A Complete Guide to Dividend Investing

January 11, 2022

Dividends are a significant part of stock returns over time and one of the biggest draws for many investors. In fact, many investors build their portfolios around stocks with strong dividends.

But what if you could earn even more money on your stock dividends? You can’t predict how the stock market will turn or what returns you’ll see in your dividends, but you can make your dividends go further. That’s where dividend investing comes in.

For investors who are new to the concept, here’s a quick and easy review of dividend investing basics to help you get started.

What is a Dividend?

A dividend is a distribution of some of a company’s profits to a certain class of shareholders, as determined by the board of directors.

When a company earns profits, it has three choices to spend the money: save it, redirect it to research and development, or return it to shareholders as dividends. It works a bit like earning interest on your savings account through your bank.

Not every stock does this—a stock has to be classified as a dividend-paying stock. Not every company offers dividends, either. Larger, well-established companies with predictable profits tend to be the most reliable dividend payers. Dividends are most common in specific industries, such as banking, pharmaceuticals, utilities, and oil.

Types of Dividends

Not all dividends are created equal. There are several different types of dividend-paying stocks, including:

  • Cash dividends
  • Stock dividends
  • Special dividends
  • Preferred dividends
  • Dividend reinvestment programs (DRIPs)

Cash dividends are the most common type, paid in cash directly to a shareholder’s brokerage firm. A company may choose to pay investors with additional stock shares instead of cash (which is a stock dividend). Special dividends are paid out to all the company’s common stock but don’t recur—think of it like a surprise holiday bonus. Preferred dividends are issued exclusively to preferred stock owners.

A DRIP can work in tandem with any of these dividend options. Programs like this allow shareholders to reinvest any dividends back into the company stock, often at a discount.

What is Dividend Investing?

Once you understand dividends, it’s much easier to grasp dividend investing.

Dividend investing is a stock buying strategy that focuses on buying dividend-paying stocks. The goal is to use dividend income as a safe way to build a nest egg from marginal earnings. Whether or not you reinvest those dividends is up to you—the strategy focuses on purchasing dividend-paying stocks, not what you do with the dividend income once you have it.

Dividend Investing Basics

As you can see, the basic concept of dividend investing is pretty straightforward. Your strategy will focus on identifying the best dividend-paying stocks from high-performing companies.

However, as with other stock investment strategies, you probably shouldn’t approach it haphazardly.

Successful dividend investing requires time, research, and dedicated effort to ensure a company is the right fit for your portfolio. The fact that a certain stock pays out dividends might not necessarily be enough of a good reason for you to include it in your portfolio—you have to research the company, see how it performs, and assess how it fits into your overall strategy.

You should also use a dividend investment strategy alongside your own risk management strategy. Remember, the fact that a stock pays dividends has little to do with the risk of investing in the company.

How Dividend Reinvestment Strengthens Your Returns

If you do your homework and invest in the right dividend-paying stocks, dividend investing—and dividend reinvesting—have the potential to strengthen your returns. It’s all about the magic of compounding.

Let’s say you invest $100 with a 10% annual interest rate. At the end of the first year, you’ll have $110. But at the end of the second year, you’ll have $121—10% interest on your original $100 investment and on the $10 in interest it earned last year. That’s compounding.

When you reinvest dividends rather than saving them, there’s the potential for additional compounding on the dividends. In other words, the money you earned can earn you even more.

Are Dividends Safe?

Of course, no investment is risk-free, and dividends are no exception.

The biggest risk of dividends is that they are not guaranteed. Companies can (and do) change the dividend terms at will, so there’s no guarantee that the dividends you signed on for are the dividends you’ll receive in the long term—and that’s before the company’s annual profit comes into play.

And speaking of profit, dividends are based on them. Here’s the catch: dividend-paying stocks are typically issued by larger, more established companies, since they’re stable enough to reward investors by growing their wealth. The problem is that larger, more established companies grow at a slower rate than younger ones—and those that have astronomical growth rates are unlikely to sustain them in the long run.

Things to Watch For

As with any other stock, you need to assess a dividend-paying stock carefully. That means a careful assessment of the company’s performance and whether it can sustain its current growth rate in the coming years.

You should also pay careful attention to the fine print if you purchase a margin account instead of cash dividend stocks through a broker.

Brokers are allowed to take shares of your stock and loan them to traders who want to short the stock, and since the traders can sell the stock without telling you, they have to pay you in dividends you missed. You’ll make the same amount you would have made on dividends paid through the stock, but there’s a catch: because it’s cash and not a dividend, it’s treated as ordinary income, which means you’ll have to pay higher income tax.

Make the Most of Your Money

Learning dividend investing basics is just the beginning. There’s a whole wide world of investment options out there, and you can grow your portfolio if you’re willing to take advantage of them.

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