Dividends can be a very valuable part of your investment portfolio. They can reduce your overall portfolio risk, increase your profits, and offer tax advantages.
But what are dividends? And how can they help you achieve your dream of financial independence?
Read on to see the efficacy and efficiency of how dividends work, and how they can become an important part of your investment strategy.
What Is a Dividend?
Dividends are payments made by a company to its shareholders, usually quarterly, but sometimes monthly. They are a distribution of the company's profits to the shareholders or investors.
There are two kinds of dividend payouts: cash and stock. Most companies give cash, which is a cash payment made on a per-share basis. Stock, on the other hand, increase the investor's number of shares.
Yields are not guaranteed, however, and are always at the whim of the board of trustees. A company can suspend or cut its payout at any time, as many did during the Covid-19 pandemic.
So, you can chose invest in these companies, that reliably pay out the company's profits on a regular basis. Often they are the more mature companies, with long solid track records. (think IBM, AT&T and Exxon Mobile).
Here's how dividends work
let's say you buy 1,000 shares of XYZ company, and its paying out a cash dividend of .25 cents per share per month. That means you would be receiving an income of $250 per month from that dividend payout.
As you can imagine, a sizable investment could produce a solid reliable income stream, for someone who's retiring or even just looking for extra spending money.
You could also reinvest your dividends right back into your portfolio. Which, if you're on the younger side, you should definitely do! This is the best way to take full advantage of the effects of compounding.
Many people don't realize that since 1930, dividends have accounted for an average of 42% of stock investing profits in the S&P 500 Index.
Now that you understand dividend basics, let's dive in a little further.
What Is a Dividend Yield?
The dividend yield is usually expressed as a percentage, and is the amount of money a company pays its shareholders for owning a share of its stock divided by its current stock price.
Going back to our example, Let's now say that you bought those shares of XYZ company for $50/share. That means you would have invested 50K.
If you multiply the 250/month by 12months, you get $3000/year. 3k is 6% of 50,000, so you would be getting an annual yield of 6% on your invested money.
So imagine you had 500K invested, you would be getting 30K. per year of spendable money. Or as mentioned above, 30K of money you can reinvest. Pretty cool.
Sounds Good! Should I Just Start Buying?!
The thing about dividend stocks though, is that they are more established companies that are not in “growth mode”. So instead of reinvesting the profits back into the company, like growth stocks do, they distribute it to the shareholders.
This theoretically would mean the stocks should be less volatile, meaning they would not have huge swing sin stock price up for down. So for very long term investors, growth stocks may offer a better return (with more volatility in the short term).
Conversely, if you are retired, you really want and need the spendable money you can get from dividend Stocks. But the value of the stock can god down. And even worse, that is often when they trim the dividend. So yo have to choose wisely.
Speaking of choosing wisely, don't be mistaken and assume that a higher dividend yield is always a good thing. In fact, the yield of a company might be elevated because its stock price is falling.
On the other hand, when companies start to offer a dividends, it usually becomes more appealing to investors, which drives up the price of their stock! Kind of dizzying I know.
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Do Index Funds Pay Dividends?
There are two kinds of funds that do this. First, there are Dividend Index Funds, which are indexed to stocks based on their yields. And then there are funds that just pay some dividends because some of the held stocks have a yeild.
There are many index funds (ETFs or mutual funds) that have sold some of their holdings and returned the profits to the shareholders, rather than investing them. This means that they aren't indexed to stocks with dividends.
In any case, even if a passive steady income is one of your investment goals, you shouldn't invest in an index fund just because it pays out a dividend.
You need to take into account its past earnings, and future potential, more so than dividend payouts. So, where should you start?
Best Dividend Stocks to Buy and Hold
There are hundreds of companies that pay out a dividend, but there are few that you would buy and hold for a long time to come.
Well-established companies that pay dividends will typically increase their payouts from year to year. The mature blue-chip companies that fall under this category would be: Coca-Cola, Johnson & Johnson, Colgate-Palmolive, Hormel Foods, and Procter & Gamble.
These are all companies that are part of the Dividend Kings (see more below), but they stand out from the rest because these companies hold well-established brands that have a loyal fan following, and you can hold them forever.
You won't have to worry that tomorrow Coca-Cola, or any of these other four companies, will declare bankruptcy and take all your hopes and dreams with them.
Kings vs Dividend Aristocrats
Dividend Aristocrats are elite members of the S&P 500 index. They are stocks that have raised their payouts for at least 25 straight years.
But the Kings blow the Aristocrats out of the water, by having increased their payout streaks to 50 consecutive years!! Wowza! Talk about reliability.
Either way, if you are a newbie to dividend investments, looking at and then investing in the companies listed in these two lists (Kings and Aristocrats) is an easy way to begin.
You know that these companies are reliable, and they have regular payouts, which keep on increasing to get you that compound interest.
If you are looking to use your dividends as a way of supplementing your income, or even being your sole income source in your retirement, you can sleep a little easier with these Kings and Aristocrats fighting in your corner.
Dividends Offer Tax Advantages
Another way to amp up the benefits of dividends is to purchase “qualified” dividend stocks, instead of ordinary ones. Most U.S. based companies (and some foreign companies) are considered “qualified.”
Your income from these dividends are taxed at lower rates than ordinary income! Qualified dividends are taxable at the capital gains rate, which depends on your individual modified adjusted gross income.
If you pay attention and buy only qualified dividend stocks, you will increase your investment gains.
If you're not looking for an income anytime soon, then you will be well advised to allow the power of reinvested dividends to do its thing.
It might not seem like a lot when only a few cents are being reinvested every few months. But remember the penny…
With the power of compound interest, you will have a large nest egg in over 20-30 years. If you are still young and have time to let your investment grow, reinvest your dividends!
Dividends Reduce Your Risk
While there is always risk involved when it comes to investing, dividend payments can mitigate losses that occur from a declining stock price.
Also, when a recession is looming, the Dividend Kings and Aristocrats are a good bet in those times. They have been around for decades now and will predictably be around for the next few.
Just remember to keep your portfolio diversified, as there are many companies, such as young tech companies, that do not offer dividends, but are fast-growing. Diversification should always be your top risk-reducing strategy.