The Basics of Investing in Dividend-Paying Stocks

Wall Street

Michael Marquand / Getty Images

Those who are investing for income have numerous options outside of bonds, and the most traditional – and easiest to understand – the choice is high-dividend stocks. Although investing in the stock market involves more risk than investing in bonds, dividend-paying stocks offer modest income and the potential for longer-term capital appreciation.

High-dividend stocks have become a more popular option for income-oriented investors in recent years since traditional fixed-income investments such as bank accounts, certificates of deposit, and U.S. Treasuries pay next to nothing. At a time of low bond yields, the typical 1.5%-5% yield you can get from dividend-paying stocks becomes much more attractive.

Benefits of Dividend-Paying Stocks

High-dividend stocks tend to outperform the broader market over time. According to the asset manager Dreyfus, U.S.-based dividend-paying stocks returned an average 9.3% annually from January 31, 1972, through December 31, 2013, far exceeding the 2.3% average annual return for stocks with no dividends. Additionally, more than half of the total return of U.S. equities from 1930 through the end of 2010 was the result of dividends rather than price appreciation.

Historically, dividend-paying stocks also perform better than the overall market during times in which stock prices are weak. Since stocks that pay dividends are generally more conservative and have stronger cash flows than those that do not, investors tend to gravitate toward dividend payers during times of trouble.

Dividends, by returning actual cash to shareholders, also provide an indication of the strength of the business underlying the stock. Additionally, companies tend to use their resources more efficiently when they are less plentiful – which cash is once dividends have been paid. Higher dividends mean more cash in the hands of investors, and less in the hands of a management team that may not necessarily make the right decisions.

What’s In a Yield?

Naturally, there is more to dividend-based investing than simply searching for stocks with the highest yields. In some cases, elevated dividend yield can serve as a warning that a stock’s price might be depressed for a fundamental reason. Investors also look for companies with strong fundamentals backing up the dividend, such as robust earnings growth, solid balance sheets, and attractive valuations.

On the other hand, it isn’t necessary to give up growth to invest in dividend-paying stocks. Many companies with attractive yields are innovative world leaders – and not the type of stodgy, slower-growth companies that would provide investors with little in the way of capital appreciation potential over time.

Bonds Versus Stocks

Investors who are trying to decide how to allocate between stocks and bonds need to look at their broader investment objective.

If safety is the primary goal, the best course of action is to invest in more conservative instruments, such as government bonds or mutual funds that invest in short term bonds.

If income is the foremost consideration and an investor can afford to take on some risk, high yield bonds and emerging market bonds will usually be the best sectors in which to find the highest possible yields.

If capital appreciation is a priority and income is secondary – but still, a consideration – dividend-paying stocks can play an important role.

Naturally, there’s no need to invest in just one asset class. Very often, a combination of these and other investments is necessary to generate the optimal combination of risk, total return potential, and yield.

How to Invest in Dividend-Paying Stocks

Investors can assemble a high-dividend portfolio in three ways: buy individual stocks, invest in dividend-focused mutual funds, or utilize the wide range of dividend ETFs that have been created in recent years. Among the most popular dividend-focused ETFs are iShares Dow Jones Select Dividend Index ETF (ticker: DVY), Vanguard Dividend Appreciation ETF (VIG), and SPDR S&P Dividend ETF (SDY). There are also numerous ETFs that invest in the highest-dividend stocks in particular market segments, such as small-cap stocks or emerging markets.

You can purchase stocks or ETFs through a broker, and mutual funds are typically available either from a broker or from the company via direct investment. Be sure to contact a financial advisor or use all the vast online resources available to conduct comprehensive research before investing.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.