“You should get some dividend stocks!”
“I live off the dividends from my portfolio.”
“The latest stock I bought pays an amazing dividend.”
We hear these types of comments from our subscribers all the time, and we want to explain exactly what dividends are, why they’re important for your portfolio, and how you should go about investing in them.
So what does a dividend mean? Here’s the formal definition.
Dividends are cash payments that a company gives you for owning their stock.
Usually dividend payouts are described in terms of a “dividend yield”. If a $100 stock has a $5 cash payment annually, then the dividend yield is 5% (i.e. you get 5% of your invested money in dividends every year).
Some companies pay no dividends, while other companies pay increasing dividends every year.
Why is this?
The reason is that dividend payouts come from the company’s earnings, so they’re mostly paid out from highly established companies. In general, newer and higher growth companies tend to not pay a dividend as they would rather reinvest that cash back into their own company in the form of research and development.
Why Dividend Stocks are Good for Your Portfolio
The quick answer is that they provide a steady income stream.
For example, if you have a stock that pays you a 5% annual dividend you will get that money regardless of what the stock price does. If you own $10,000 of that stock, then you will get paid $500 a year.
Now $500 might not seem like a lot, but some people build up huge portfolios of dividend stocks. Imagine you’re a retiree with a $500,000 nest egg and have invested all of it in a stock that pays the same 5% dividend. You would now be getting paid $25,000 a year – again regardless of what the stock price does. If you hold this stock in a tax-sheltered account such as a Roth IRA (USA) or TFSA (Canada), then you won’t even have to pay taxes on this $25,000. Now we’re getting into some serious money.
In other articles we have suggested that you should invest in index funds. The good news is that you also get paid dividends from an index fund! The reason is that a lot of the stocks that are in the index pay dividends, so you are entitled to the payouts.
Should you use a Dividend Reinvestment Plan (DRIP)?
A dividend reinvestment plan (DRIP) is a powerful tool.
Most investment accounts will give you the option to “reinvest” your dividends automatically to buy more shares of the stock or fund.
For example, if you’re getting a $500 dividend with your $10,000 investment you can automatically purchase additional shares of the stock or fund with that $500. If you don’t have enough dividends to buy a full unit of the stock or fund, then you will just get the cash payout.
There are a couple of benefits to using a DRIP:
- You don’t have to pay a trading fee. When you purchase an investment, your investment brokerage often charges you a fee (eg. $10.00 for buying a stock). If you’re buying under the DRIP, then you don’t have to pay this fee.
- The additional shares you purchase will also provide dividends. This will allow you to compound your earnings, and is a great strategy for the long haul.
We recommend always using a dividend reinvestment plan.
How do you Invest in Dividend Stocks?
So what stocks actually pay dividends, and how do you go about investing in them? There are two main ways.
First, you can straight up buy a stock that pays dividends. This is the riskier approach, but will give you the opportunity for higher dividends as you can concentrate your money in a stock that pays a juicy dividend.
Now be careful, a stock can have an unnaturally high dividend yield if it’s price has dropped recently. For instance, if a stock was $100 per share and paying a $5 annual dividend then the dividend yield is 5%. However, if the company is doing really poorly and the stock price dropped to $50 then that becomes a 10% dividend yield. The risk here is that the company might cut their dividend payments if they can’t afford to pay out the cash – and a tanking stock price is one indicator that things at the company are not going well.
If you’re looking for a stable dividend stock, then check out the list of Dividend Kings and Aristocrats. These are companies that have a long history of paying good dividends.
- Dividend Kings. A dividend king is a stock that has increased its dividends for at least 50 consecutive years.
- Dividend Aristocrats. A dividend aristocrat is a stock that has increased its dividends for at least 25 consecutive years.
The second way to get into dividend investing is to buy a fund that pays dividends. A fund is a collection of stocks, and some of these stocks may pay a dividend. This is a lower risk option as the price of the fund is less likely to fluctuate as much as an individual stock. However, the dividends you collect will be lower than what you can get with a good dividend stock. For example, Vanguard’s S&P 500 fund will payout around 2% in dividends annually, and you can easily find a good dividend stock that pays over 4% annually.