A Beginner’s Guide to Investing in Dividends
Several years ago, I finally opened an Individual Retirement Account, or IRA . (A small step in investing, a giant leap into adulthood.) As I built my own portfolio , I noticed something interesting. Every quarter, I found the money “credited” to my account. They are called dividends , and investing in dividends is becoming an increasingly popular investment strategy.
How dividend investing works
Dividends are money that a company regularly pays to its shareholders. It’s like saying, “Hey, thanks for investing in us, here’s a little cash bonus.”
Some people consider investing in the form of dividends as a form of passive income . If you put enough money into a dividend-paying company, you can get some serious income every quarter . Most of us lack the funds to make this profitable, but in theory it is possible.
“Publicly traded companies in different ways share their profits with their shareholders / owners,” – said Warren E. Ward, a certified financial planirovaniyu® in WWA the Planning & Investments is . “A company like Apple usually succeeds in increasing its share price in the hopes of increasing its investment value.”
In other words, instead of using their profits to pay dividends, many companies simply reinvest those profits to increase the value of their shares. On the other hand, “an older company like Texas Instruments may be nearing the end of a fast growth phase and decide to split the profits through dividends,” says Ward.
So there might be a trade-off here. You receive dividends from a company, but this may come at the expense of the growth of that company and therefore the value of your shares. Randy Kurtz, chief investment officer at Betavisor , puts it this way:
“Suppose you only own one share of one share, and that share is valued at $ 100. Every day you check your portfolio and every day it costs $ 100. Then one day the company pays out a regularly scheduled dividend of $ 1. You check your portfolio and you now have $ 1 in cash. But your shares are only worth $ 99. Your total portfolio is still worth $ 100. Dividends have not increased the value of your portfolio. ”
The growing popularity of dividend investing is due to the low interest rates we’ve had over the past 5-10 years , Ward said . “Dividends were attractive because their yield was the same as interest rates, and often even higher,” he explains. “If you can get 2.5 percent on a bond or on a stock that can also rise in value, you might lean towards stocks.” Of course, interest on bonds is guaranteed, he notes, but that’s a completely different topic.
If you haven’t noticed it yet, there is a slight contradiction here. There are some advantages and disadvantages to dividend investing, and even the smartest investors disagree on whether it is a good strategy for creating wealth and making money.
Pros of dividend investing
However, there is reason for this, and investor Mark Lichtenfeld makes a strong case:
“For wealth creators, if you reinvest dividends over the years, compounding works wonders. Each year you will receive more shares as dividends are paid. And when those dividends rise, it’s like stepping on the gas pedal in a compounding machine.
Then, when you need income, you will have a much larger capital base, generating more income than if you were simply receiving dividends in cash. “
And if you want income in the short term, there are options for that too. Lichtenfeld offers “perpetual dividend increase funds” to generate more income every year. He even wrote about them on MarketWatch :
“[These are] stocks that have experienced dividend growth every year. It helps beat inflation … To stay ahead of the erosive force of inflation, you want to own a stock whose dividend is growing faster than inflation. The company, which annually increases its dividend, provides a solid platform for generating long-term shareholder returns. ”
In the same article, Lichtenfeld explains exactly how to find these stocks , but we’ll come back to that a little later. Other experts also argue that dividends are more reliable than company value. Dr. Robert Johnson, President and CEO of the American College of Financial Services , told us:
“Investing in stocks with high dividend yields is definitely a value-based approach. Over the long term, dividends are much more stable than earnings or cash flow. Most dividend paying companies want to gradually increase these dividends. Companies rarely cut their dividend payments as this is interpreted by the market as a strong signal that the firm is in financial difficulties, as was the case with GE. “
Overcoming inflation, steady growth, tough profits … these are all good reasons to invest in dividends. Despite this, the same number of experts object to this.
Cons of dividend investing
Our friend Sam Dogen of Financial Samurai says that while dividend investments can indeed be a great source of passive income after retirement, there is a capital issue. Dividends will probably only pay off when you have a lot of money like Scrooge McDuck to invest in. He writes :
“… with a relatively low dividend yield of 2-3%, you will need a lot of capital to generate any meaningful income. Even if you have a $ 500,000 portfolio of dividend stocks with a 3% yield, that’s only $ 15,000 per year. Remember, the safest withdrawal rate for retirement does not involve the principal . “
Simply put, you won’t make that much money if you don’t have the money already invested. This may take time. In Dogen’s words: “If you are relatively young, say under 40, investing most of your capital in dividend-paying stocks is not an optimal investment strategy in my humble opinion. You will be hoping for filet mignon for decades, until you eat the Hamburger Helper . ”
In addition, it can be somewhat risky to target certain types of dividend-paying stocks, so the question arises whether the return justifies the risk. “If I’m going to take risks in the stock markets, I’m not gambling for crumbs,” he continues .
Fair enough: who needs crumbs? There is also a trade-off that we mentioned earlier. As Investopedia explains, “Any money paid as dividends is not reinvested in the business.” They argue that if a business is giving away too much of its profits, it could be a red flag that the company has little room to grow, so they don’t bother reinvesting.
Finally, Money magazine argues that dividend stocks have simply become too expensive to pay off. “For example, high-yield utility stocks have risen 70% in the past year alone, based on their price / earnings ratio, which is a common measure of stock valuations,” they write. “This reduces the likelihood that dividend payers will be able to continue to generate better-than-market returns.”
The author argues that it would be better to look at companies that are willing to reinvest in themselves.
How dividends affect your taxes
If you’re still following the news, let’s add taxes to this mix to complicate things even further.
The money you earn as dividends may be taxed as a “qualified dividend” or as ordinary income.
Qualified dividends are taxed at a lower rate than regular income ( 0% to 20% ), making them a much more attractive option than unqualified dividends. Unqualified dividends are taxed at your regular income tax rate, which can be as high as 39.6% if you are lucky enough to make that much money. (At least in 2017. In 2018, the maximum rate will be 37%.)
So what makes dividends qualified? First, the company that issues it must be located in the United States or, if it is a foreign company, trade on a major US exchange (for example, the NYSE). You must also own the shares of the company for more than 60 days of the holding period.
So if you are in the 35% tax group and have qualified dividends, they will be taxed at 15%. If it does not qualify, it means it is taxed as normal income at your 35% rate. Either way, to avoid paying these taxes now, you can keep the dividend in your regular taxable investment account and instead use a tax-exempt account such as a 401 (k) or IRA. Of course, this also usually means that you cannot touch the money until retirement.
Otherwise, you can reinvest the dividend. When a company pays you a dividend, you have the option to use that money to buy more shares in the company or to reinvest. Investopedia explains how this affects your taxes:
“Some companies offering dividend payments to investors will also allow them to automatically use the dividend to buy additional shares instead of receiving cash payments. The so-called dividend reinvestment, investors whose dividends are reinvested in more stocks will not take risks due to tax events. This is because dividends on stocks are usually not taxed until the stock is sold. But if the dividend is reinvested and then the investors get a cash payment instead of the stock, it will lead to a tax event. ”
It seems obvious, but if you put that money in your pocket, be it through dividends or the sale of stocks, you will usually have to pay taxes. And the tax blow could partially offset the dividend yield.
Where to begin
If you are interested in investing in the form of dividends, there are several important metrics to consider when deciding which stock to buy.
(Note : since this would be too much to include in one post, we will assume that you already know the basics of how to get started with investing, including how to buy stocks and bonds. But if you don’t, here’s a primer .)
Dividend yield
The dividend yield is the expected annual dividend divided by the company’s current share price, and you can view it here for any company . For example, General Motors’ profitability is 3.47%. How does this compare with other companies? Average returns vary by industry. You can see how different industries are shaping up here.
However, as a general rule, most dividend investors recommend a yield of around 4-6%. For example, the money site Pocketsense.com suggests that “a good dividend yield will depend on interest rates and general market conditions, but usually a yield of 4 to 6 percent is considered good. Lower yields may not justify buying stocks to generate dividend income, and higher yields may indicate that dividends are unsafe and may be cut in the future. ”
Growth of dividends
Of course, profitability is not the only metric. “Just investing in stocks because they have high dividend yields is problematic,” Johnson says. “Because some very high dividend yield stocks may have volatile dividend levels.”
Growth is another key metric when deciding whether to pay dividends. Remember, Lichtenfeld and other experts recommend companies that increase their dividends every year. Use the same Dividend.com site to find out about the dividend increase.
“Finding good and reliable candidates for dividend investing doesn’t have to look beyond stocks that have been increasing in dividends for years on end,” Johnson says. “Some people call them ‘ruler stocks’ because if you put the ruler on the dividend over time chart, the ruler will point to the northeast, and most of the points will be very close to the ruler. Others call these stocks “dividend kings” … There are 20 companies that have managed to increase their dividend annually over the past 50 years, and this list includes 3M, Coca-Cola, Colgate Palmolive, Genuine Parts, Hormel Foods, Johnson & Johnson. Procter & Gamble and Tootsie Roll Industries. “
Johnson suggests dividend investors not only look at performance, but start with stocks that have stood the test of time.
Dividend payout ratio
Note another metric called the payout ratio . It measures the percentage of profit that a company pays out to its shareholders annually. If the company earns $ 10 per share and pays out an annual dividend of $ 5, for example, this equates to a payout ratio of 50%.
It looks like a higher payout ratio would be nice, but a lower ratio might tell you dividends are safe, explains The Motley Fool , because it tells you how much a company wants to reinvest its profits to grow the business. After all, whether dividends are paid or not, you still want to invest in a company that is growing in value. In addition, Investopedia even notes that historically low dividend stocks have performed better.
Look for dividend funds
However, picking individual stocks is not easy. It’s also risky if you don’t know what you are doing (and most of us don’t). It also kind of goes against Warren Buffett’s old set-and-forget strategy of investing. The idea behind lazy investing is that you pick several solid funds or investment groups that have performed well over time, and sit in your portfolio for a long time, adjusting it from time to time as you approach retirement.
With dividend funds, you can get the best of both worlds. Morningstar lists a few solid ones here . Instead of “dividend yield” look for the term “distribution rate”. From there, you can buy into the fund just like you would buy any other fund in your investment portfolio .
Even if you go with a fund, it is helpful to know the above key metrics. Like most investment strategies, dividends can get complicated very quickly. However, if you break it, it’s pretty easy to get started – if you think it’s worth it.