Is Dividend Investing a Smart Alternative to Savings Accounts

Dividend investing involves investing in stocks, mutual funds, or ETFs that pay dividends. Recently, I’ve started to move cash out of a savings account and into stocks that have really high dividend yields. The result is that I’m earning more than 5% just on dividends alone. Why have I made this change? Dismal interest rates.

Watching interest rates on savings accounts is downright depressing. About two months ago I opened an online bank account at American Express. While the American Express bank account qualifies as a “high interest savings account“, at 1.00% APY, the rate is just dismal. And after about one month, I couldn’t take it anymore and pulled all my money out.

I transferred the cash over to my Vanguard account with the intention of investing in the Vanguard Short-Term Investment-Grade Fund (VFSTX). To make a long story short, on Friday I sunk a big chunk of the cash into Verizon Communications (NYSE:VZ). Some cash will still go to the bond fund, but I want to explain why I moved a good piece of the cash from an FDIC insured bank account to a dividend paying stock.

While you probably don’t think of Vanguard as a discount broker, I get trades in my Vanguard Brokerage account for $7 each through its Voyager Services. You need $50,000 invested in Vangaurd funds or ETFs to qualify.

Dividend Investing in a Nutshell

For those new to investing, a dividend is a payment a company makes from its earnings to shareholders. Dividends typically are paid once each quarter. Public companies generally aren’t required to pay dividends, but many of them do. Often you’ll find that older, established companies pay dividends.

If you are considering investing in companies that pay dividends, you must understand the dividend yield. The DY is nothing more than the amount of dividends a company pays each year divided by its stock price. What this means is that as the price of stocks go down, the dividend yields go up (assuming dividend payouts don’t change). And that’s exactly what’s happening in the market today. Stock prices have come way down, even though corporate earnings remain strong.

In the case of Verizon, it currently sports a dividend yield of more than 5.5%. Here’s the Google Finance snapshot of Verizon as of August 19, 2011:

Now it’s vital to interpret this information correctly. As you’ll see in the above screenshot, the divided is 49 cents and the dividend yield is 5.62%. But if you take the 49 cents and divided by the stock price of 34.71, you get a dividend yield of just 1.41%. So what’s going on?

Dividends are typically reported on a quarterly basis. Verizon’s dividend is paid quarterly, so you need to multiple the dividend by 4 to get a yearly dividend before dividing by the stock price. Forty-nine cents times four is $1.96, which when divided by $34.71 results in a dividend yield of 5.6%.

Why I Like Dividends

So what does all this mean. It means that my investment in Verizon will pay me $1.96 per share each year regardless of the stock price. The price could go down 50%, and I’d still make 5.6% on my investment. On top of that, if I reinvest the dividend back into Verizon stock, I’ll be buying the stock at the lower price (assuming the price goes down) with an even bigger dividend yield (remember, as price goes down, dividend yield goes up.

Now it is absolutely critical to keep in mind that all of this assumes Verizon keeps paying $1.96 each year in dividends. And that brings me to the risks of dividend investing.

The Downside to Investing in Dividends

Like any investment, investing in stocks that pay dividends is no sure thing. For example, a company may have a high dividend yield thanks to a low stock price that reflects a company on the decline. If earnings begin to dwindle, it’s very likely that the company will lower dividend payments. And in some extreme cases, my stop paying any dividends at all.

In my opinion, however, the risk is worth the potential return. In the case of Verizon, for example, its dividend yield reflects the overall market decline, not some fundamental weakness with Verizon. Again, this is just my opinion, and I’d love to hear contrary views. But the fact is that the market is scared right now and selling on that fear.

The result can be some excellent buying opportunities. For example, here are some other dividend paying stocks I’m looking at right now:

• McDonald’s Corporation (ticker: MCD): Dividend yield of 2.77%
• Intel Corporation (ticker: INTC): Dividend yield of 4.32%
• The Proctor & Gamble Company (ticker: PG): Dividend yield of 3.40%
• Duke Energy Corporation (ticker: DUK): Dividend yield of 5.41%

As a final thought, there are those who prefer the long-term potential of growth companies. These are companies that typically do not pay a dividend because they have better ways of using their cash on behalf of investors. For example, if a company can put its money to good use and earn say 20% on its investing (e.g., opening new stores, investing in research & development), why would it pay a dividend?

A good example of this philosophy is Google, which currently pays no dividends. Another good example is Warren Buffett’s company, Berkshire Hathaway, which likewise pays no dividends. Buffett is famous for saying that the $0.10 dividend paid in 1967, the only dividend Berkshire has paid under Buffett’s watch, was declared at a Board meeting when he must have been in the bathroom. What Buffett always neglects to add, however, is that Berkshire is heavily invested in dividend paying companies.

If you’ve taking this approach to investing, leave a comment and let us know how it’s worked out for you.