Unlike capital gains investing, wherein a portfolio generates money when you sell its underlying assets, income investing involves generating income by holding dividend-paying stocks. Income investing can be a good way to generate compounding returns with the goal of living off your dividends without diminishing your capital. However, dividend investing also tends to generate lower overall returns than capital gains investing, and can be more volatile than bond-based income investing.
Thinking of putting together a portfolio based on a dividend investing strategy, but don’t know where to start? Consider reaching out to a financial investor.
What Are Dividend Payments?
A dividend is a payment that a company makes to its shareholders. These payments are issued on a per-share basis, meaning that as a shareholder you receive a dividend for each share of stock you own. While the per-share payment that dividends issue may look relatively small, they can add up quickly.
For example, in May 2024, Apple issued a $0.25 dividend. This means that Apple paid $0.25 per share to each of its shareholders. If you owned 1,000 shares of Apple stock, you would have received $250.
Absent some other agreement, companies issue dividend payments on an entirely voluntary basis. This means that there is no fixed schedule or amount for how a company will make payments, because they are not required to do so. In general, companies issue dividends based on quarterly corporate profits. The stronger a company’s revenue and profits, the more significant its dividend payments.
That said, while dividends can be unpredictable, regular dividends are often a core part of a company’s business and financing strategy. In these cases, dividend payments are more predictable, if not guaranteed.
For investors, dividends are a form of direct income known as “yields.” An investment’s yield is the money you make by holding it, rather than selling it for capital gains. Interest payments are the other main form of yield for retail investors, which are typically generated by bonds and banking products.
What Is Dividend Investing?
Dividend investing is an overall investment strategy of building your portfolio around stocks with regularly issue dividend payments.
This is one of the two main forms of income investing, because you are structuring your portfolio around generating payments while you hold your assets. The other main form is bond investing, in which you build your portfolio around the interest paid by government, corporate and banking debt products. Of the two, dividend investing is generally seen as the more aggressive approach. Compared with debt, dividend stocks tend to offer more potential growth, but also more potential volatility.
It’s important to note that dividend investing doesn’t mean you exclusively invest in dividend-bearing stocks. A typical portfolio will hold a mix of assets to protect against market fluctuations. However, the portfolio will focus on these equities.
Here are the top three common reasons why investors might choose a dividend investing strategy:
Income Investment
For income investors, the payments are the purpose. Here, the investor looks to withdraw their dividend payments as long-term income. By building a portfolio with enough dividend-bearing stocks, it’s possible to generate a steady income without ever needing to sell the portfolio’s underlying assets.
Income investment strategies are particularly popular among retirees. A portfolio built around yields, such as dividend payments and interest, can effectively secure an indefinite retirement because you don’t need to worry about drawing down on your assets.
But it’s important to note that the idea of “securing” a retirement, or any other portfolio, always comes with an asterisk of risk. Dividend stocks are strong assets for their growth and long-term inflation protection. However, they’re potentially risky for their volatility, and for the voluntary nature of these payments. Retiree income investors in particular might want to make sure they spread their portfolios out among a mix of equity, debt and annuity assets for a cross-section of growth and stability.
Compounding Returns
You can also use income investing to accelerate growth. In this case, you wouldn’t take the payments out. Instead, you roll each set of dividend payments back into the underlying asset or other investments. This can generate what’s known as “compounding returns.” Your investments generate cash, which you will use to buy more stock, which in turn generates more cash. This positive feedback loop can be a very strong approach to growth-oriented investing.
Asset Maturity
Other investors use dividend investments as an additional benefit while they wait for long-term investments to grow.
In most cases, when investing for capital gains, the long-term approach can be more profitable. This is particularly true for retail investors. You will almost always do better by leaving your money in place for several years at a time, rather than actively trading it in and out of positions. The problem is that this means keeping your cash locked in one place for years.
Dividend investing can be a best-of-both-worlds solution to that problem. It allows money to grow over time, taking advantage of the market’s long-term growth, but also provides payments with that money, which you can use to make additional investments.
How to Create a Dividend Investing Strategy
More than anything else, it’s important to remember that dividend investing is a long-term strategy. Look at that Apple stock example again.
At time of writing it costs $191 to buy a single share of Apple stock, which in turn might net you about $1 in dividend payments over the following year. That’s a current dividend yield of about 0.53%. Or, to look at it another way, you would need to hold almost $10 million worth of Apple stock just to generate about $50,000 per year of dividend income.
It’s important to remember that these are long-term investments, and that dividend investing is often the opposite of growth investing. The companies most likely to pay dividends are large, well-established firms that can afford to dedicate their profits to shareholder value. This tends to correlate with strong, stable share prices, but also relatively slow growth.
By contrast, smaller, newer companies tend to reinvest their profits in the organization. That makes them less likely to pay dividends, but it also positions their stock for stronger capital gains growth.
If you’re looking to build a dividend portfolio, there are three key things to look for:
Start With Strong Dividend Yields
Start by looking for companies with solid dividend yields.
The dividend yield tells you, historically, how much income this stock will generate for every dollar invested. It is calculated as:
- Yield = Annual Dividend Per Share / Price Per Share
The yield is generally expressed as a factor of $100. So, for example, Apple’s 0.53% dividend yield means that the company historically has paid out about $0.53 for every $100 worth of stock an investor owns.
Ideally, you would look for a company with a solid, sustainable dividend yield. It should be high enough to generate real income for your portfolio (that 0.53% number won’t do much good), but not so high that it suggests the company is pumping all of its cash back to the shareholders. What makes a “good” yield differs widely between industries, but in general you can start by looking for yields between 2% and 4%.
From there, compare the company among its peers. Does this dividend yield seem right for the company’s size and industry? If not, is there something particular about this firm that might justify outsized payments?
Look for Dividend Traps
You’ll then want to dig a little deeper to ensure you’re avoiding any dividend traps. Dividend traps are companies that issue strong dividends for a while to attract investors, but ultimately find those payments unsustainable. In the end they either stop issuing dividends, because they could not maintain that kind of spending, or the business suffers cash flow problems.
There are a number of ways to look for dividend traps, but a good place to start is with the company’s history and earnings per share (EPS). Does this company have a history of consistent dividend payments? Be careful of companies with erratic or relatively recent payment schedules. In particular, be careful of companies that issue “special” dividends. These are one-off payments, rather than scheduled dividend payments. Special dividends are a good windfall for capital investors, but not much help for an overall strategy.
How strong are this company’s fundamentals? Does it have a good P/E ratio, for example, and a strong EPS? Those kind of cash flow indicators can help you analyze a company’s ability to keep making payments in the future.
Looking at the company’s fundamentals is important because dedicated dividend information is trailing. The published history and the yield tell you what the company has done in the past, but looking at its financial information can tell you how likely it is to make these payments in the future. A cash-flush company is more likely to continue making dividend payments, while a company with struggling revenue may struggle to keep up with those payments.
Consider the company from a whole-business perspective. You want strong dividend payments, to be sure, but make sure you have good reason to believe those payments will continue.
Look Into Diversification and Dividend Funds
Once you begin selecting assets, it’s important to diversify your investments. Some industries tend to pay higher dividends than others, which can make it easy to concentrate your investments. Deliberately spreading money around can help to diversify portfolio holdings.
A good way to do that is by investing in ETFs and mutual funds built around dividend investing. There are a great many funds on the market that focus on dividend-generating assets, and they can be an excellent source of inherent diversification. As always with a fund, make sure you examine the asset’s fee structure, but you can often get a lot of value out of adding some dividend funds to an income-oriented portfolio.
Bottom Line
Dividend investing is a form of income investing, in which your portfolio generates money without you having to sell your portfolio’s underlying assets, as you would with a capital gains investing strategy. It can be an excellent way to structure your portfolio, but make sure you analyze your assets carefully.
Income Investing Tips
- While every company reports its past dividends, these are known as lagging indicators. They’re important, but it’s just as critical to consider a company’s predictive indicators to get a sense of how the company might pay dividends going forward.
- A financial advisor can help you build a comprehensive retirement plan. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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