What is Dividend Investing?
This guide explains everything you need to know about dividends — how they work, how they're paid, what to look out for, and how to get started.
All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on tokenist.com. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.
What is dividend investing – and does it have a role to play in your financial strategy?
Before diving head first and starting to invest in dividends, you’ll need a bit of know-how to get it right. This guide will help you understand this often overlooked approach to investing.
One of the most common motivations behind investing is securing financial independence for retirement. The famed 4% drawdown rule, pioneered by William Bengen in a 1994 study, showed how a 60% stock, 40% bond portfolio could help investors achieve this lofty goal. But this isn’t necessarily the case anymore, as bond yields are breaking new ground – by plummeting and reaching new all-time lows.
The 2019 survey conducted by The Harris Poll on behalf of TD Ameritrade bears grim news. A large percentage of Americans aren’t managing to put away enough money for when they exit the workforce – 46% of all Americans have less than $100,000 currently saved for their retirement, and the percentage is even greater for the 40-49 age group – a whopping 59%!
Now that Bengen’s gold standard isn’t that golden anymore, can anything fill the gap that it left vis-à-vis safe retirement investing strategies? Dividend investing can – in fact, this approach can offer you even greater returns than the once-coveted 4% drawdown method. But it requires patience, diligence, and knowledge – luckily, we can help you when it comes to the last part of that particular equation.
How Dividend Investing Works
First we must explain what a dividend is. When a company earns profit, it keeps a part of that profit to reinvest into the business – these are called retained earnings.
So, what happens with the rest of the profits? They get distributed – often in the form of a dividend. A dividend is basically a regular payment from a company to its shareholders.
It’s easy to see how dividends can make a particular company more enticing. But can dividends be more than a simple footnote in the grand scheme of things? They can – this investment strategy may lack glitz and glam, but the fact that it isn’t exciting doesn’t mean that it isn’t effective.
Accruing a large amount of high-quality dividend-paying stocks will give you a solid base of passive income – which can be reinvested to increase your total dividend earnings. The best thing about this approach – you’ll still benefit from capital appreciation. Once you reach retirement age, you can transfer a portion of your dividend earnings to your account each month – and if you do it right, your investment will be self-sustaining by that point.
Basing your investment strategy around dividends entails an entirely different perspective when compared to how investors usually understand the stock market. Dividend investing is underappreciated, dare we say, underrated – but we’ll do our best to make the case for dividend investing in this article.
Are Dividends a Good Investment?
This depends on the investor in question, and there’s no one size fits all answer. Dividends are a great way to diversify your portfolio, but they might not be the perfect solution for everyone.
However, dividends have historically always accounted for a large percentage of market returns. Although the exact percentage varies by decade, looking at the long-term data for the S&P 500 can give us a clearer grasp of this fact.
If that fact isn’t impressive enough on its own, on average, dividend-paying companies, particularly those that have consistently raised their dividends, outperform companies that don’t. Generally speaking, they tend to outperform the market at large as well. These companies also boast lower volatility.
So, are dividends a guarantee that a business will perform well? No – in fact, it’s the other way around.
Companies that perform well and exhibit lower volatility can afford to pay dividends and regularly raise them. These companies don’t owe their successes to dividends – but to a well thought out, long-term perspective and conservative management.
Average Annual Returns and Volatility by Dividend Policy
|Equal-Weighted S&P 500 Index||7.70%||1.00||17.31%|
|Dividend Growers & Initiators||10.07%||0.87||15.66%|
Who Does Dividend Investing Appeal To?
As a rule of thumb, dividend-paying stocks are good long-term investments, offering less volatility, coupled with a steady stream of income to investors. But to truly benefit from the advantages of dividend-paying stocks, you need to invest a significant amount of money.
For younger investors and those who are just starting out, investing in high-quality growth stocks is usually the better option. While good dividend-paying stocks can provide more than 100% returns in the long run, the capital required to play into the strengths of dividend investing, which is to say passive income, is quite large. For young investors, who have time to make up for losses, a higher risk but higher reward approach might seem more inspiring.
On the other hand, if you’re closer to retirement age, and already have a decent amount of capital at your disposal, dividend investing is a great way to increase your passive income, diversify your portfolio, and still retain the advantages of capital appreciation.
Are Dividends Considered Income?
The ever-present issue of taxes also rears its ugly head when it comes to dividends. Taxes are a complex topic that is difficult to navigate, so you should always consult an accountant in order to maximize the performance of your investments.
That being said, you will have to pay taxes on your dividends. The actual tax rate that you will be subjected to varies depending on a couple of factors. Although there are a lot of variables in play, we’ll cover the basics and the most important points here.
Dividends fall into one of two categories – qualified and unqualified. Unqualified dividends are taxed as income, at the ordinary rate of your tax bracket, seeing as how they do not meet the IRS’s criteria for passive income. Qualified dividends, on the other hand, are taxed as capital gains, which is to say at a preferential, lower rate when compared to your income tax rate.
So, what are qualified and unqualified dividends? You’ll be happy to hear that most regular dividends meet the criteria to be considered qualified. The criteria in question are that the dividend is paid by a US corporation or a qualifying foreign entity and that the stock has been owned by the investor for a minimum holding period, which is 60 days for common stock, and 90 days for preferred stock.
If a dividend does not meet these two criteria, it is considered unqualified. In most cases, you should avoid unqualified dividends due to the higher rates at which they are taxed.
Certain types of dividends can never be qualified, even if they meet the criteria above. These include dividends paid by real estate investment trusts (REITs), master limited partnerships (MLPs), business development companies (BDCs), tax-exempt companies, credit unions, or dividends paid by a company’s employee stock ownership plan.
So, should you avoid unqualified dividends at all costs? The answer is no – in fact, certain sources of unqualified dividends, such as REITs and MLPs have a host of benefits – but we’ll go into greater detail down below when we cover how to actually build a dividend portfolio, and what it should ideally include.
Are All Dividends Paid in Cash?
No – but most are. However, you should be aware of the other potential ways in which dividends can be paid.
Cash dividends are the most common type of dividend by far, and they’re the type that you’ll want to focus on as an investor. With cash dividends, investors receive regular payments, and the entire operation is rather straightforward.
Stock dividends entail a system in which shareholders are issued additional shares. This can either be in the form of more shares of the company, or so-called spin-off shares, where investors are given fresh shares of an operating division which is slated to break off and go public. Stock dividends present investors with a choice – either you can keep the new stock and hope for capital appreciation, or you can sell it off – in which case, the practical effects are the same as if it were a cash dividend.
Scrip dividends are transferable promissory notes issued to shareholders. They guarantee payment of a dividend at a future date, have short maturity periods, and may or may not bear interest. Bond dividends operate on the same principle, but have longer maturity periods and always bear interest.
Property dividends are non-monetary – instead of cash, investors are paid in property. That property can be in the form of physical assets such as inventory, real estate, or vehicles, or it can be in the form of subsidiary shares. Although they are non-monetary by form and definition, these dividends do have a monetary value.
Seeing as how they can be held for long periods of time without liquidation, they can help offset your tax burden. However, property dividends are yet another rare occurrence, and you shouldn’t give them much thought when devising your overall strategy.
Finally, liquidating dividends present a return of capital that occurs when a company is getting ready to terminate operations. Stuck somewhere between a formality and a parting gift (or a payment of debt, depending on your viewpoint) liquidating dividends shouldn’t concern you because you probably won’t be thrilled by the idea of investing in a failing business.
These types of dividends apply to common stock.
Preferred stocks operate differently, and always receive cash dividends. For the purposes of dividend investing, you should focus on common stocks. We’ve covered the issue of regular vs preferred stocks before – so check out our article if you’re interested in a more in-depth explanation.
How Often Are Dividends Paid?
There are no concrete rules which dictate how often dividends are paid. Dividend payment policies, both regarding size and timing, are left to the corporations themselves. However, a vast majority of US-based companies will pay out dividends quarterly, which is to say four times a year.
Some companies choose to pay dividends once or twice a year, or every month, but these are very rare cases – monthly dividend payments, particularly, are found once in a blue moon. MLPs and REITs, on the other hand, usually pay a monthly dividend.
International companies will either pay dividends once a year or make two payments per year. European companies, in particular, have a habit of making two unequal dividend payments each year – a smaller interim payment, followed by a larger sum later in the year.
All of what was said above applies to regular dividend payments – but there is also another type of dividend. Special dividends are irregular, one-time payments that occur in the case of excess cash flow, asset sales, investment liquidations, or litigation wins. These are highly uncommon, unpredictable factors, and as such they shouldn’t affect your long-term investment strategy – due to their unreliability, as well as the fact that they are always unqualified dividends.
How Are Dividends Decided?
This is yet another area where there are no hard and fast rules. The final decision rests with the board of directors, although it is standard practice for a company’s CEO to make a recommendation regarding dividend policy.
Quite commonly, you’ll find that a company does not have any sort of publicly stated policy when it comes to dividends. Although some companies do publicly state their goals concerning dividends, most do not – so you will have to refer to the company’s history regarding dividends to get a good feel as to where they stand.
The most important thing to keep in mind is that the final decision rests with the board of directors. Overall, this is a good thing – a company with a solid track record speaks to a board of directors that values dividends and affords them a good deal of thought.
Changes in management, even those that end up changing a company’s CEO, are much more likely to occur than a significant change in the board of directors. As such, the priority that dividends take in a company’s operations is much less likely to change.
Important Dividend Metrics
Before we proceed any further, there are a couple of important terms and metrics that we have to discuss. The criteria that you’ll be using to judge a stock’s worth from the perspective of a dividend investor aren’t what you’re used to.
Researching stocks is an important skill – knowing how to read stock charts and forecasts is a must for any savvy investor. In much the same way, these metrics will be the lens through which you will observe potential investments, so it’s key to have a fundamental understanding of how they work, and what they mean.
What is Dividend Yield?
One of the most important metrics that you will be using in dividend investing is dividend yield. Simply put, a stock’s dividend yield tells you the percentage of the company’s current share price that is being paid out in the form of dividends on a yearly basis.
Of course, stock prices change throughout the day, and as such, a company’s dividend yield will also fluctuate. A stock’s dividend yield is an important metric, and one that should always be considered – but it doesn’t give you enough information on its own to make a well-informed decision.
So, how is the dividend yield calculated? We take a company’s annual dividend, divide it by the current stock price, and multiply that by 100 to get a clean percentage. If a company’s stock is trading at $35, and it pays out a yearly dividend of $2, then the dividend yield would be calculated thusly : (2/35) x 100 = 0.057 x 100 = 5.7, for a 5.7% dividend yield.
The dividend yields you’ll want to pay attention to should outperform the dividend yield of the S&P 500 Index by close to 50%, and you should always compare a company’s dividend yield to competitors and the industry in question at large.
What is a Payout Ratio?
A company’s dividend payment ratio is another important metric, which is key to understanding the sustainability of a company’s dividend policy. To calculate a company’s payout ratio, we take the dividend that is paid out per share and divide it by the company’s earnings per share.
Although dividends are much more closely and realistically tied to cash flow, looking at them through the lens of earnings can give us a better sense of the long-term prospects of the dividend. Let’s once again illustrate with a hypothetical example. A company with earnings per share totaling $5 with a dividend per share of $1 would have a payout ratio of 20%.
So, how do we leverage this knowledge to our advantage? Is a higher payout ratio better than a lower one? A lower payout ratio is more sustainable and bears a potential for increasing dividends down the line.
It also tells us that a company is choosing to reinvest money, which could translate to growth and capital appreciation down the line. A lower payout ratio also means that a company can keep paying its dividend in the case of a downturn in earnings.
High payout ratios are a common sight with older, established companies that are leaders in their respective fields. These large companies boast stable cash flows and have very little room for growth, so they can maintain high payout ratios. This is particularly common for companies that deal with utilities, pipelines, telecommunications, or staple products.
Dividend payout ratios higher than 100% are unsustainable – they tell us that a company is distributing more money than it earns. This is a clear sign that a dividend cut is coming, or that the dividend will be completely eliminated soon. Dividend ratios above 75% are undesirable, as they also speak to a lack of sustainability.
As a practical matter, you’ll want to focus on companies that offer a dividend payout ratio between 40% and 70% to maximize sustainable passive income, as well as potential future capital appreciation.
One final note regarding payout ratio – certain businesses, such as real estate investment trusts (REITs), master limited partnerships (MLPs) and business development companies (BDCs) are required by law to pay 90% of their income in the form of dividends. This means that they’re an exception to the rule of looking for a dividend payout ratio in the 40% to 70% range – but we’ll take a more in-depth look at such companies later on.
What is Dividend Coverage?
A company’s dividend coverage is the inverse of its payout ratio. It is yet another metric that can help us gauge the risk of investing in a particular stock. It is calculated by taking a company’s annual net income and dividing it by the total amount of dividends that is to be paid.
Once again, we’re going to use the favorite tool in our toolbox – an example. If a company has an annual net income of $400,000 and pays out a total dividend of $100,000, then it has a 4.0 dividend cover. Put simply, that company could pay out its dividend four times with its net income.
Higher dividend coverages are a sign of financial stability and maturity, and companies that boast high dividend coverages are generally safe investments. A dividend coverage over 2.0 is considered healthy, and you should focus on companies that can meet that requirement.
But keep this in mind – dividend coverage is calculated using net income, not cash flow. There are a variety of ways for a company to present a more positive but inaccurate net income using accounting methods.
So, should you pay attention to dividend coverage? Yes – but only when combined with an overlook of the company’s cash flow. Net income can vary from year to year, and it doesn’t represent a solid foundation for basing your decision on its own.
A company’s dividend coverage is liable to change – and if the dividend coverage ever dips down below 2.0, you should pay extra attention to that company. Such occurrences are still within the territory of fairly normal – but a dividend coverage that drops below 1.5 is a fairly certain warning sign that you should abandon the business in question and invest your money elsewhere.
What’s a Dividend Cut?
A dividend cut means that the amount of money paid to investors per share is either reduced or outright eliminated. Dividend cuts are bad news – you want to avoid them altogether if possible, as they are clear signs of a company’s financial wellbeing deteriorating.
Dividend cuts most often occur due to reduced earnings or mounting debt to equity ratio. As if the notion of reduced dividend payments wasn’t bad enough on its own, dividend cuts can (and as a rule, do) cause investors to sell off their stock – leading to a fall in share prices and a much more grim perspective regarding capital appreciation.
Dividend cuts don’t have to be a sign of impending doom – but they quite often are. In certain cases, such as an upcoming stock buyback, a large acquisition or merger, or a recession, dividend cuts can be temporary and arguably justified.
You should focus your attention on companies that haven’t had a dividend cut in years or even decades when building your portfolio. However, if a company decides to cut its dividend, you should take a good look at their future prospects and overall financial wellbeing before deciding to sell.
How Do I Start Investing in Dividends?
If you’re sold on the idea of dividend investing, you’re on the right track to achieving a good stream of passive income – but you’ve still got a lot of work ahead of you. Finding good potential investments, researching and buying stocks, reinvesting your dividends, monitoring your investments – it’s a lot to take in. But we’ll go over it step by step – and you’ll always have a handy guide to refer to.
What a Dividend Portfolio Should Look Like
Before we go on to concrete measures and steps, let’s take a step back to evaluate what the end goal should be. Dividend investing can offer you a fantastic way to achieve financial independence in the later stages of your life – but only if you manage to build a proper portfolio.
An ideal dividend portfolio should include at least 25 high-quality dividend-paying stocks. These stocks should cover a number of different industries and sectors.
Investing in 25 dividend-paying stocks in a single industry is asking for trouble – even if it could benefit you in the short term, such a move can easily cause issues down the line. If an industry-wide drop occurs, a large portion of your dividends will be cut.
As a rule of thumb, you should invest in no less than 4 different industries, and you should preferably own stock that is divided among 6 or 7 industries. Any more than that, and you’ll likely be spreading your investments too thin – but there are no hard and fast rules here.
What about other sources of dividends, such as REITs, BDCs, and MLPs? REITs can play an important role in your portfolio – but you should avoid mortgage REITs due to their volatility, and focus specifically on property REITs.
BDCs might seem like an appealing option due to the legal requirement to pay out 90% of earnings via dividends – but those earnings are very uneven and unstable. The volatility of BDCs simply makes them inconsistent – and this doesn’t mesh well with the overall goal and idea of dividend investing.
MLPs are closely tied to energy and utility companies – and if you’ve been reading the news lately, that might give you some pause. However, MLPs tend to own energy-related infrastructure, such as pipelines or terminals – making them quite a bit less sensitive to the volatility of energy prices.
MLPs have traditionally been a solid investment – but the recent dramatic events in the energy sector have led to a series of dividend cuts. It’s impossible to predict whether MLPs will regain their once prestigious place in the world of dividend investing – so if you’re considering investing in one, make sure to consult your financial advisor.
Now that we know what we’re looking for, how do we know when we’ve found it? The answer to that question can only be obtained by researching stocks.
We’ve already discussed the most important metrics when it comes to dividend investing – but most important doesn’t mean that they provide enough information on their own. The tenets of fundamental analysis will supplement the core metrics and criteria of dividend investing well.
You’ll want to familiarize yourself with researching stocks in a broader sense – but that is a lifelong process of education that we can’t even summarize here. Instead, we’ll briefly cover the most important things to look out for, as well as give certain recommendations.
Let’s begin with our ever-important dividend metrics. Seasoned dividend investors seek out stocks that pay out a dividend yield that is at least 50% higher than the dividend yield of the S&P 500.
Stocks with dividend yields that are three times greater than that of the S&P 500 require a great amount of research. Although such stocks are enticing, they’re more than likely volatile and unsustainable investments.
In practice, this means that the focus should mostly be on stocks with dividend yields between 3.5% and 6.5%, with an increasing level of care when approaching and going over the 7% mark. So, what about the dividend payout ratio? As far as this metric goes, the 40% to 70% range represents the sweet spot.
Because these investments are meant to grow, only companies that have raised their dividend for a number of years in a row should be considered – and in this case, more means better. The annual dividend growth of these stocks should ideally be between 5% and 10%.
None of these metrics should be looked at without factoring in the others – a stock with a high dividend yield will logically have lower annual dividend growth, for example. Veteran dividend investors are also vigilant regarding a company’s overall wellbeing – monitoring industry trends, cash flow, net margins, and the company’s debt to equity ratio. Another important factor to consider is Beta—a stock’s volatility compared to the market at large.
One of the best ways to narrow your search is by using dividend lists. These lists consist of companies that meet criteria such as certain market caps and capital requirements, as well as large average daily trading volumes. These companies have regularly paid out dividends for a number of years without cutting them, and they’ve also raised their dividends for a number of consecutive years.
The S&P dividend aristocrats list consists of companies that have raised their dividends each year for the past 25 years. The list currently consists of 66 companies, and it boasts an average annual return rate of 9.97% when looking at a 10 year period.
NASDAQ’s dividend achievers index lists companies that have raised their dividends for 10 consecutive years. As expected, it’s a much larger list, but it is no less worthy of your attention – the stocks listed here might well graduate to the S&P dividend aristocrats list in time, and they’re likely to have good growth prospects.
Finally, the dividend kings list consists of companies that have raised dividends for 50 years straight. Half a century of dividend increases is a strong selling point – there’s no denying the fact. But should it be the only factor that you’ll want to consider? No.
As we’ve said, these lists are a good way to narrow down your search, and they can be a good starting point. But none of these lists have a requirement in the way of minimum dividend yield or a required amount of dividend growth.
Once a company makes its way onto these lists, a token dividend increase is usually worth it from their perspective, as it allows them to retain this prestigious status. These lists don’t guarantee good long-term prospects – but you’re more likely to find companies that do have such prospects in these lists.
What Stocks Should I Buy?
Before we move on to concrete recommendations, let’s deal with this question in general terms. You’ll want to focus a large part of your attention on blue-chip stocks.
If you’re unfamiliar with that term, it’s borrowed from gambling – in poker, blue chips have the highest value. But don’t let that fool you – in an ironic twist of fate, blue-chip stocks are the farthest possible thing from gambling.
Blue-chip stocks are stocks in companies that have large market caps, solid long-term track records, brand-name recognition, and that are leaders in their respective fields. These giants are industry-defining, nationally recognized household names, dare we say American classics – think Coca-Cola, Wal-Mart, General Electric, IBM, and Apple – names that you’ll likely find in the Dow Jones industrial average.
But the coveted status of a blue-chip stock doesn’t mean that you should automatically invest – and neither should your investments consist solely of blue-chip stocks. All of the criteria and considerations that we’ve mentioned up to this point still apply – no matter how well-established or large a company may be.
We’ve previously covered 10 high-quality stocks that pay good dividends. We stand by this list but you shouldn’t treat it as gospel – it isn’t a guide, but a recommendation – one you could use as a solid starting point.
Once you’ve made the decision to buy a stock, you should purchase it through your broker. Although you can buy stocks directly from a company, a lot of companies don’t offer this option – and when they do, they often have a minimum investment requirement. Your choice of broker will depend on your concrete needs – we’ve done an in-depth review of the 6 best online stock brokers which could be helpful.
Brokers simplify your flow of operations to a great degree and offer a host of benefits such as research and analysis tools, educational courses, customer support, and even stock trading via mobile apps. If that sounds like a lot to handle, don’t worry – we’ve also reviewed the top 6 online stock brokers for first-time traders.
Dividend Mutual Funds – To Buy or Not to Buy?
Researching at least two dozen companies spread out across different sectors and industries can be a lot of work. Particularly when you factor in how in-depth you have to go to truly make a sound, educated decision. With all of that in mind, dividend mutual funds can seem enticing – on paper they’re a much more simple, hands-off approach to dividend investing.
But do they merit your consideration? Simply put – no. Dividend mutual funds have a history of underperforming – less-than-stellar yields are the norm for such funds, not the exception. Although it may be tempting to think that these funds allow you to benefit from diversification, the same effect can be achieved – to a much greater degree, by simply putting together a properly-structured portfolio devised of high-quality stocks.
The smaller yields of dividend mutual funds are reason enough to give them a wide berth – but they aren’t the only reason. Dividend investing forces you to take an active, well thought out approach to your future financial security.
It encourages in-depth research, as well as investing in companies that truly have solid long-term prospects. Depriving yourself of these benefits in order to invest in a fund that you have no control over is a mistake.
Reinvesting Dividends (DRIP)
DRIP stands for dividend reinvestment program. These programs allow you to automatically reinvest dividend payments into more of that company’s stock. Since the primary goal of dividend investing is building a healthy foundation of passive income for your retirement, reinvesting your dividends is the way to go.
DRIPs allow you to immediately increase your total dividend income, as well as secure better long-term prospects regarding capital appreciation. A lot of companies offer incentives for enrolling in these programs, such as slightly below market prices – but opening and monitoring so many different accounts on your own is a hassle. Luckily, a lot of brokers offer this service for free – and if you’re still mulling over your choice of broker, check out our report of the top free trading platforms.
DRIPs are generally the way to go, with one major exception – if a stock is currently overvalued, you’re likely going to get a better return by investing the dividend payment into a different stock. DRIPs basically amount to dollar-cost averaging, and allow you to purchase fractional shares – all in all, they’re a cornerstone of every single successful dividend investing strategy.
Selling Dividend Stocks
Dividend investing is very much a long-term strategy, which means that you’ll want to hang on to your stocks for a long period of time. Capital appreciation is not the goal of dividend investing (although it’s quite a nice bonus), so this begs a couple of questions – when should I sell my dividend stocks, and why?
The first-case scenario is practically a no-brainer. If a company finds itself in dire straits, either by lieu of low earnings, low cash flow, or a mounting debt-to-equity ratio, it is likely going to cut or significantly reduce its dividend.
One of the best ways to predict this is by looking at a stock’s dividend payment ratio. If the DPR of a stock rises above 90%, it’s time to move on to a different company before you accrue additional losses.
That’s simple and straightforward. But is there any reason why you should sell a stock that is, at least nominally, performing well under the usual criteria for dividend investing? In fact, yes – if you can reinvest that money into a more attractive stock – say, one with a more sustainable dividend, better growth prospects, or a better dividend yield.
Start Investing with a Stock Broker
DIY stock trading
Pioneer of commission-free stock trading
Beginners and mutual fund investors
Minimum initial deposit
DIY stock trading
Beginners and mutual fund investors
Pioneer of commission-free stock trading