Know what feels even better than getting some money from a hard day’s work? Making money passively! While some investments take a lot of research and speculating to choose the right place to put your money in a growth stock, you can rest easy when putting some of your finances into a dividend stock and let it earn you some payouts regardless of the company’s growth.
Why to Invest in Dividend Stocks
So why should you have some dividend stocks in your portfolio instead of just growth stocks? Sure, the sky is the limit if you think you have a real winner in a growth stock, going up and up in stock price and raising your value along the way. That can lead to a happy retirement, however, on the flip side, that stock could tank and you can be out a lot of money if you’re still holding your shares below the price that you bought in at.
The fact of the matter is that it is difficult to predict which companies will grow and continue to grow. It can be stressful to obsessively be checking the stock price every day. You may also be tempted to sell your shares too early after gaining a little bit, thinking that you are cashing out before the inevitable fall. There is the saying that “a bird in hand is worth two in the bush”, and after you make a little bit of money you have a tendency to make sure you cash out those gains. While coming out ahead is nice, you may also be getting out too early and not fully realizing the appreciation of the stock price where you could earn a whole lot more.
For that reason, I’m a big believer in dividend stocks as they are a better fit for my risk philosophy. While it may be a bit boring for some, like those who love to tinker with their portfolio and trade a lot, I like the consistency and passive earning that comes with dividend stocks.
When you invest in a dividend stock, you get the following advantages:
- Long-term investing: When you have a stock that is paying you dividends on a regular basis, you tend to stay with it longer. You don’t have to worry as much over the stock price, because you are getting a return on your money regardless. Even if the price stays flat, you’re coming out ahead.
- Less volatility: The stock price of a dividend stock doesn’t have as much fluctuation as a growth stock. I like that stability.
- Income predictability: I like knowing that I’m getting money, and that it will come reliably and give me a net-positive return on my investment. If you are investing at retirement age and don’t need to see a meteoric appreciation of stock price, this is a particularly nice attribute. Also, the tax rate on dividend income is lower than the tax rate on your active income.
Strategy for Dividend Stock Investing
The main philosophy behind investing in dividend stocks is to do your research and find a company that has a track record of paying dividends regularly, as well as raising their dividends year after year. Even if you don’t add new money to your investment, your dividend income will still grow as the company raises their dividend amount.
Your dividend income can grow in a few ways:
- Dividend Growth: This comes from the company raising the value of the dividend per # of shares owned. As a general rule, I only put my investments with companies that raise their dividend amount with regularity.
- Reinvesting Your Dividend: When you get your dividend payout, instead of taking that as cash, put it back into the investment in that company. Your total shares will grow, as well as your future dividend income.
- New Investments: Similar to reinvestment described above, you can also take your dividend income and use it towards a new investment in another dividend stock.
Tips for Investing in Dividend Stocks
Now that you know the basic strategy, how do you go about finding the winners in this area of investment? I recommend following these basic guidelines:
- Use a resource like the Dividend Aristocrats which keeps track of what companies in the S&P 500 index have increased their dividend payouts over the last 25 consecutive years. That should give you a solid list of choices that fulfill some of the criteria I described above in the dividend strategy. You don’t have to be perfect at research when this guide already gives you a list of potential options.
- Find a company with a PE (price to earnings) ratio of less than 20. When they are at that metric or lower, it indicates they are undervalued.
- Look for a dividend yield of 2.5% or greater. This means that, at a minimum, you are getting a 2.5% return on your investment just through dividends alone. If the stock price appreciates, you are in even better shape.
- Lastly, I try to find a payout ratio of less than 70%. This ratio is dividends / earnings per share. If a company is paying out higher than this threshold, it tells me that they aren’t keeping enough of their earnings to reinvest in the company to fuel their continued growth. Plus, if they are paying out a huge amount, it makes it hard to increase it year after year.