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Dividend investing is purchasing stock from companies that dole out regular payments as a way to share some of the company's profits. It's a different investment strategy from stock investing, which usually focuses on potential investment gains—if you sell your shares for more than you paid for them, you'll turn a profit. With dividends, shareholders can earn gains on the shares they own without having to sell them off.
On top of regular investment gains, dividend investing can be a nice bonus payment, and can provide a steady stream of income. Since 1930, dividend payments have made up roughly 40% of the stock market's return, according to research from Fidelity Investments.
The process of dividend investing is relatively straightforward, but understanding the details can help you get the most out of this investment strategy.
How Dividend Investing Works
Dividends are recurring payments some companies make to shareholders to redistribute a portion of their profits. You're more likely to see dividends offered by more established companies that don't need to devote as much capital to growth. This is why dividend payments are less common among startups and younger companies.
Being strategic about dividend stock investing can position you to reap rewards on a predictable schedule. Dividends are usually paid quarterly, but some are paid annually, semiannually or monthly.
There are several types of dividends you may receive as an investor:
- Cash dividends: These are typically paid out as cash deposits into your investment account. Cash dividends are the most common type of dividend.
- Stock dividends: Some companies choose to pay investors with additional shares of stock in lieu of cash.
- Preferred dividends: Preferred dividends blend characteristics of a bond and a common stock. One benefit of holding preferred dividends is that you'll be paid dividends before common stock shareholders.
- Dividend reinvestment program (DRIP): DRIPs let you use cash dividends to buy more shares. You can then accumulate more stock over time—and benefit from the dividends paid out on those shares. DRIPs may also open the door to fractional shares. Instead of buying full shares, you can buy slices of shares based on how much you receive in cash dividends.
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How to Invest in Dividends
If dividend investing is something you want to explore further, take these steps before investing your money:
Decide Which Dividends Are Right for You
To decide which dividend stocks are right for you, narrow your search to companies that have a strong track record of financial stability and stable stock prices. Beyond that, consider the following:
- Dividend yield: The stock's dividend yield gives you a sense of how much you can expect to receive. It represents a company's annual dividend and is expressed as a percentage of the share price on a given date. If there's a stock that's worth $75 and pays out $1.50 per year in dividends, that's a 2% yield.
In the decade that followed the 2008 financial crisis, the average S&P 500 dividend yield was around 2%. As of February 1, 2022, it was 1.33%. Keep in mind that a very high yield can actually be a red flag because investors might wonder whether it's sustainable.
- Dividend payout ratio: This shows how much of their net income a company is funneling toward dividends. Many financial experts agree that 35% to 55% is a good benchmark. While it can be tempting for investors to chase dividends with a higher payout ratio, a lower ratio might indicate that the company has room to grow and may eventually increase dividend payments.
One way to invest in dividend stocks is with a mutual fund or exchange-traded fund (ETF) that invests in a group of dividend-paying companies. These funds allow you to buy small shares of a wide variety of dividend stocks, are generally considered less risky than individual stocks and can also help diversify your portfolio. If one dividend payment goes down, others in the fund may go up or continue to provide stable payments. Dividend funds that invest heavily in one particular industry sector could be more vulnerable to changes within that industry compared with funds that include a mix of industry and company types.
Keep in mind that a company's ability to provide dividends can change. If they encounter financial distress, they may decrease or suspend dividend payments. To reduce the likelihood of investing in these kinds of stocks, rely on companies that routinely increase their dividends year after year and have strong cash flow.
Look at Your Big-Picture Investing Plan
Whether you're leaning toward dividend funds or individual stocks, dividend investing should mesh well with your overall investment strategy. An experienced financial advisor can help you plan accordingly.
When strategizing, take your bigger financial picture into account as well. Investing heavily in dividend stocks may indeed increase your income—something that can be particularly attractive in retirement, especially when inflation is high. But depending on the stocks you choose, you could also miss out on greater investment gains within the broader stock market.
Understand the Tax Implications of Dividend Investing
Dividend income is taxable. Tax rates depend on your income and whether dividends are qualified or nonqualified. Qualified dividends are taxed as long-term capital gains, which is a lower rate than what you pay on your ordinary income. Nonqualified dividends are taxed at your ordinary rate.
Generally speaking, qualified dividends must be issued by a U.S. company or a company in U.S. possession, though there are some exceptions for foreign companies.
There are also rules around the ex-dividend date, which is when you must have purchased a stock in order to collect dividend payments. If you hold common stock, look back on the 121-day window beginning 60 days before the ex-dividend date. During this time, you must have held your shares for over 60 days for dividends to be considered qualified. If not, those payments will be taxed as ordinary income.
Pros and Cons of Dividend Investing
Pros
- Steady income: Dividend investing can create a steady income stream on top of gains from other investments in your portfolio.
- Steady growth: Many companies offer dividends that grow every year, which can help make up for the effects of inflation over time.
- Diversification: Investing in dividend-focused ETFs or mutual funds helps to diversify your portfolio, which can reduce some risk.
Cons
- Potential cuts: A company may cut dividend payments due to factors such as weakening earnings or limited funds.
- Interest rate vulnerability: As interest rates go up, dividends become less attractive to experienced investors.
- Inability to keep up with high yields: A company with a high dividend yield may seem appealing, but a high yield might not be sustainable if the company can't continue to afford funding dividends.
The Bottom Line
Dividend investing can provide a steady flow of reliable income, but there are other moving parts to consider. Before going all in with investing, it's wise to build your emergency fund, pay down debt and maintain a strong credit score. Experian Boost®ø can help increase your score relatively quickly by rewarding you for paying regular monthly bills on time.