What Is Dividend Investing and How Does It Work?

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Dividends are payments that a corporation makes to shareholders. When you own stocks that pay dividends, you are receiving a share of the profits that the company makes.

Dividend investing allows you to create a stream of income in addition to the growth in your portfolio's market value from asset appreciation.

What Is Dividend Investing?

Dividend investing is a strategy of buying stocks that pay dividends in order to receive a regular income from your investments. This income is in addition to any growth that your portfolio experience as the stock in it gains value.

If the company you own shares of has a dividend reinvestment plan, or DRIP, you can also choose to have your dividends reinvested to buy additional shares, rather than having them paid out as a profit. This is a useful strategy when your dividends are small, for example, because the company is growing or because you don't own much stock.

However, experienced dividend investors will generally invest significantly in stocks that pay large dividends in order to make money.

Tips for Profitable Dividend Investing

Buying stocks that pay can reward you over time as long as you make intelligent buying choices.

1. Look for Dividend Safety

Good dividend investors tend to look for dividend safety, or how likely it is that a company will continue to pay dividends at the same or higher rate. While there are companies that assess and rank dividend safety for different stocks, you can also begin to analyze a corporation's level of safety by comparing earnings to dividend payments.

If a company earns $100 million and pays out $90 million in dividends, you'll make more of a profit than you would if they only pay $30 million in dividends. However, in the $90 million case, if profits fall by 10%, the company wouldn't be able to continue paying dividends at the same rate.

In general, companies that pay 60% or less as dividends are safer.

Dividend safety is also determined by how risky or new an industry is. Even if a company has a low dividend payout ratio, your dividend payment is less safe if the industry is unstable.

Look for companies that have a history of stable income and cash flow. The more stable the money coming in to cover the dividend, the higher the payout ratio can be.

2. Choose a Strategy and Stick With It

Good dividend investors tend to focus on either a high dividend yield approach or a high dividend growth rate strategy. Both serve different roles in different portfolios.

A high dividend yield strategy focuses on slow-growing companies that have substantial cash flow. This allows them to fund large dividend payments and produces an immediate income.

For Example

If a stock pays a $1 dividend and you can buy shares for $20, the stock has a 5% dividend yield. If you invest $1 million, you would receive $50,000 in dividend income.

A high dividend growth rate strategy focuses on buying stock in companies that currently pay lower-than-average dividends but are growing quickly. This allows investors to buy profitable stocks at a lower rate and make a large absolute dollar income over a five- or 10-year period.

For Example

During Walmart's expansion phase, it traded at such a high price-to-earnings ratio that the dividend yield looked quite small. However, new stores were opening rapidly, and the per-share dividend increased quickly as profits climbed. In this case, a buy-and-hold strategy would have produced significant income as dividends increased.

Different dividend investors may prefer one strategy over another, depending on whether the goal is immediate, stable income or long-term growth and profit. When choosing a strategy, determine what level of risk you prefer and how long you are willing to wait for your dividends to produce a substantial income.

3. Set Yourself up for Tax Benefits

Look for dividends that are designated as "qualified" to take advantage of tax benefits. Most income from dividends is taxed as ordinary income. However, qualified dividend stocks held for a longer period of time—usually 60 days or more—are taxed at the lower capital gains tax rates.

If you buy dividend stocks to get the dividend payment and then want to sell them quickly, you'll have to pay your regular tax rate on the dividend income.

Dividend Investing and Margin Accounts

If you invest through a margin account instead of a cash account, it is possible your broker will take shares of stock you own and lend them to traders who want to short the stock. These traders, who will have sold the stock you held without telling you, are responsible for paying you any dividends that you missed since you don't actually hold the stock at the moment.

The money comes out of their account as long as they keep their short position open, and you get a deposit equal to what you would have received in actual dividend income. Since the cash is not actually a dividend, it is treated as ordinary income. Instead of paying the low dividend tax rate, you'll have to pay your personal income tax rate.

Article Sources

  1. Pennsylvania Department of Banking and Securities. "The Basics for Investing in Stocks," Pages 2-8. Accessed Mar. 6, 2020.

  2. Wharton Magazine. "Beware High Dividend Yield Stocks." Accessed Mar. 6, 2020.

  3. Internal Revenue Service. "Topic No. 404 Dividends." Accessed Mar. 6, 2020.

  4. FINRA. "Understanding Margin Accounts, Why Brokers Do What They Do." Accessed Mar. 6, 2020.