So what are dividends? They might be one of the most important parts of your investment portfolio.
In order to explain how dividends can reduce your overall portfolio risk, increase your profits, and offer tax advantages, let me first ask you this…would you choose to receive 1 million dollars today, or a penny today that doubles every day for the next 30 days? If you’ve already heard this story, you would choose the second option.
But if you haven’t, you would probably go for option 1! A million dollars today? Yes, please! Not so fast. What if you learned that the penny that’s doubled every day turns out to be over 5 million dollars in 30 days!? You would 100% change your mind.
Well, that’s the power of compound interest, and this is why dividend stocks are such a good bet — especially dividend growth stocks. But what are dividends? And how can they help you achieve that investment dream of financial independence?
Read on to see the efficacy and efficiency of how dividends work, and how they can become the most important part of your investment strategy.
What Are Dividends?
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, to reward them for supporting the company. Kind of like a bonus!
You can invest in dividend stocks, which are companies that reliably pay out dividends. They are usually more mature companies with a good track record.
Dividends are not guaranteed, however, and are always at the whim of the board of trustees. A company can suspend or cut its dividend at any time, as many did during the Covid-19 pandemic.
There are two kinds of dividends: cash dividends and stock dividends. Most companies give cash dividends, which is a cash payment made on a per-share basis. Stock dividends, on the other hand, increase the investor’s number of shares.
Here’s how dividends work: let’s say you own 10,000 stocks in a company that pays out a cash dividend of 5 cents per month. That means you would be receiving an income of $500 per month from that dividend payout.
That could add up to a pretty decent income for someone who’s retiring, or maybe just looking for extra budget padding. This is especially great if you are trying to reduce your reliance upon your job and diversify your income sources.
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.
Certain industries, such as the utility or consumer staple industries, have a higher dividend yield.
Don’t be mistaken and assume that a higher dividend yield is always a good thing. In fact, the dividend yield of a company might be elevated because its stock price is falling.
On the other hand, when companies start to offer a dividend, it usually becomes more appealing to investors, which drives up the price of their stock!
Thus, you need to be careful when using dividend yield to decide whether to invest in a stock or not.
Do Index Funds Pay Dividends?
There are two kinds of funds that pay dividends. First, there are Dividend Index Funds, which are indexed to stocks based on their dividend payments. And then there are funds that pay dividends (which are something completely different).
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 dividend 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.
Dividend Kings vs Dividend Aristocrats
Dividend Aristocrats are elite members of the S&P 500 index. They are dividend stocks that have raised their payouts for at least 25 straight years.
But the Dividend 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 if your dividends end up 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.
Dividends are Every Long-Term Investor’s Dream!
If you are a long-term investor and looking to take advantage of the power of compound interest, dividends will become your secret sauce.
And if you are an investor looking for a passive, monthly income, dividends will become your best friend.
Either way, dividends are a great asset to keep in that investor back pocket. Slow, but steady, they grow on and on.