Dividend investing has come a long way; from being a strategy reserved only for the wealthy, to becoming a popular way for everyday investors to grow their wealth. What used to be the domain of a few, nerdy investors has now become mainstream. This is thanks, in part, to the growth of online brokerages and the ease of investing in individual stocks. It’s never been easier to become a dividend investor.
Dividend investing is a method of creating passive income from personal investments by buying stocks from companies that dole out payments as a way of sharing portions of their profits.
When a company makes profits, it can opt to use for its growth and expansion, channel it to research or give to its shareholders as dividends. If you as a dividend investor own two shares of stock in a company where a share value is $50, a 10% dividend yield will pay you $10 annually as dividend income. Dividend investing is not only a lifelong source of cash flow but a key component in your stock portfolio.
While in stock investing you can make profits from selling shares at a higher price, in dividend investment you earn profits without having to make any disposal.
An understanding of dividend investment will not only help you become an enlightened and thriving investor but will also equip you with techniques to strengthen your income portfolio.
How Dividend Investing Works
When businesses expand, they provide investment opportunities to investors and as a result give them a share of the profits as dividends, which is paid quarterly, semi-annually, or annually.
A company’s board of directors determines how much it pays as dividends based on the previous year’s profits and losses and how much it wants to keep in the business. While some companies pay high percentages of their profits to shareholders, other companies pay less so that they can keep more profits and use them for the growth of the company.
As a dividend investor, you receive returns in the following forms:
- Cash- This is the payment of dividends in cash into the investors’ brokerage accounts.
- Stock- Stock dividends are additional shares.
- Re-investment- Here, investors reinvest their dividend income into the company for increased future returns.
- Special dividends- Special dividends are profits accumulated over time and have no current use in the company.
Dividend Investment Strategy
A company with a time-tested business model which generates high profits is likely to increase its dividends. There are several companies that have shown exponential growth over the years by paying dividends. By combining this with a share price that is growing rapidly, you have a double compound effect which is dividend and share growth. Dividend-paying companies experience this effect because companies with continuous growth also show growth in share price.
In summary, this dividend investment strategy follows a 3-step plan:
1. Research and choose companies that have continuously shown a consistent dividend payment.
2. Make monthly investments in these companies but ensure they are not in the same industry. Investing in different industries means risk reduction.
3. Re-invest dividends again and again.
Continuously investing and reinvesting dividends received will raise your dividend income. Continually reinvest without withdrawing the funds, however tempting the returns may be, will guarantee you huge gains in the long run.
Notably, more shares translate to increased dividend income. Reinvesting in a company whose dividend payout is increasing over time will increase your future income potential. The secret lies in reinvesting all dividends received because any withdrawal will make you lose the double compound effect.
Factors to Consider for Dividend Investment
1. Dividend Yield
Understanding a company’s dividend yield is key to your success in dividend investment. A dividend yield refers to the ratio of a year’s dividend compared to the current share price. When the economy is booming, a dividend yield goes higher. Ultimately, it depends on the economic time and the market. A dividend yield of 4-5% means more dividends now and in the future.
Most investors only put into consideration high dividends and low growth stocks when making dividend investment decisions. Investing in low growth and high yield dividend stock makes the double compound effect slow. High-dividend-paying stocks are riskier since they are likely to reduce their dividends in the future.
Investing in high growth and low yield dividends means the double compound effect will not be fully effective and it will take time for you to earn enough dividends to reinvest. This will only work if you are to invest for over 70 years, which is unrealistic for you and unsustainable for the business. In brief, average growth and average dividend yield in a company make an ideal investment choice because it fully uses the double compound effect.
2. Dividend Growth Rate
A dividend growth rate is necessary for dividend investment. When researching a company to invest in, it is necessary to analyze its dividend growth history. To be on the safe side, you can look as far back as 10 years into the future.
To compute dividend growth,
Dividend growth rate = (Current dividend – Past dividend) / Past dividend
A good company to invest in is one that has maintained consistent growth in its dividends over the years and at a constant rate.
When a company has huge debts, its performance in the stock markets drops because it can’t grow in a profitable manner. If a company cannot pay its debts, its potential becomes limited. Is a company able to generate money without taking debts? There are companies that depend on loans for growth and expansion. These companies lack funds to reinvest into the business for growth.
The main goal of these companies is loan repayment which comes with huge interests. Their growth slows down because they cannot embrace growth opportunities. High debts equal low dividend payout. It is a company’s decision to lower dividends as per its financial situation. Therefore, you as an investor cannot influence this decision.
4. Dividend Payout Ratio
A higher dividend payout ratio isn’t a better option if you are thinking long-term goals. A high ratio means there’s no room for your dividend to grow in the future. Alternatively, a low dividend payout ratio means you are not getting good returns from your investment. A payout ratio of about 50% is an ideal starting point.
A Look into Stock Portfolios
A stock portfolio is a collection of all financial assets that an investor has in different stocks. Through it, an investor helps a company to realize its objectives while earning profits. Simply put, it’s where investors keep their assets.
A balanced portfolio is key to every investor’s success. That’s why understanding asset allocation is important. A stock portfolio goes hand in hand with one’s long-term goals.
Examples of Stock Portfolios
- Harry Browne’s Permanent Portfolio- Harry’s portfolio is suitable for all economic environments and is simple to use. According to this portfolio, every asset class has its role: Treasury Bonds will prosper in deflation, stocks will flourish in economic growth times, Treasury Bills will hold up in recession and gold is beneficial in inflation. Practically, it states that you can handle anything the economy throws your way. Harry Brown allocated an equal share to each asset as follows:
- 25%-Treasury Bonds
- 25%-Treasury Bills
- 25%-Stock market
The aim is to perform well despite the economic situation. Such an equally split portfolio is an ideal investment composition for those investors seeking safety and growth.
- Warren Buffett’s 90/10 Portfolio- the 90/10 portfolio borrows its idea from instructions that Warren spelled out for his wife in his will. Its emphasis is on owning a portion of businesses that are guaranteed to flourish. Warren believed that this strategy is beneficial to those people who are against investing for a living. Historically, this portfolio has shown remarkable performance over the years, especially during hard economic times. Warren’s asset allocation was as follows:
- 10%- short-term government bonds
- 90%- S&P Stock
Warren made this portfolio for investors who desire asset protection more than financial growth. In present-day times, the 90/10 portfolio comprising 90% stocks in Europe, U.S and China would make a good investment. The reason for this global diversification is the regional vulnerability that COVID has shown in recent times.
- High Growth Dividends Stocks Portfolio- Do you want to invest in companies that raise their dividends over time? This portfolio emphasizes investing in companies that have recorded increased dividend growth for over a decade.
- Bill Bernstein’s No Brainers Portfolio- Bill used academic research and history to arrive at this long-term asset allocation strategy:
- European Stocks- 25%
- U.S Stocks-25%
- S&P 500-25%
In the modern world, the No Brainer Portfolio can replace Either the U.S or European stocks with Chinese stocks or new market stocks.
Both the 90/10 and the Permanent stock portfolios recommend owning both bonds and stocks. Although Warren is at 10% and Harry is at 25%, they both show the importance of having bonds in a stock portfolio. A portfolio without bonds seems risky in the short term but it is quite rewarding in the long term.
In most stock portfolios, real estate as an asset is used to handle issues that come with stocks and bonds falling together, especially in times of inflation. Some portfolios include all these assets but those that include a few, favor allocations to real estate up to about 30% allocation.
With the right strategy, dividend investment can reap huge amounts of value to an investor’s portfolio. The purpose of a dividend investment strategy is to guide you into achieving financial freedom which is realized when one can live off dividend income from investments. To be successful in dividend investing, you must research dividend-paying stocks to pinpoint the ones that give good returns while minimizing risk.