When it works, dividend growth investing is a best-case scenario for income investing. In this strategy you buy a stock that not only grows in value year after year, but it also pays you a steady yield in the process. On top of that, the payments themselves grow each year as the company earns value. With a dividend growth strategy you buy shares of a dividend-paying stock and hold them. You then use the stock’s dividend payments to buy more shares, which you also hold. Ideally over time your portfolio snowballs, growing off of its own returns. Of course, like all strategies dividend growth investment has its risks as well. Here’s what you need to know.
Consider working with a financial advisor to help you balance investing for income as opposed to investing for capital appreciation.
What Are Dividends?
When a stock pays dividends, this means that the company has elected to directly pay some of its profits to its various shareholders. Dividend payments are generally spread across all of a company’s shareholders, and may vary based on the class of shares that the company has issued. For example, a company might make payments first to holders of its preferred stock and then see if there’s enough left over to make dividend payments to holders of common stock. Or it might make proportionally larger payments to certain classes of shareholder. However, in a typical dividend payment, everyone gets at least something.
A company makes dividend payments on a per-share basis. The more shares you hold, the more money you will receive. While other asset classes can have active returns, only stocks pay dividends.
In most, if not all, cases, paying dividends is entirely at the discretion of a company’s leadership. If a company does pay dividends it will typically do so on a quarterly or annual basis. The amount of money that the company pays is also typically at the discretion of its board of directors, and will fluctuate based on profits and expenses.
Large companies are more likely to pay dividends than small ones. By one estimate, more than 80% of S&P 500 firms pay dividends on a regular or semi-regular basis compared to about half of all small-cap firms.
What Is Income Investing?
Dividend payments are a form of what’s known as income investing.
With income investing you receive direct payments from your assets. The goal of this strategy is to hold assets over a longer period of time, collecting the income that they generate from regular or semi-regular payments. This is as opposed to capital gains investing, in which you sell assets after they appreciate in value and then buy new ones.
The profit from income investing is the money your assets pay you for holding them. The profit from capital gains investing is the money you make by selling your assets. Most investors pursue a mix of both strategies.
The most common form of income assets are bonds and certificates of deposit. These pay a fixed rate of interest, generating a steady stream of income for the lifetime of the asset. However, because their payments are guaranteed (at least so long as the underlying institution remains creditworthy), bonds and CDs tend to have fairly low rates of return.
Dividends tend to pay higher rates of return than the interest payments on bonds. This offsets the fact that dividends are less reliable than bond interest. Where bond payments are the contracted interest on a loan, dividends are based entirely on corporate cash flow and profit. A company may have a good quarter or a bad one. Its leadership may decide to use profits for dividend payments, or it may decide to direct that cash elsewhere.
There are no guarantees when it comes to dividend payments, which is why they are more rewarding.
What Is Dividend Growth Investing?
Dividend growth investing is a common form of income investing. It focuses on buying what are known as “dividend growth stocks.” These are stocks which perform from both an income and a capital gains perspective. They pay regular dividends and their share price grows. With income investing, you seek out income-generating assets and hold them for a long period of time. As noted above, your goal is to generate value through your portfolio’s active returns rather than the capital gains that come from selling your assets.
As an offshoot of income investing, dividend growth investing has three prongs:
- Build an income-oriented portfolio around dividend-paying stocks, then hold those stocks for a long period of time.
- Seek out stocks likely to increase in value. This indicates companies that are growing, and so will likely pay larger dividends over time.
- Use the returns from your dividend payments to buy additional shares of the company’s stock, then hold those shares as well.
Dividend growth investing mixes the strategy of income investing with the approach of a capital gains trader. You will look for companies with growing stock prices, not because you want to sell them but because of what those share prices represent. The more a company’s stock grows, the better it’s likely doing.
Ideally, a dividend growth strategy will have a snowball effect. You will compound your gains by purchasing more shares of stock, and you will target stocks likely to pay larger dividends year-over-year. This will ensure that each year you make more money than the last, accelerating the growth of your portfolio.
Variations on the Theme
Within a dividend growth portfolio there is room to pursue additional strategies based on your own preferences. Some of the most common approaches include:
A high-risk strategy entails seeking out more speculative assets that can post higher-than-average returns. Startups are a very common target for this kind of portfolio. With this approach you’re looking for high-risk, high-reward investments, the kind of firm that might make it big and pay out in kind.
The smaller the firm, the less likely it is to pay dividends. However those lower share prices also mean you can buy shares in greater quantities. A small-cap approach lets you offset the firm’s potentially lower value with larger holdings.
The more expensive the share price, the more expensive it is to buy in. A portfolio that focuses on large companies will generally hold fewer shares than one which focuses on small-cap firms, but you are more likely to receive dividends and they will generally be larger. This strategy offsets smaller holdings with larger payments.
As with capital gains investment, you can build your portfolio around its underlying industries. For some investors this means focusing on industries that you expect to do well. For others this means diversifying across a range of industries to mitigate risk.
In a standard dividend-growth strategy you will use your returns to buy more shares of the same stock. In a diversification-oriented approach, you use your returns to buy shares of new dividend-paying stocks. This allows you to pursue a strategy of overall growth while still spreading your portfolio across a range of assets.
The Bottom Line
Dividend growth stocks are stocks that pay quality dividends and look poised to grow. The companies issuing such dividends often slowly increase the dividends, too. They also base their dividends on actual growth and profit rather than debt or creative finance. A dividend growth strategy is a buy-and-hold approach to investing that seeks out these kinds of equities and then doubles down on them.
Tips on Investing
- Dividend investing is a popular, and very strong, way to build a portfolio. It emphasizes long term payments and a steady rate of returns over the active investments of a capital gains portfolio. While no investment is without its risks, dividend investments are well worth considering for just about any class of investor.
- Should you pursue a dividend growth stock strategy? It’s the question that an investor should be asking every time they see a new potential market strategy. How can this help your portfolio? Should this help your portfolio? While we can’t answer that for you, SmartAsset’s matching tool will help you find a financial professional in your area who can. It only takes a few minutes to connect with a financial advisor. If you’re ready, get started now.
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