Dividend investing is the only way to make passive income in the stock market.
Investing in dividends is a great tool to use if you want to have a reliable stream of cash flow.
Dividend Investing Basics
What is a Dividend?
A dividend is a payment that a shareholder receives for holding the stock of a company.
What are the types of Dividends a company can give?
Well, the most common dividend type is the cash dividend. However, there are more dividend types that a company can offer.
A company can also offer:
- A stock dividend – when the company issues common stock to its shareholders.
- A property dividend – a non-monetary dividend that is used for accounting purposes.
- A scrip dividend – a promissory note used to pay shareholders a dividend in the future.
- A liquidating dividend – the return of initial capital back to shareholders. This can happen before a business shuts down.
Although these are all called dividends, the only one that gives you passive income is the cash dividend.
Why do companies offer a Dividend?
A company usually decides to give a dividend when it has reached a level of maturity in its life cycle.
The executives feel comfortable about their predictions of future cash flows and the long term needs of the company.
This decision is usually made when the company is growing at a slower rate than before, but is still profitable.
The company can use the dividend to entice buyers and help to maintain a good stock price in the stock market.
How are Dividends Created?
The executives of the company reserve a portion of the profits for dividend payments.
This portion of profits is what they feel can be sustained and given back to their shareholders without jeopardizing the future needs of the business.
Examples of future business needs would be pursuing projects to move the business forward, acquisitions of other companies or material, etc.
The dividend is usually set at a very conservative figure. This is to safeguard the dividend against risks like profits declining.
By keeping the dividend conservative and accounting for risks out of their control, the company can still pay a dividend for a long time into the future.
What makes dividend investing a powerful investing strategy?
Well, there are 4 reasons we think dividend investing is a a powerful investing strategy:
1. The compound effect. With dividend investing you actually have two sources of compounding taking place.
The initial source of compounding comes from reinvesting your dividend payment to buy more shares.
For example, let’s say you own 100 shares of stock XYZ and XYZ pays a quarterly dividend. Instead of cashing out the dividend, you decide you want to reinvest it to buy more shares of XYZ.
Now you have 102 shares of xyz.
After that reinvestment, you will now receive a dividend payment based on 102 shares.
As you keep reinvesting, both your shares and your dividend payment increase.
The second source of compounding comes from the growth of dividends. When the economy grows, dividends tend to grow too.
That’s because companies that provide dividends are growing and earning more through their business activities.
As the price of the stock increases the dividend payout tends to grow as well. Earnings are the driver.
To illustrate this, let’s take a look at this graph from macrotrends.net that shows the quarterly dividend of SPY for the last 20 years. SPY is an ETF that mimics the S&P 500.
If you don’t know what the S&P 500 is and why it’s important please check out our stock market basics video.
As you can see over the last 20 years, as the price of SPY rose so did the dividend payout.
2. Dividends are also like a social contract.
A company only starts to give a dividend when it believes it will be profitable enough in the future to be able to give part of their profits to their shareholders in the form of dividends.
The dividend is usually a very conservative number so that even if the profits decline, it can still pay out a dividend for a long time in the future.
Investors are willing to buy the dividend stocks because they are reasonably certain that they will receive the dividend.
Companies try their best to not cut their dividend. Cutting a dividend sends a bad signal to the market. A company that cuts a dividend tends to be penalized by the price of the stock dropping.
3. Stock Market Returns
Over the last 50 years, more than half of the stock market total returns from the companies in the S&P 500 index have come from dividends.
For example, Over the last 10 years 2010 – 2020 Coca cola has had a return of over 250%.
Only around 56% percent of that return came from a price increase. The remaining 200% has come from reinvested dividends.
This is crazy and amazing at the same time!
4. Business Owner Mindset
When you are investing for dividends, you should see yourself in the position of a business owner. As the author/investor Lowell Miller stated:
The very attention we place on rising dividends puts us squarely in the position of ‘owners’ of a company, of true investors who understand that a satisfying and reasonable return from a stock investment isn’t a gift…”
As an investor, you are a partial owner of a company and you should be concerned with the dividend. We are not in this for cool points, we are in it to make passive income.
Risks Involved when Investing in Stocks that Pay Dividends
One of the risks involved when investing in stocks that pay dividends is that the company may, as previously mentioned, cut the dividend.
Companies are very hesitant to cut a dividend. However, if they didn’t calculate their future spending and profits correctly, then they will need to hold onto their cash and not pay it to shareholders.
Benefits of Dividend Investments
There are multiple benefits to investing for dividends. They include
- consistent passive income generation
- lower taxes on income from dividend payments than regular income
- a double win when the stock price increases (appreciates) and distribution
We have listed a couple here. If you want to go into more detail please check out our video
3 Easy Dividend Investing Strategies
There are 3 investing strategies that you can use for dividend investing for passive income. The goal with dividend investing is to find dividend stocks at attractive prices.
1. High Dividend yield investing.
High dividend yield investing is when you invest in companies that have a high dividend yield. The dividend yield is the ratio between the company’s dividend payout in relation to its stock price.
There are a few reasons why the dividend yield is high.
- The dividend could be high because the company’s stock price is being penalized for something outside of their control.
For example, Royal Caribbean the cruise line. During the coronavirus pandemic, their stock price dropped significantly.
In addition to that, their dividend yield was little over 7% which is very high.
How does a High Dividend Yield Investor Act?
A high dividend yield investor may see this scenario and decide to buy Royal Caribbean’s stock because she is getting a dividend stock at a low price.
She also has to believe that Royal Caribbean will not go bankrupt and will be able to pay a dividend for a long time into the future.
She is taking a bet against the downside.
Once she decides to get into the stock she is no longer concerned with price fluctuations.
All she cares about is that the company won’t go bankrupt. This is the scenario they are betting on.
2. Identify Mature Companies with Solid Income
Another scenario for high dividend yield investing is to use the dividend yield to find companies that are mature and have a ton of income.
These companies are mature and in a sector that is not going to grow fast.
However, there is a market demand for the company’s stock, because of the dividend.
The company is able to pay a high dividend and that is what a high yield dividend investor cares about.
Risks of High Yield Dividend Investing Based on Stock Price
Now, if she is right and the company doesn’t go bankrupt, once the pandemic is over the price of the stock should go up.
The investor now gets the benefit of price appreciation and can sell her shares.
That same investor can also now go out and buy another stock she feels is underpriced and has a high dividend yield.
It’s a bet, but if the bet pays off she makes money by selling and can do it again.
If it doesn’t, then she is out of money for taking such a risk.
2. Dividend growth strategy.
This is when you are trying to find companies that are mature enough to pay a dividend, but are still growing fast.
You are buying very profitable companies with a small dividend.
You are making a bet that the company will continue to grow and they will eventually increase their dividend.
On top of that, you are betting that their share price increases.
If you get in early enough, you can enjoy a growing dividend that is based on the earnings as well as stock price appreciation.
Basically you are taking a bet on the upside.
For example say you buy a growth stock at $100, because you are believe that this company is doing something unique and will be a leader in the future.
You believe that the company will be around for a while even though they are only paying a dividend of 10 cents a share.
You are sure that the company has a great business model and therefore their earnings should grow and they may eventually dominate their market.
Now after a few years, the company stock price is now $400.
A company that can be used as a prime example for this scenario would be Apple.
Risks of Dividend Growth Investing
If the company’s growth suddenly stops or slows tremendously, then you made the wrong bet. It does not fit your criteria for your dividend growth strategy.
3. Broad-based Index investing.
Broad-based Index Investing can be considered a middle of the road approach. You want dividends, but you admit you don’t know enough about companies.
You don’t want to make a bet one way or the other so you focus on the general outlook of companies.
For example, you buy an index fund that mimics the S& P 500, because you believe that the US economy will continue to grow.
Buying securities that mimic this index will get you a piece of some growth businesses, a piece of some mature businesses, and even some businesses that don’t offer a dividend.
You give up some upside potential on the dividend and price appreciation, but you do not suffer a higher than average loss if your bet goes wrong.
For example – Buying the ETF (SPY) which mimics the S&P 500 and gives you an idea of the US economy. As long as you believe the US economy will grow in the long run, you would buy this for the dividends.
Risks of Broad Based Index Investing
The main risk is the general outlook investors have of the future of earnings growth. Sometimes they can act euphoric or pessimistic based on the type of growth they priced in. The market can fluctuate because of these estimates.
Another risk is that you do not have the flexibility to try to beat the market with these funds, because they are meant to track an underlying index.
Another small risk to consider with broad-based index investing is that you may invest in companies you don’t agree with morally (like cigarette companies etc).
Final Thoughts on Dividend Investing
In the end, each one of these dividend investing strategies has its own pros and cons.
However, all share the same goal of investing for passive income.
With the right mindset, a dividend investor can withstand the down turns of the market and not sell.
Additionally, a long term mindset allows dividend investors to not get too excited when the market starts to go up.
They are using dividends as the marker to determine what stocks to buy and which stocks to sell. This helps limit emotional trading.
Although there are many ways to invest, if your goal is to achieve financial independence, then you need to include dividend investing.
Remember, the goal is to generate enough passive income to cover all of your expenses.
The fastest way to do that is to focus on activities that will bring in streams of consistent passive income.
That is exactly what dividend investing can provide.
So if you like what you learn and want to learn more about dividend investing check out our youtube channel.
Want to discover and discuss other ways to generate passive income for financial independence, please leave a comment below!
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What is Dividend Investing and How to Start (3 Easy Strategies)
Nicole is a partner at Wealth Twins LLC. She holds a B.A from Columbia University and an M.B.A in Financial Instruments from New York University. She has worked in Investment Banking and Financial Services for 15 years and retired early in her 30s because of Financial Independence. She is an entrepreneur, investor, and passionate about teaching others how to reach Financial Independence.