When you have some leftover money after maxing out your 401k and IRA’s. You should look for alternate ways to invest and grow. Dividend investing is a powerful way to grow your wealth completely passively. in the longer term, historically, dividend stocks outperformed the real estate investments. Today we will discuss some of the basics of dividend investing
When it comes to investing, everyone has their own strategy. Some are seeking big gains, others are looking for steady supplemental income. Every investing strategy has different risks and rewards. Those looking for a low-risk strategy should look no further than dividend investing. It is easy to understand, and simple to execute.
Although bonds and govt. notes have lower investment risks, if you combine return and risk together, dividend investing would definitely stand out and it’s one of my favorite investment strategies.
What is a Dividend?
When an investor buys a stock, they own a fraction of the company. Because of this relationship, the company shares its profits with the shareholders.
So, A dividend is a sum of money paid regularly (typically quarterly) by a company to its shareholders out of its profits.
Dividends are decided by the company’s board of directors. The size of the dividends depends upon the company’s performance.
If the board of directors expects higher profits, they might declare higher dividends. Companies usually pay cash dividends, although there are other types.
Most companies issue cash dividends. Cash dividends are paid out on a per share basis. Let’s say you own 1,000 shares and the company decides to pay a cash dividend of $2 per share. You would receive $2,000 for owning that company’s stock.
Stock dividends are payments in the form of additional shares. Sometimes companies issue stock dividends because they need the cash for operating costs. Stock dividends are given as a percentage of existing shares.
For example, if a company issues a 5% stock dividend and you own 100 shares, your total would become 105 shares.
Stock dividends are not taxable until they are sold. So, investors who do not immediately need capital may prefer stock dividends.
Property dividends are less common than cash or stock dividends. Property dividends can take many forms, such as real estate, products, equipment, software, or any other assets excluding cash and stocks.
What is Dividend Investing?
Dividend investing is the strategy of creating a portfolio that consists of dividend-paying stocks. Dividend-paying companies are usually long-established companies with a history of financial health.
These companies have enough free cash flow to reward shareholders with dividends. So, if you follow the best practices of dividend investing you can make good use of your cash.
There are two key aspects of dividend investing. First, picking the right companies to invest in. You want companies with the financial wherewithal to continue their dividend for years down the road.
Second, reinvest your dividends. DRIPs or dividend reinvestment plans allow investors to reinvest their cash dividends back into the company in exchange for more shares. Reinvesting dividends is how you grow your income.
Dividend Reinvestment Plans (DRIPs)
Dividend reinvestment plans can compound your returns. Here’s how it works: by reinvesting your dividends, you buy more shares. With more shares, you’d receive more dividend income.
You could then buy more shares, which would generate even more dividend income… Dividend reinvestment plans are a powerful method for growing your wealth.
According to NerdWallet’s analysis of data, The S&P 500’s average return from 1928 through 2017 was about 7.6%. But, if all dividends had been reinvested, it would have been about 11.5%. That proves DRIPs increase your wealth over the long-term regardless of economic downturns.
In most cases, DRIPs allow shareholders to get shares commission-free. And in some cases, the company will offer shares at a discount to the current share price.
To see the value of your future investments with and without reinvesting dividends you should use a dividend reinvestment calculator.
Compound interest is a key concept to understanding dividend reinvestment plans. Albert Einstein is noted for saying that it is “the most powerful force in the universe.”
And Warren Buffet called compound interest one of the three biggest factors contributing to his wealth. It is crucial to growing your assets and preparing for retirement.
The Benefits and Drawbacks to a Dividend Investment Approach
There are many benefits to a dividend investing strategy, with several key drawbacks that must be understood. Before putting your money in high-yield stocks, get familiar with these pros and cons:
- Passive income can be reinvested to increase share ownership or collected as supplemental income.
- Ability to purchase more shares without any out-of-pocket capital expenses or borrowing from brokers (margin).
- More stability and less volatility in your portfolio, as dividend-paying companies are usually “blue chip” bellwethers.
- Reduced risk by investing in companies that are able to generate self-sustaining capital from their operations.
- The prospect of rising dividends, which will reward stock owners for being long-term shareholders.
- Fewer taxes paid as opposed to frequent trading, which incurs fees and capital gains payments on profits.
- Because of their stability, investment in dividend-paying stocks can be a hedge against inflation that may drive the general stock market down.
- It can be hard to diversify a portfolio around dividend stocks since many high yield companies are based in a small pool of industries.
- There’s lower growth potential from dividend stocks, meaning they’re unlikely to appreciate much faster than inflation.
- Stocks are riskier than bonds, which can prove to be a more stable alternative to a dividend investing strategy.
- High dividends by themselves can be misleading. Some companies pay an unsustainable dividend and will eventually need to cut the dividend or perform a reverse split.
- Taxation tends to be high on dividend income. While still lower than capital gains on sold stock, dividend taxes outweigh other investment vehicles (like bonds).
- A dividend investment strategy requires a long time horizon to be effective. Investors starting later in life won’t be able to maximize their returns.
If you haven’t explored dividend investing yet and have some cash to invest, you should start now, as early as possible to make the best use of the power of compound interest.