You might not guess it from the way many investors base their mood on the day-to-day movements of the stock market, but for most people, an investment account represents money that’s being put away for the long term.
It isn’t like a bank account, with money regularly going in and out. The profits and losses those investors see on their statements—especially younger savers—won’t be realized until they actually sell their holdings. And that could be years or even decades down the road.
For those who are looking for money right now, however, there is a way to generate income from a stock portfolio on a more predictable basis—even if you’re just starting out. And that’s by investing in stocks that pay a dividend.
How Does Dividend Investing Work?
A dividend is a portion of a company’s profits that’s paid to its investors, as directed by the board of directors. Dividends usually are paid quarterly, but they also may be distributed monthly or yearly.
Most dividends are cash payments made on a per-share basis. For example, if the company pays a dividend of 30 cents per share, an investor with 100 shares of stock would receive $30.
The “dividend rate” is the total expected payments for the year, plus any non-recurring payments the investor might receive during that same period. If the investor receives $30 monthly, the dividend rate is $360.
Why would a company make dividend payments? It’s often a sign that the company’s growth has begun to slow. Instead of reinvesting in itself, the company may decide to share its profits in an effort to keep stockholders from moving on to something else.
It’s a normal part of the business cycle—and it’s generally thought of as a positive sign when a company is stable enough to offer its investors reliable dividend payments.
Dividends aren’t guaranteed, though; a company can skip or stop making payments at any time. That’s pretty rare, however, which is why so many older investors make dividend payments part of their retirement plan: They look at it as a dependable way to replace some of their income when their regular paychecks go away.
Younger investors also might use their dividends to help pay the bills—or to save for a big vacation or some other hefty purchase. But those who don’t need the income may choose to reinvest the money with the idea of boosting portfolio growth.
The more dividends they reinvest in the stock, the more shares they can own. And the more shares they own, the larger their future dividends could be.
No matter what the purpose behind the purchase might be, it’s usually a slow and steady process compared to investing in growth stocks, which are stocks that rarely pay dividends because the profits are reinvested in the company. Still, investors should take care when picking dividend-paying stocks.
How to Invest in Dividend Stocks
So, what should an investor look for in dividend-paying stocks? That’s a tricky question. Did we mention that there are no guarantees and all investing comes with risk?
Even with help from a financial professional, investors may want to look at several criteria before moving forward.
Here are a few things investors can consider when looking for the best dividend stocks:
Investors often go by a stock’s “dividend yield” to determine its potential. Yield is presented as a percentage (annual dividends per share divided by price per share) that represents the return per dollar invested that a shareholder receives in dividends.
Stocks that offer the highest yields may appear to be the most promising, but that number can be misleading. The dividend yield could be rising because the share price is falling—and that can be a sign that a company is struggling. So yield is an important factor to follow, but it shouldn’t necessarily be the only one.
Dividend Payout Ratio:
Another number to look for is the “dividend payout ratio” (annual dividends per share divided by earnings per share). This percentage can help determine if the dividend payments a company is making make sense in the context of its earnings.
Again, a high ratio is good, but an extremely high ratio can be difficult to sustain. If a stock is of interest, it may help to check out the company’s payout ratios over an extended period.
Investors also may wish to focus on stable, well-run companies that have a reputation for paying consistent or rising dividends for years.
To be considered a “dividend aristocrat,” a company must have paid its dividends for at least 25 years with a steady increase each year.
Think about the products people use every day and the businesses that are expected to be around for a long, long time: popular fast-food restaurants and snack brands, soft drink companies, well-known big box stores, and utility companies.
Keep in mind a company’s future prospects, though, not just its past success, when shopping for high-dividend stocks.
For those who are drawn to the growth potential made possible through reinvesting, timing also may be a factor.
Stocks that pay monthly dividends are less common, but they can make it possible to purchase additional shares more quickly. (They also can help those who use their dividends for income to get their bills paid on time every month.)
Real estate investment trusts (REITs), many of which distribute dividends monthly, are a popular choice for those who want consistent payments.
A “qualified dividend” is a type of dividend that qualifies for a favorable or a lower tax treatment. A “non-qualified dividend” doesn’t get that lower tax preference and is taxed at an individual’s normal tax rate.
Investors will receive a Form DIV-1099 when $10 or more in dividend income is paid out during the year. (If the dividends are in a tax-advantaged account (an IRA, 401(k), etc), the money will grow tax-free until it’s withdrawn.)
What Are Some Other Pros and Cons?
We’ve discussed two of the biggest pros to investing in dividend stocks: passive income (income that requires little to no effort to earn and maintain) and reinvestment (using dividend payments to buy more stocks—or to get into other investment options).
Another plus for those who choose solid dividend stocks is that they likely will receive payments from those investments even if the market takes a dip or dive.
That can help insulate investors during tough economic times. It might keep those who are making regular or occasional withdrawals from their stock portfolio from having to sell at a low to get the money they need.
It also may allow investors who don’t need the income to buy stocks at a lower price while the market is down. Stock in a mature, healthy company also may be less vulnerable to market fluctuations than a start-up or growth stock.
But no investment strategy is perfect, and there are some disadvantages to dividend stocks. Dividends are not obligations, and a company can decide to cut its dividends at any time. It could be that the company is truly in trouble or that it simply needs the money for a new project or acquisition.
Either way, if the public sees the cut as a negative sign, the share price could fall significantly. And if that happens, an investor could suffer a double loss.
Then there’s the matter of double taxation. First, the company must pay taxes on its earnings. Then the shareholder must pay taxes again as an individual.
Finally, choosing the right dividend stock can be tricky. As noted above, the metrics are quite different than they are for selecting a growth stock.
This isn’t about finding the next big thing—but you don’t want the big thing that’s nearly over. While perusing the possibilities it may help to remember that what enables a company to stay healthy typically keeps its dividends healthy, too.
Dividend-paying stocks can be used to grow and diversify your portfolio and to help shield your savings in a downturn. But they aren’t foolproof.
Like any stock, they can be subject to company-specific, sector-specific, and general market risks. And as with any stock purchase, it’s important to consider the big picture before making the investment.
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