Dividend Investing 101

November 17, 2021

Are you one of the 56% of Americans who own stocks? It’s the vehicle of choice for dividend investing, yet far too many investors don’t know what dividend investing is.

And if you aren’t familiar with dividend investing, you’re missing out on an opportunity to grow your money even further.

Here’s a look at dividend investing basics and how you can make this strategy work for your financial goals.

Dividend Investing Basics

Dividend investing is based on dividend income, the very feature that draws so many investors to stocks in the first place. Here’s the thing: just because you’re collecting stock dividends doesn’t mean you’re engaging in dividend investing, and if you’re not incorporating dividend investing, your money may not be growing as much as it could.

What are Dividends?

If a publicly traded company generates profits, it has three options for using the extra cash:

  1. It can put the funds toward research and development
  2. It can save the money for a rainy day
  3. It can return the profits to its shareholders

The third option is the one we’re focusing on—this is how you get dividends in the first place. A dividend is a share of the company’s annual profits distributed among its shareholders (you). In other words, when you own stocks that pay dividends, you get a share of the company’s profits. This is why dividend stocks are popular—you get income on top of the money you’ll eventually receive when you sell the stock for a profit.

Dividends are paid out of the company’s common stock, though a company has several dividend options to pay to shareholders, including:

  • Cash dividends
  • Stock dividends
  • Dividend reinvestment programs
  • Special dividends
  • Preferred dividends

These options are important to understand because dividends are not created equal. No dividends are guaranteed, but certain dividends take precedence. In tough times, if the company has to cut dividends, it starts at the bottom and works up (first paying bondholders, then preferred shareholders, then distributing the leftovers to common stockholders). But, conversely, companies use the same hierarchy in good times, paying preferred shareholders first (and with a larger cut than common shareholders). If you own stocks with preferred dividends, this makes you a preferred shareholder.

This is not to be confused with special dividends, which are one-time payments that are usually more than the regular dividend made in especially good times. Think of them as a bonus on top of your regular dividend paycheck.

What is Dividend Investing?

This brings us to dividend investing.

Dividend investing is a strategy in which you craft a portfolio primarily of dividend-paying stocks. This means that you focus on established companies with an excellent financial health record and a strong reputation as a dividend-paying company (as opposed to a growth strategy, which focuses on buying cheap stocks from up-and-coming companies to turn a profit when they grow in value).

The dividend investing strategy has two parts. Let’s assume you’re purely a dividend investor. First, you would spend most of your investing career shopping for dividend paying stocks, supported by reinvesting dividend payments into buying more shares. Second, you would stop reinvesting dividends once you reach retirement age—instead, those dividends would become a source of income.

How Dividend Investing Works

In order to successfully execute dividend investing, you have to understand the concept of a dividend yield. This is the annual dividend per share divided by the stock’s price per share.

For example, let’s say you bought 100 shares in Company A at $100 per share, for a total investment of $10,000. The company board decided to pay shareholders $10 per share annually as cash dividends. This would net you $1,000 in cash dividends. Dividing that $1,000 in cash dividends by the total $10,000 cost per stock, this gets you a dividend yield of 10%.

However, if you instead purchased shares in Company A at $200 per share, your dividend yield would drop to 5%, since 100 shares now costs $20,000 but you’re getting the same amount of dividends per share. As you can see, this means that as a stock price increases, its dividend yield actually decreases—a key mistake for many investors, who assume higher stock prices mean a higher dividend yield.

Is Dividend Investing the Right Choice for You?

Like all forms of investing, dividend investing is all about the magic of compounding. In this case, you can actually increase your compounding through dividend reinvestment. Basically, every dividend payout that you reinvest grants access to more dividend payouts in the future, which will in turn be reinvested to supercharge the compounding process.

Obviously, nothing is guaranteed in investing. Also, dividend investing is a rather involved form of investing (if you practice it as a portfolio-wide strategy, that is—most people who own stocks or index funds engage in dividend investing to a certain degree, even if they don’t realize it).

That said, if you’re willing to do your homework, it opens you up to greater compounding, which can be a serious long-term boon.

How to Evaluate Dividend Stocks (and Other Dividend Investments)

As with types of dividends, dividend-paying stocks (and dividend-paying companies) are not created equal.

As a rule, you should stick to companies that pay 60% or less of their annual earnings as dividends. The appeal of a higher income percentage payout is high, but it also leaves the company vulnerable to restricted cash flow if business weakens. Companies that pay 60% or less are generally more reliable in terms of actually delivering the promised dividends.

You should also assess dividend safety based on the relative riskiness of the industry. If the industry is unstable, a lower payout ratio doesn’t guarantee safety, since the industry itself may be too volatile to be reliable.

The Right Dividend Investing for Alternative Investors

As the dividend investing basics demonstrate, it pays to have an expert in your corner. And no matter how confident you may be in your investment success, it pays to insulate your portfolio against stock market volatility.

That’s where we can help. Here at Masterworks, we’re on a mission to democratize blue-chip art investing for ordinary investors. We handle the research and authentication for you so that you can purchase shares in multi-million-dollar art and collect your dividends when we make a sale. The perfect compliment to traditional dividend investing. Ready to get started? Then let’s talk. Fill out your membership application today to learn more.

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