Dividend stocks offer dual benefits: income from dividends and capital appreciation, outperforming with lower volatility.
Key metrics like dividend yield and payout ratios mitigate risks and assess dividend sustainability.Diverse strategies—portfolio building, DRIPs, ETFs—leverage dividend stocks' outperformance and lower volatility.
Dividend investing can be a great investment strategy. Dividend stocks have historically outperformed the S&P 500 with less volatility. That's because dividend stocks provide two sources of return: regular income from dividend payments and capital appreciation of the stock price. This total return can add up over time.
Because of their lower volatility, dividend stocks often appeal to investors looking for lower-risk investments, especially those in or nearing retirement. But dividend stocks can still be risky if you don't know what to avoid. Here's a closer look at how to invest in dividend stocks.
Let's look at an example. Say you buy 100 shares of a company for $10 each, and each share pays a dividend of $0.50 annually. If you invested $1,000, you would receive $50 in dividend payments over the course of a year. That works out to a 5% dividend yield -- not too shabby.
What you choose to do with your dividends is up to you. You can:
Regardless of whether the company's stock price goes up or down, you would receive those dividend payments as long as the company continues to disburse them.
The beauty of stocks that pay dividends is that part of your return includes predictable quarterly payments. Not every company offering dividend stocks can maintain a dividend payout in every economic environment, but a diversified portfolio of dividend stocks can produce reliable income rain or shine.
Combine those dividends with capital appreciation as the companies you own grow in value, and the total returns can rival and even exceed those of the broader market.
Here are some well-known companies that have a long history of paying dividends, along with their dividend yields at recent stock prices and the per-share amount of each dividend:
| Company | Industry | Dividend Yield | Quarterly Dividend Amount |
|---|---|---|---|
| Chevron (NYSE:CVX) | Energy | 3.99% | $1.51 |
| Procter & Gamble (NYSE:PG) | Consumer defensive | 2.53% | $0.94 |
| Lowe's (NYSE:LOW) | Consumer cyclical | 2.05% | $1.10 |
Both Procter & Gamble and Lowe's have increased their stock dividends for more than 50 consecutive years, placing them in an elite group of companies known as the Dividend Kings. They're also part of the Dividend Achievers, S&P 500 Index companies with more than 25 years of consecutive dividend increases. Chevron is also an Aristocrat, with a 35-plus year streak of dividend growth. Dividend stocks can come from just about any industry, and the amount of the dividend and percentage yield can vary greatly from one company to the next.
Before you buy any dividend stocks, it's important to know how to evaluate them. These metrics can help you understand how much in dividends to expect, how reliable a dividend might be, and -- most importantly -- how to identify red flags:
Inexperienced dividend investors often make the mistake of buying stocks with the highest dividend yields. While high-yield stocks aren't bad, high yields can be the result of a stock's price falling due to the risk of the dividend being cut. That's called a dividend yield trap.
Here are some steps you can take to avoid falling for a yield trap:
Sadly, a yield that looks too good to be true often is. It's better to buy a dividend stock with a lower yield that's rock-solid than to chase a high yield that may prove illusory. Moreover, focusing on dividend growth -- a company's history and ability to raise its stock dividend -- often proves more profitable.
Most dividend stocks pay "qualified" dividends, which are taxed at a rate of 0% to 20%, depending on your tax bracket. The range is significantly lower than the ordinary income tax rates of 10% to 37% or more. (An additional 3.8% tax is levied on certain investment income for the highest earners.)
Although most dividends qualify for the lower tax rates, some dividends are classified as "ordinary" or non-qualified dividends and are taxed at your marginal tax rate. Several kinds of stocks are structured to pay high dividend yields and may come with higher tax obligations because of their corporate structures. The two most common are real estate investment trusts, or REITs, and master limited partnerships, or MLPs.
Of course this extra tax burden doesn't apply if your dividend stocks are held in a tax-advantaged retirement plan such as an individual retirement account (IRA). However, investing in MLPs can sometimes leave you owing taxes even on your IRA.
These companies pay their shareholders regularly, making them good sources of income.
These companies have at least 10 years of dividend growth.
These companies have increased their dividends every year for 50+ years.
There's a formula to calculating dividends. Learn how to use it to find yours.
There's a misconception that dividend stocks are only for retirees or risk-averse investors. That's not the case. You should consider buying dividend-paying stocks whenever you start investing to reap their long-term benefits. Dividend stocks, especially those in companies that consistently increase their dividends, have historically outperformed the market with less volatility -- expressed in a measure called "beta". Because of that, dividend stocks are a great fit for almost every investor; they can help you make a diversified, wealth-building portfolio.
There are a few dividend strategies to consider. The first is to build a dividend portfolio as part of your overall portfolio. When you're building a dividend portfolio, it's important to remember that paying dividends isn't obligatory for a company in the same way that companies must make interest payments on bonds. That means if a company has to cut expenses, the dividend could be at risk.
You cannot completely eliminate the risk of a dividend cut, but you can lower the risk. Focus less on a company's dividend yield and more on its ability to consistently increase its dividend. Look for a company with a sound financial profile focused on a growing industry.
Another aspect of a dividend investing strategy is to determine how you want to reinvest your dividends. Some investors opt to reinvest their dividends manually, while others use a dividend reinvesting plan, also called a DRIP. This powerful tool will take every dividend you earn and reinvest it -- without fees or commissions -- back into shares of that company, automatically. This simple set-it-and-forget-it tool is one of the easiest ways to put the power of time and compounding value to work in your favor.
Another dividend investing strategy is to invest in a dividend-focused exchange-traded fund (ETF) or mutual fund. These fund options enable investors to own diversified portfolios of dividend stocks that generate passive income.
No matter which dividend strategy you use, adding dividend stocks to your portfolio can be beneficial. They can help reduce volatility and boost your total returns so you can reach your financial goals a little faster.
