A dividend is a payment that companies make to their shareholders as a means of sharing a portion of their profits. Companies typically pay dividends as cash payments on a quarterly basis, but may choose a monthly or annual payment schedule instead.
Along with stock appreciation, dividends are one of the primary ways that investors can earn income from their stock investments. Dividend investors can choose to cash out their dividend payments or may be able to reinvest them through a DRIP program (Dividend Reinvestment Plan.
While most investors earn some dividends on their stock market investments, some put more focus on dividends than others. Let’s take a look at what it means to be a dividend investor and the pros of cons of dividend investing.
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What is Dividend Investing?
With a dividend investing strategy, investors focus on stocks that have a consistent history of paying dividends to its shareholders. Many dividend investors also look for companies that have a track record of raising their dividends over time.
Dividend investing is all about creating a stable income stream separate from the stock’s appreciation. When times are good, both forces can work together to maximize profit. But dividends can also act as a safety net if the stock depreciates.
For example, let’s say you buy 100 shares of XYZ company at $50 per share for an initial investment of $5,000. We’ll also say that XYZ pays a quarterly dividend of 50 cents per share. In that case, you’d earn $50 in dividends per quarter, or $200 per year.
So, at the end of year one, your $5,000 investment would be worth $5,200 if the stock price stayed exactly the same at $50. If the price per share increased to $52.50 (5% growth), your investment would have grown to $5,450 ($250 in stock appreciation + $200 in dividend income).
And even if the stock price decreased to $47.50 per share, your investment would only decrease by $50 for the year to $4,950 ($5,000 – 250 in stock depreciation + $200 in dividend income = $4,950).
Related: How to Start Investing
How Does Dividend Investing Compare to Growth Investing?
Not all stocks pay a dividend or are worried about increasing their dividends over time. Instead, some “growth” stocks pour most of their profits back into the business.
Many startups or fast-growing tech stocks feel that money could be better spent on research and development, building new products, or hiring top talent. Some aggressive investors like to focus on growth stocks because they believe a growth investing strategy (while more volatile) can provide a better overall return.
To understand why this is the case, consider our example from above. If the dividend-paying stock enjoyed 5% in capital appreciation, your investment would grow from $5,000 to $5,450 (including dividend payments). That’s $450 in total profit for an overall return of 9% ($5,000 x 0.09 = $450).
This means that any stock that could provide more than 9% of capital appreciation growth would outperform the dividend-paying stock. For example, a growth stock that grew by 10% from $50 to $55 per share would have earned $500 in overall profit for the year. And the growth stock would come out further ahead if it experienced even faster growth.
Dividend investing is all about building up a predictable income stream to supplement capital appreciation. But the dividend investor should understand that by prioritizing stability, their annual capital appreciation is likely to be more modest than investors who target growth. And, in some cases, this could also result in a lower overall return.
Related: Value vs. Growth Funds
What is the Dividend Yield?
The dividend yield is a number that shows you how much dividend you get for each dollar you invest in a company. For example, if you’ve invested $10,000 in a company and you receive annual dividend payments of $100, the dividend yield is 1%. But if you earned $500 per year in dividends, the yield would be 5%.
How Stock Appreciation Affects Dividend Yield
It’s important to understand that stock appreciation has an inverse effect on dividend yield. Put another way, as a stock’s price goes up, its dividend yield goes down.
To illustrate why this is the case, consider a stock with a price of $25 per share and annual dividend payments of $1.25 per share. In this example, this stock’s dividend yield is 5% ($25 x .05 = $1.25).
But if the stock price were to double to $50 per share? In this case, the dividend yield would drop to 2.5% ($50 x .025 = $1.25).
This doesn’t mean that dividend investors should root against capital appreciation. Overall, appreciation is a good thing because it’s a sign the company is healthy and more capital appreciation means more return on your investment.
Also, companies can increase their dividend over time to keep their yield attractive.
Why Investors Should Closely Examine High-Yield Dividend Stocks
Many dividend investors look high and low for stocks that offer high dividend yields. While the yield on most stocks ranges between 2% and 5%, some stocks may offer dividend yields of 6% to 10% or even higher.
But while the thought of earning 6% or more in passive income on a stock investment is enticing, you’ll want to be careful. If a stock has an unusually high yield, it could be a sign that its stock price has recently dropped significantly.
For example, imagine that a stock is trading for $75 per share and pays an annual dividend of $1.50 per share. That’s a dividend yield of 2%–right in the average range ($75 x .02 = $1.50).
Next imagine that news breaks the company is running out of cash and they may be considering bankruptcy. The bottom falls out of the stock and a few days later it’s trading for $25 per share. In that situation, the stock’s dividend yield would immediately skyrocket to 6% ($25 x .06 = $1.50).
At first glance, a stock with 6% yield would look like a strong choice. But upon closer examination, you’d realize that the high yield is simply a result of massive stock price depreciation. For this reason, if a stock is paying a dividend yield of more than 5%, you’ll want to be sure to do extra homework before investing.
What Are Dividend Mutual Funds?
Not comfortable with trying to pick and choose individual dividend stocks? Thankfully, you don’t have to. There are many high-yield dividend mutual funds for investors to choose from.
These funds only invest in stocks that pay high dividends. Throughout the year, the mutual fund will accumulate a large amount of cash from the dividend payments of each of its underlying securities.
These mutual funds are required by law to distribute their accumulated dividends to each of their shareholders at least once per year. But some funds may send dividend payments on a more frequent basis.
How is Dividend Income Taxed?
One of the downsides to dividends is how it affects your tax bill. With capital gains, you don’t pay taxes on the growth until you sell the investment. But dividend payments are taxable in the year that you receive them. And this is the case whether you choose to cash out the dividend or reinvest it.
Typically, income from dividend payments is taxed as ordinary income. But some stocks called “qualified dividend stocks” are taxed at the capital gains tax rate if held for at least 60 days. Also, dividend income is shielded from taxes if the investments are held with a retirement account like an IRA or 401(k).
Pros and Cons of Dividend Investing
- Dividend stocks provide a predictable income stream.
- Dividend stocks can offer insulation against stock market volatility.
- Investors can maximize compound interest by reinvesting dividends through DRIP programs.
- Dividend stocks may underperform growth stocks in overall returns.
- High-yield dividends stocks can be deceiving.
- Dividend payments are taxable in the year received.
To decide if dividend investing is right for you, you’ll need to consider your personality and risk tolerance. If you prefer stability and predictability in your investments, a dividend strategy could be a great choice.
However, if you don’t mind a bumpy ride, a growth strategy could provide the best return in the long run. Or, if you’d like a little of both in your portfolio, try investing an equal amount of money each month in a dividend mutual fund as you invest in a growth stock fund.
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