Few tactics are as well-established and reliable as dividend investing. For many years, both novice and seasoned professional portfolio managers have searched through the entire stock market for the best yields that have the potential to produce sizable income.

Creating a strong procedure to choose dependable businesses to acquire while steering clear of possibly hazardous, high-risk equities is the fundamental component of dividend investing. The abundance of exchange-traded funds (ETFs) on the market now also allows you to customize a fund portfolio with a dividend concentration.

Even with the protracted period of outperformance from many high-flying tech stocks that pay no dividends, dividend investing is still a popular way to deploy wealth. Both retirees and those pursuing financial independence find the idea of being able to live off profits from company shares to be enticing. US companies usually pay out cash to shareholders once a quarter, although many non-US companies pay out dividends every other month.

However, did you realize that special dividends and stock dividends exist as well? In addition, there are dividend-growth and high-yield investing strategies. Investing in dividends involves far more than you may have imagined!

Dividend investing dates back decades, in contrast to many popular financial fads. As a matter of fact, dividends have accounted for the vast bulk of US stock market returns since the 1970s. Comparable to the tortoise and the hare, just owning businesses dedicated to returning shareholders’ capital through dividends has shown to outperform investors hoping to earn handsomely from rapid price growth. As you can see, some of the top dividend-paying businesses are those that are less likely to go bankrupt and have more stable finances; these businesses typically generate earnings that are constantly increasing and manage their debt.

In general, investing in companies that distribute profits to shareholders can be a profitable and successful strategy for managing a long-term portfolio without going overboard when it comes to risk. Let’s go over some essential vocabulary, discuss dividend investing techniques, and go over the advantages and disadvantages of dividend investment. We will also discuss taxation. Determining whether dividend investing is a good fit for you is the aim.

What is Dividend Investing

Investing in dividends is easy. You scour the stock market for businesses that consistently deliver dividend payments. Today’s research instruments make it simpler than ever. Let’s go over some important terminology before we get into how to choose individual stocks.

A company’s discretionary distribution of profits to its shareholders is known as a dividend. A dividend yield may not be present for emerging businesses or those with modest profitability, but established corporations with expanding profits and free cash flow are more likely to pay dividends.

That being said, a dividend yield can be calculated by dividing the annual dividend payment by the stock price. The dividend yield may be reported either on a “forward” or “trailing” basis, which projects the dividend payments for the upcoming year, or as the total of all dividends paid for the preceding 12 months.

A variety of investment types find dividend investing to be popular. Although there is never a one-size-fits-all approach, many investor types have found success with portfolios consisting of a few dozen companies that have a track record of prioritizing their shareholders by growing their dividend payouts. Those who are risk averse and choose steady-eddy blue-chip corporations over high-risk companies frequently invest in dividends.

Additionally, it’s a strategy that can enhance a more diverse stock and bond portfolio to create a well-rounded investing mix. However, it has been demonstrated that making long-term investments in respectable businesses that pay regular dividends yields significant profits. Some studies even show that dividend-paying corporations have beaten non-dividend-paying ones.

Types of Dividends

Quarterly cash dividends from excess earnings and cash flow are paid by the majority of large-cap US firms. The figure is frequently disclosed in an earnings report, and the investment community typically applauds a dividend rise headline. When it comes to how to allocate its capital, a company can buy back stock to reward shareholders and cut down on potentially expensive equity financing, reduce debt to strengthen its balance sheet, reinvest in the company through high-growth projects to increase earnings per share, or distribute dividends.

Depending on the number of shares in circulation and the dollar amount of the distribution, the dividend payout itself might range from a penny per share to a very substantial amount. In addition, there are four different kinds of dividends to be aware of:

1. Cash dividends: Cash dividends are the most common, and they are what investors think about when they research various dividend investing strategies. With a cash dividend, a company takes a portion of its profits and pays it out to its owners. The amount of the distribution is expressed as a dollar amount per share. 
2. Stock dividends: Stock dividends are sort of like little stock splits. Instead of receiving cash, you get more shares of stock. Of course, if you want to live off your dividends, you would have to then sell those additional shares to generate cash.
3. Property dividends: In rare instances, a capital-intensive business might distribute physical assets to its owners, or a conglomerate company could pay out stocks and bonds, or other securities, to its shareholders. 
4. Special dividends: Some businesses prefer to have more flexibility with their dividend payout policy. A special dividend helps them do that since it is paid out on a non-recurring basis, usually after a period of strong operating performance and high earnings. It can also be paid following the sale of significant assets. Special dividends are often made on top of an existing dividend policy.

The easiest way to find dividend stocks is to use stock screens whereby you can filter for dividend-paying companies with yields within a certain percentage range. Some prudence may be needed, as selecting stocks that simply have the highest yield could lead to owning overly risky companies. An extremely high yield is considered a warning flag, suggesting that the company might not be able to continue distributing such a large amount to shareholders.

Such investments could be “dividend traps.” What’s more, the reason a yield might be so lofty is that its stock price might have declined sharply in a short time, another danger warning. So, many experts suggest discarding those mega-high-yielders, and focusing on the next tier of high-dividend stocks to maintain a robust long-term strategic asset allocation.

Along with scanning stocks by dividend yield, you should also review other fundamental indicators to ensure that the companies you consider owning are healthy. Digging into a firm’s profit trends, debt levels, and free cash flow metrics may be useful. You can also dig into the list of so-called “dividend aristocrats” – companies that have increased their dividends every year for at least 25 years.

This is what is known as a “dividend growth” strategy since it aims to only identify and invest in firms that are raising their dividend, not just paying one out. You can piece together your own dividend growth allocation or select from the world or dividend-theme ETFs for a more hands-off approach.

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With today’s technology and slick tools, is that it’s easy to create a high-quality portfolio of dividend stocks. Just take a look at some of the world’s largest companies – you will see that many of them have dividend yields of 3% or more. Forming a portfolio from stocks of various sectors can help ensure diversification and an investment strategy that can endure for decades. Quality dividend companies may be better able to weather economic downturns than riskier ones, and when bear markets strike, dividend growers may have the ability to provide a steady income stream during tumultuous times. 

Reinvesting dividends is also quite common. While a retiree might prefer to live off the dividends they receive, younger investors focused on growing their wealth may be better served to buy more shares rather than let cash build in their accounts. Most brokerage firms allow you to reinvest dividends in the security – that goes for individual stocks, ETFs, and mutual funds. A dividend reinvestment plan (DRIP) commonly has no commission attached and it can be an effective way to dollar-cost average into a portfolio that meets your needs and makes compounding returns your friend.

How do you Build Dividend Wealth?

Knowing is power when it comes to investing. You should make an effort to understand what you are doing and why, to borrow a phrase from Ben Graham’s investing counsel. Don’t play the game if you don’t comprehend it. Until you do, keep your distance.

Below, we will assist you in reaching your goals if you’re thinking of creating a portfolio to generate revenue. This entails building up portfolio income that will sustain your demands long after you leave the workforce. But this isn’t a ploy to get rich quick. We actually contend that patience and common sense are the keys to making the best investments.

For a variety of reasons, a lot of investors decide to include dividend-paying companies in their portfolios. Initially, they give investors a consistent flow of income on a monthly, quarterly, or annual basis. They also provide a feeling of security. Investors want to make sure they have some stability because stock values are volatile due to a variety of variables, including news about specific companies or industries or the state of the economy as a whole. Many dividend-paying businesses already have a proven track record of profitability and profit-sharing.

Risks associated with an equity portfolio include economic and non-guaranteed dividends. Let’s say you invest in a 4% yielding portfolio of dividend-paying stocks rather than a portfolio of bonds, as in the preceding example. Over the course of those same 12 years, these stocks’ dividend payout should increase by at least 3% annually to offset inflation and probably by 5% annually as well.

Here are the six steps to guide you in setting up your portfolio:

1. Diversify your holdings of good stocks. Remember, you are investing for your future income needs, not trying to turn your money into King Solomon’s fortune. Bearing this in mind, leave the ultra-focused portfolio stuff to the guys who eat and breathe their stocks. Receiving dividends should be the main focus, not just growth. You don’t need to take company risk.
2. Diversify your weighting to include five to seven industries. Having 10 oil companies looks nice unless oil falls to $10 a barrel. Dividend stability and growth is the main priority, so you’ll want to avoid a dividend cut. If your dividends do get cut, make sure it’s not an industry-wide problem that hits all your holdings at once.
3. Choose financial stability over growth. Having both is best, but if in doubt, having more financial wherewithal is better than having more growth in your portfolio. This can be measured by a company’s credit ratings. The Value Line Investment Survey ranks all of its stocks in the Value Line Index from A++ to a D. Focus on the “As” for the least amount of risk.
4. Find companies with modest payout ratios. This is dividends as a percentage of earnings. A payout ratio of 60% or less is best to allow for wiggle room in case of unforeseen company trouble.
5. Find companies with a long history of raising their dividends. Bank of America’s (BAC) quarterly dividend yield was just 0.1% in 2011 when it paid out $0.01 per share. Ten years later, the dividend yield has increased to 2.2%, with a $0.21 quarterly dividend in 2021—a 20x increase.1 That’s how it’s supposed to work. Good places to start looking for portfolio candidates that have increased their dividends every year are the S&P “Dividend Aristocrats” list and Mergent’s “Dividend Achievers.” The Value Line Investment Survey is also useful to identify potential dividend stocks. Companies that raise their dividends steadily over time tend to continue doing so in the future, assuming the business continues to be healthy.
6. Reinvest the dividends. If you start investing for income well in advance of when you need the money, reinvest the dividends. This one action can add a surprising amount of growth to your portfolio with minimal effort.

Although not flawless, the dividend strategy offers us a better chance than a bond-only portfolio to outpace inflation over the long run. It is ideal if you have both. It is unrealistic to anticipate a risk-free, safe 5% return from an investor. It’s like trying to find an insurance policy that would always protect you—it simply doesn’t exist.

The low but steady inflation makes it impossible to even conceal cash in the mattress. Whether they like it or not, investors must take on risks since there is already a risk of inflation and growth is the only way to reduce it.

What is the Best Strategy for Dividend Investing?

The five tips below are both things to do and things to avoid doing. In investing, it’s often just as important to avoid doing unwise things as it is to actively do smart things.

1. Find sustainable dividends

Finding a sustainable dividend is one of the surest ways to avoid loss, which is the No. 1 (and No. 2) rule of legendary investor Warren Buffett. When it comes to dividend investing, one of the best ways to avoid loss is to look for a company that can sustain its payout even if business declines in the short term.

Why is a sustainable dividend so vital to an investment? If investors think that a company has an unsustainable dividend, they’ll push down the stock price in anticipation of a dividend cut. Then if and when a dividend cut actually happens, the stock may get pummeled again, as investors flee. Many large investors such as investment funds will reduce their positions or may be forced to sell entirely if the company cuts its dividend completely.

One quick check on whether a dividend may be sustainable is to see what percent of the company’s profit goes to pay the dividend. Companies that pay less than 50 percent of their profit out as dividends are more likely to weather a downturn in the business without cutting. Still, some companies such as REITs can safely pay out more cash flow without much trouble.

Investors can also check out stocks that are included in lists such as Dividend Aristocrats, to see which companies have long-term track records of maintaining and growing their payouts.

2. Reinvest those dividends

Getting a cash payout from your stock is valuable, but if you spend that cash, you won’t be able to take advantage of the compounding effect of reinvesting your dividends. Reinvesting your dividends can give your portfolio a needed boost and supercharge your investment gains.

“Since the 1930s, more than 40 percent of the returns of the S&P 500 can be attributed to dividend income,” says Evans, who says that dividends play a particularly important role when the market’s returns are low. “Dividend income tends to cushion the price volatility of stocks and, therefore, mitigate overall volatility in a portfolio.”

Many brokerages will reinvest your dividends automatically if you instruct them to do so, and they’ll even buy fractional shares, so you can put all that money to work immediately. Then when the next dividend is paid, you’ll make even more money on your payout. At its best, you’ll create a virtuous circle, in which your wealth continues to compound with each quarterly payout.

It’s worth noting that dividends are taxable, even if you reinvest them. So dividend reinvestment may work best inside tax-advantaged accounts such as an IRA or a 401(k). Inside these accounts, you won’t owe taxes immediately (or maybe ever, if you use the Roth versions.)

3. Avoid the highest yields

When you’re looking at lists of the market’s top-yielding dividend stocks, it can be tempting to pick the ones with the highest dividends. After all, that would seem to be the quickest way to compound your money. But often those high yields are dangerous. They’re a sign that the market does not trust a dividend’s sustainability, and so the market pushes the stock price down to compensate.

Buying the highest yields “can be detrimental, as many times these high yields are transitory and may be made up of one-time distributions that increase the yield temporarily,” says Brian Robinson, CFP, financial advisor and partner with SharpePoint, a wealth management company in Phoenix. “These types of securities tend to be extremely high in price volatility as well.”

So unless you’re an expert at analyzing investments, it’s best to avoid the market’s highest-yielding stocks. If you buy the highest yields, you could quickly lose much more money than you’d ever earn with that tempting but illusory 8 or 9 percent yield.

4. Look for dividend growth

“Dividend growth is far more important than dividend yield,” says Evans.

Many investors get caught up in looking at a stock’s current high yields and fail to consider how much a company can grow its payout over time. But a growing payout will help you mitigate the effects of rising costs on your portfolio, and that’s crucial if you’re investing for decades.

“Don’t forget inflation,” says Robinson, who advises that a good dividend portfolio “should keep up with the average annual increase in the cost of goods.”

Investors can run a few checks on their company to see what its dividend growth might look like in the coming years:

• Dividend payout ratio: This is the ratio of dividends to total profits. The lower the figure, the more the company could raise its dividend safely.
• Dividend growth rate: This is how quickly the company has raised its dividend in the past. Higher growth may signal that a management is willing to pay shareholders more.
• Earnings growth rate: A company that continues to grow its earnings will have more capacity to grow its dividend, too. For example, a company that grows its earnings at 10 percent annually could potentially also grow a dividend sustainably at that rate.

“If a company can generate strong and sustainable free cash flow from operations, then there is a greater likelihood that the company will be able to grow its dividend and continue to deliver strong returns to shareholders over time,” says Evans.

5. Buy and hold for the long term

If you’re really looking to turn your portfolio into a dividend dynamo, then you’re going to need to invest for the long term. That means finding a solid dividend-payer and then sticking with it over time. That time element is absolutely crucial, but it’s easy to get tripped up when bad news hits.

Look at the experience of Warren Buffett and his purchase of Coca-Cola stock at his holding company Berkshire Hathaway. Berkshire purchased 400 million shares of the drink company for about $1.3 billion nearly three decades ago. The stock has risen, of course, and is worth about $22.4 billion, as of September 2023. But check out what Berkshire earns in dividends.

Coca-Cola pays about a 3.1 percent dividend yield today – not especially high – but Berkshire’s yield on its investment is enormous. Coke is due to pay out more than $700 million this year to Berkshire. So, the company is earning more than half its original investment each year on dividends alone.

And that’s the power of dividend investing with a buy-and-hold mentality.