The term ‘dividend’ is widely used in the stock market. If you’ll be playing in this market, you’ll need to know about the concept of dividends.
In this post, you’ll learn about dividend and how it works.
What are dividend stocks?
Dividend stocks are stocks that distribute a portion of the company’s earnings to investors on a regular basis. Most American dividend stocks pay investors a set amount each quarter, and the top ones increase their payouts over time, so investors can build an annuity-like cash stream.
Companies that pay dividends tend to be well-established, so dividend stocks may also add some stability to your portfolio. That’s one reason they’re included on our list of low-risk investments.
How Dividend Stock Works
There are two main ways to invest in dividend stocks: Through mutual funds — such as index funds or exchange-traded funds — that hold dividend stocks, or by purchasing individual dividend stocks.
Dividend ETFs or index funds offer investors access to a selection of dividend stocks within a single investment — that means with just one transaction, you can own a portfolio of dividend stocks. The fund will then pay out dividends to you on a regular basis, which you can take as income or reinvest.
Dividend funds offer the benefit of instant diversification — if one stock held by the fund cuts or suspends its dividend, you can still rely on income from the others.
Whether it’s through dividend stocks or dividend funds, reinvesting those dividends can greatly enhance your return on investment; dividends typically increase the return of a stock or dividend fund by a few percentage points.
How to invest in dividend stocks
Building a portfolio of individual dividend stocks takes time and effort, but for many investors it’s worth it. Here’s how to buy a dividend stock:
1. Find a dividend-paying stock. You can screen for stocks that pay dividends on many financial sites, as well as on your online broker’s website. We’ve also included a list of high-dividend stocks below.
2. Evaluate the stock. To look under the hood of a high-dividend stock, start by comparing the dividend yields among its peers. If a company’s dividend yield is much higher than that of similar companies, it could be a red flag. At the very least, it’s worth additional research into the company and the safety of the dividend.
Then look at the stock’s payout ratio, which tells you how much of the company’s income is going toward dividends.
A payout ratio that is too high — generally above 80%, though it can vary by industry — means the company is putting a large percentage of its income into paying dividends. In some cases dividend payout ratios can top 100%, meaning the company may be going into debt to pay out dividends.
3. Decide how much stock you want to buy. You need diversification if you’re buying individual stocks, so you’ll need to determine what percent of your portfolio goes into each stock. For example, you’re buying 20 stocks, you could put 5% of your portfolio in each.
However, if the stock is riskier, you might want to buy less of it and put more of your money toward safer choices. If you’re going to reinvest your dividends, you’ll need to recalculate your cost basis — the amount you originally paid to purchase the stock.
The No. 1 consideration in buying a dividend stock is the safety of its dividend. Dividend yields over 4% should be carefully scrutinized; those over 10% tread firmly into risky territory.
Among other things, a too-high dividend yield can indicate the payout is unsustainable, or that investors are selling the stock, driving down its share price and increasing the dividend yield as a result.
Another thing to keep in mind is that dividends in taxable brokerage accounts cause taxes to be realized in the year the dividends occur, unlike stocks that do not pay dividends whose taxation primary occurs when the stock is sold. For investors with taxable accounts and in high income brackets, dividends stock might not be as tax efficient as other options.
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