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How to Pick Dividend Stocks for Long-Term Investing


Dividend stocks are often a main component of a long-term investor’s portfolio, as they offer the dual benefit of potential capital appreciation and regular income. While growth-oriented companies often reinvest profits back into the business, more established companies may distribute a percentage of their earnings directly to shareholders in the form of a dividend. This can provide a steady cash flow, making them attractive to investors seeking stability and passive income. Selecting dividend stocks strategically could help you ensure steady returns and enhance portfolio stability.

A financial advisor can help you select and manage your investments, including dividend stocks. Connect with a fiduciary financial advisor today.

What Is a Dividend Stock?

A dividend stock is a type of equity investment where the company pays out a portion of its earnings to shareholders on a regular basis, typically in the form of cash or additional shares. These payments, known as dividends, are usually distributed quarterly, but the frequency can vary. Dividends provide investors with a tangible return on their investment, separate from any potential capital gains realized when selling the stock at a higher price than the purchase price.

Investors seek out dividend stocks for several reasons. Dividends offer a steady income stream, which can be particularly appealing for retirees or individuals looking for regular cash flow. This income can help mitigate the effects of market volatility, providing a level of financial stability even during downturns. 

Additionally, companies that consistently pay dividends often have strong fundamentals and a proven track record of profitability, making them attractive to risk-averse investors. Dividends can also signal a company’s confidence in its financial health and future earnings potential.

How Dividend Stocks Factor into a Long-Term Portfolio

An investor looks over a stock that he's interested in buying.

Dividend stocks can play a pivotal role in a long-term investment portfolio. One of the main benefits is the income stability they provide. Unlike growth stocks, which rely solely on capital appreciation, dividend stocks offer regular payouts that can be relied upon regardless of market conditions. This makes them particularly appealing to retirees or investors looking for steady cash flow.

Incorporating dividend stocks into a long-term portfolio also helps diversify risk. Dividend-paying companies are often more established with stable earnings, which can reduce the overall volatility of a portfolio. During market downturns, these stocks tend to perform better than non-dividend-paying stocks, providing a cushion against significant losses.

Moreover, dividend stocks can enhance total returns. Investing in dividend stocks can also offer the advantage of compounding returns. Reinvesting dividends to purchase more shares can significantly enhance your investment’s growth potential. 

While the primary focus might be on the income generated from dividends, these stocks also have the potential for price appreciation. Over time, the combination of dividend income and capital gains can lead to substantial wealth accumulation, making dividend stocks a dual-purpose investment. 

How to Invest in Dividend Stocks

An investor researches dividend stocks to add to his long-term portfolio.

Dividend stock investing is an attractive strategy for many investors seeking both income and growth. Here’s what to consider when seeking out dividend stocks for your portfolio.

1. Look Beyond High Yields

While a high dividend yield may seem attractive, it may signal underlying issues within the company. High yields can be a result of a declining stock price, which may indicate poor financial health or diminishing future prospects.

High yields can sometimes be a trap, enticing investors into unstable companies. Conduct thorough research, including assessing the company’s debt levels and industry position, to ensure the dividend is sustainable. Diversification is also crucial to mitigate risks associated with any single stock’s performance.

2. Focus on Dividend Growth

Dividend growth refers to the increase in a company’s dividend payments over time. This growth is a strong indicator of a company’s financial health and its ability to generate consistent profits. Companies that regularly increase their dividends typically have robust business models, making them more reliable investments.

Dividend growth also serves as a hedge against inflation. As the cost of living rises, companies that can raise their dividends help investors maintain their purchasing power. This makes dividend growth stocks an attractive option for those seeking to preserve and grow their wealth over time.

3. Calculate Payout Ratio

The payout ratio measures the percentage of a company’s earnings that shareholders receive as dividends, indicating the sustainability of its dividend payments. To calculate the payout ratio, divide the annual dividends per share by the earnings per share (EPS). For example, if a company pays $2 in annual dividends and has an EPS of $5, the payout ratio is 40%.

This ratio is important because it helps investors assess whether a company can maintain or grow its dividend payments. A lower payout ratio typically indicates that the company retains enough earnings to invest in growth and sustain future dividend payments. A payout ratio above 100%, meanwhile, suggests a company’s dividend payments exceed its earnings.

4. Look for Realistic Earnings Projections

Stocks of companies that promise rapid earnings growth can be risky if those projections fall short. The market often punishes such companies harshly, leading to significant declines in stock value.

Instead, dividend stock investors should prioritize companies with a history of consistent earnings growth. These companies are typically more stable and reliable, providing a steady stream of income through dividends. By focusing on realistic earnings projections, investors can avoid the volatility associated with overly ambitious growth targets and benefit from the predictable, long-term returns that dividend stocks can offer.

5. Avoid Companies With High Debt

Companies with substantial debt may be forced to allocate a significant portion of their earnings to interest payments, leaving less available for dividends. This financial strain can lead to reduced or suspended dividend payouts, negatively affecting your investment returns. By focusing on companies with low debt levels, you increase the likelihood of receiving consistent and growing dividends.

6. Assess Tax Implications

When it comes to tax treatment, dividends are separated into two categories: qualified and nonqualified. 

Nonqualified dividends are treated as ordinary income and taxed as such. Qualified dividends, on the other hand, are subject to long-term capital gains tax rates, which can be significantly lower than ordinary income tax rates. This distinction can greatly affect an investor’s after-tax return.

When choosing dividend stocks, investors should consider their tax bracket and the type of dividends the stock pays. For those in higher tax brackets, prioritizing stocks with qualified dividends can result in substantial tax savings. Conversely, investors in lower tax brackets might not see as much benefit and may focus on the stock’s overall performance instead.

Bottom Line

Investing in dividend stocks could help you generate passive income and build long-term wealth. Monitoring your investments regularly also ensures they continue to meet your financial goals. Keep an eye on changes in the company’s performance and market conditions that might impact dividend payouts. Reinvesting dividends can accelerate growth through compounding, enhancing your returns over time.

Income Investing Tips

  • If you’re interested in taking an income-based approach to investing, there are a variety of strategies and assets that you may consider for your portfolio. While dividend-paying stocks and funds are one way to generate investment income, bond ladders and rental properties are two other common strategies.
  • A financial advisor can also be a valuable resource if you’re interested in investing in dividend stocks or other income-producing assets. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches 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.

Photo credit: ©, © Balakov, © Anthony Eddy