What Is Dividend Investing?
- February 27, 2019
- by StojFinance
This guest post was provided by Jasper Levi Stojanovski at StojFinance.com StojFinance.com is a personal finance blog with a focus on stock market investment.
Dividend investing is an investment strategy in which stocks with a high dividend yield and strong financial position are typically preferred.
When adopting this strategy, your goal is to receive regular income through dividends - while experiencing a low level of portfolio volatility.
I will now explore the pros and cons of dividend investing - to help you decide whether or not this investment strategy is right for you.
Advantages of Dividend Investing
As mentioned, dividend investing provides you with regular income through dividends. A dividend is a payment made by a corporation to its shareholders - usually to distribute profits. The yield is the payout divided to the stock price (as a percentage).
Here is a quick example. Let's say you own 10 shares of ABC Corp on the day of the dividend. The dividend is $2/per share. If ABC Corp is trading for $100/share the dividend yield is 2% and you would get $20. If you owned 1000 shares you would get $2000. If ABC Corp was trading at $200/share the yield would be 1%.
Here are some of the advantages of dividend investing:
Minimal Portfolio Volatility:
As a dividend investor, you will generally experience less volatility in the value of your stock portfolio. You can achieve this by purchasing companies with a strong financial position, a long history of consistent dividend payments and a large market capitalization - among other metrics that I will explore further below.
Large, well-established companies are generally referred to as “Blue Chip Stocks”. Blue chip stocks got their name from poker chips—the simplest sets of poker chips include white, red, and blue chips. With blue chips traditionally being the most valuable.
Dividends Are Less Volatile Than Earnings:
Overtime, dividends are typically less volatile than earnings. Therefore, you can still expect to generate dividend income - even when the stock price has temporarily dipped.
Disadvantages of Dividend Investing
Now that I have explored some of the advantages of dividend investing, I will now explore some of the disadvantages of this investment strategy:
Significant Returns Are Unlikely:
When employing this strategy, you will aim to meet the growth rate of the market—whilst obtaining an income concurrently. Significant annual returns are unlikely to be realised when employing this strategy.
The compound annual growth rate (CAGR) of the S&P 500 over the past 100 years was 6.98% - with an average dividend yield of 4.3%. This means you would need to attain an 11.28% return annually to meet US historical averages.
To reiterate, it’s unlikely that your “dividend stocks” will experience a significant amount of capital appreciation.
With steady income comes steady taxes. Income taxes are a significant disadvantage to dividend investing; however, the current federal tax rates on dividends in the United States are typically lower than you can expect to pay on other types of income.
Dividend income is typically taxed at a rate of 0% to 20% - depending on your tax bracket. Even so, this is still a disadvantage and you should consider this factor when making your next stock purchase.
What to Look for In A Dividend Stock
There are many ways to identify a dividend stock - as I will explore further below.
High Dividend Yield:
A high dividend yield means a significant payout for you as a dividend investor and should be one of the main factors you consider when making a purchase.
You should not by any means purchase a stock with an unsustainable dividend yield - especially one with a payout ratio in excess of 100%.
You are simply trying to attain an above average dividend while maintaining a stable portfolio. Any stock with a dividend above 4.3% is preferable. As the historical average dividend yield for the S&P 500 is 4.3% over the past 120 years—as mentioned earlier.
Blue chip stocks, or stocks with a large market cap - are typically well established and are preferable to the dividend stock investor. Well established companies are less likely to be affected by adverse market conditions and present less risk to the dividend investor.
Strong Financial Position:
As a dividend investor it is a prudent decision to avoid buying stocks of companies that have a weak financial position. As a general rule, you should avoid companies with a debt/equity ratio (D/E) of 2 or more.
If a stock isn’t generating a profit they cannot afford to pay out dividends to shareholders. Thus, it is a good idea to avoid stocks that are not generating any earnings, especially for investors that are targeting a high dividend yield.
Long Term Dividend Record:
Dividend investors should favour stocks that have a long history of consistent dividend payments; however, there are other things to consider when browsing through a stock’s dividend history.
The payout ratio of a particular stock should also be observed when deciding on a purchase. The payout ratio shows us what percentage of the company’s profits were paid out to shareholders.
It’s also important to know whether the particular company has been regularly increasing their dividend over a period of years.
A stagnant dividend tells us the company in question has not been experiencing a level of growth significant enough to allow for an increased dividend.
An Average Price/Earnings Ratio:
You should be looking to purchase a stock with an average price/earnings ratio. The average historical p/e ratio for a stock within the S&P 500 is 15.74. An average p/e ratio indicates to us that a stock is not significantly overpriced, nor significantly under-priced and unfavoured by shareholders.
Who Is Dividend Investing For?
Dividend investing is for the long-term investor, someone who is looking to build wealth overtime, perhaps for retirement. Or perhaps you want to gain exposure to the stock market without risking your capital on dicey stocks?
Either way, dividend stocks are a great way to generate passive income - and are one of the many ways you can generate significant wealth through stock market investing.
To learn more about investing, visit The 5 Best Investing Books to Buy In 2019—where Jasper explores some of the greatest investing books of all time.