come with more risks, and large caps offer more safety.
- Purchase the EFT. Investors can buy dividend ETFs the same way they buy stocks, via an online broker. Most experts recommend buying them regularly and taking advantage of dollar-cost averaging.
Buying dividend ETFs allow individual investors to buy a single ETF without having to track multiple companies, a requirement when purchasing individual dividend stocks.
How to Invest in Individual Dividend Stocks
Investing in individual dividend stocks requires more time, effort, and experience from the investor, but can provide higher returns if done successfully. Steps for buying an individual dividend stock include:
- Locate a dividend-paying stock. Investors can search for dividend-paying stocks on various financial and online broker websites.
- Analyze companies of stock you are considering. Perhaps the hardest but most crucial step. Confirm the company you are considering is healthy and can maintain its dividend for years to come. This step requires investors to spend a significant amount of time understanding a company’s industry and financial statements.
- Analyze the safety of the dividend. What is the payout ratio, or percentage of income the company pays out in dividends? The lower the payout ratio, the safer the dividend is, and the faster it can grow over time. Payout ratios of more than 80% are generally a red flag, though, in some industries, investors won’t want a payout ratio of more than 50%.
- Determine how much of the stock you want to purchase. Diversification is essential, especially when buying individual dividend stocks.
Individual dividend stocks are ideal for investors who enjoy the challenge of watching the market for attractive stocks and have the time to do so. Successful investors will likely be able to build an investment portfolio that included dividend stocks offering a higher yield than what would be found with dividend ETFs.