You can elect to receive the dividends as cash. Or you can reinvest the dividends, which means you’ll use them to buy more of that company’s stock.
A dividend stock is stock in a company that’s currently paying a dividend. Companies can choose to start or stop paying dividends. However, some of the largest, most stable, publicly-traded companies try to increase the amount of their dividend payments each year.
Dividend stocks generate passive income, and that makes them attractive to a lot of investors.
How Do Dividend Investing Strategies Work?
Investing in dividend-paying stocks as a strategy has bounced in and out of favor over decades.
But the sales pitch sounds attractive: Build up a large enough portfolio of dividend stocks and get a series of fat, comma-laden checks sent your way each quarter. Retain the underlying investments (your initial principal) and live off your dividends.
If a stock doesn't pay dividends, the only way to get cash from it is to sell the stock. However, just because Stock A pays a dividend and Stock B doesn't, it doesn't mean that Stock A is a better investment. I'll go into more detail on that point in the next section.
Dividend portfolios can be defensive during bear (downtrending) markets. Shareholders who follow this strategy heavily will still get rewarded via income or by grabbing up shares at a potentially discounted price.
In many cases, dividend stocks are blue chip value stocks with long histories of success.
Financial Theory: Dividends Are Neutral for Investors
It’s important to understand where a dividend comes from. Companies that pay dividends are taking a percentage of their earnings and giving them to shareholders.
Growth-stage companies almost never offer dividends. Instead, they invest that money into product development, customer acquisition, marketing and other things.
Dividends also aren’t some magic money-making machine: For every action, there’s a reaction.
In this case of dividend-paying stocks, it goes like this. Let’s say you hold one share of stock in Company A, which is valued at $100. The company then pays a 1% dividend, or $1. In theory, the stock market is efficient. So the share price of Company A should drop $1, the same amount paid out, (from $100 to $99).
So that makes dividends “neutral” to the investor in terms of value. In other words, the worth of your investment should be the same in the short term whether a company pays out the earnings to you via a dividend, keeps the money in cash, uses it to pay off debt or reinvests it.
There are two major differences, though. If your stock pays a dividend, you’ll get the option to remove that money from the market in the form of cash without giving up any of your shares. Also, if you’re investing in a taxable account, your dividends will be counted as income on your tax bill.
Income Investing: The Problems With Dividend Portfolios
Passive income is the upside of dividend-focused investing. However, there are several potential downsides.
It's important not to get mesmerized by dividends: Stock X, Y and Z pay $5 per share every year! Remember, dividends are neutral, meaning that they don't impact the overall value of your investment positively or negatively in the short term.
Here are some of the potential negatives that come along with building a portfolio mostly focused on dividend stocks.
- Cost. Dividend portfolios often are much more expensive than broad index funds. For example, Vanguard's High Dividend Yield ETF carries an annual expense ratio of 0.06%. Vanguard's Total Stock Market ETF carries an annual expense ratio of 0.03% — half the cost. The difference is more pronounced if you buy through iShares: 0.03% for its total stock market ETF and 0.39% for its dividend ETF.
- Diversification. If you build a portfolio filled with dividend stocks, your holdings will be concentrated around specific types of companies. Money expert Clark Howard doesn't like making concentrated investments (what he calls "bets") on individual stocks or even on specific industries.
- Performance. Dividend stocks often don't perform as well as the market as a whole. When you're investing for retirement, what matters ultimately is total return whether it's via dividends or an increase in the value of your portfolio due to stock prices increasing. Check out this chart comparing Morningstar indexes and their average annual performance in the last 15 years.
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- Taxes. Dividends generate tax bills even if you elect to reinvest them unless you're investing within a tax-advantaged retirement account such as an IRA.
- Volatility. Dividend stocks aren't bonds. Even though they tend to be among the most stable, consistent stocks, they're still risky in terms of investments especially at the individual company level.
Best Dividend Stocks: What To Evaluate
Clark doesn't advise putting a meaningful percentage of your retirement portfolio into any individual stock. He suggests that a portfolio of fewer than 50 individual stocks is too concentrated — even if you want to be aggressive in your strategy.
Whether or not you take Clark’s advice and avoid stock picking, it’s still helpful to understand some of the elements one would consider when looking at a dividend stock:
- Fundamentals. Companies that have always paid dividends usually try to continue that even if their fundamentals decline. Remember, you're investing in an individual company when you buy a stock. The dividend may be a shiny object. But if the underlying company is stagnant or rotting, it's probably a bad investment even considering the dividend.
- Dividend yield. You'll often see a stock's dividend expressed as a yield percentage. If a stock is $100 per share and pays a $1 dividend per share, that's a 1% dividend yield. The average dividend yield of the S&P 500 was 1.35% as of June 2021, according to YCharts.
- Payout ratio. This metric looks at the percentage of a company's earnings that it pays out via a dividend. If a company is paying out a huge percentage of its revenue, it may not be investing enough in growing or sustaining the business.
- Dividend history. Is the company consistently increasing its dividend payouts? And for how many years has the company paid a dividend to its shareholders?
What Are the Dividend Aristocrats?
The Dividend Aristocrats are a group of S&P 500 companies that have increased their dividends in each of the last 25 years.
There are currently 65 companies within this group, including giants like Walmart, McDonald’s, Johnson & Johnson and Coca-Cola.
Every year, some companies drop off the list or get added to it. In the first half of 2021 alone, three new companies joined the list and five companies fell off.
If you’re relying heavily on dividend stocks to fund your retirement, you’re counting on those dividends staying the same or increasing over time.
True investing means parking your money in something for a decade or more. You don’t want to keep moving your money around to chase big dividends.
You’re also counting on each company’s stock to perform relatively well. Some companies take immense pride in their dividends and prioritize continuing their strong history of increasing those payouts.
Dividend stocks aren't inherently bad. In fact, if you follow Clark's investment advice (target date funds or low-cost index funds), you'll almost certainly own some dividend stocks within your well-diversified portfolio.
Just be careful of falling in love with the idea that you can outperform the market simply by investing almost totally in dividend-paying stocks.
There may be valid reasons to set up a dividend-paying portfolio. But it’s important to fully understand the downsides and limitations of dividend stock portfolios and not buy only on the promise of passive income.
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