How to Invest for Dividends
How to Invest for Dividends
How Dividend Investing Works
Dividends can play a role in any investor’s portfolio that desires a little more bang for their buck. Once investors understand what dividends are and what kinds of funds pay them, they can strategically invest in dividend-paying stocks and funds to supplement their income and assist in growing their wealth over time.
For a beginner, you may want to have some questions answered first. Questions like, "how are dividends paid on shares?" or a dividend's meaning, in business terms.
This article serves as your guide to get started on the basics of dividend investing in today's market, along with various dividend examples to assist you in finding the best dividend stocks for your personalized portfolio.
What are Dividends?
First, one of the most important questions to answer, what are dividends?
For companies, dividends are a way to reward investors for owning their stock by paying them a share of the company’s profits. This "reward" that comes from the profits is the dividend.
Investors purchase shares of dividend-paying stocks or funds where they receive these payments that can supplement income or be reinvested to grow the position automatically over time. Investors often search for stocks and funds with dividends to reduce volatility and boost growth in their portfolios.
Companies that choose to pay dividends usually don’t see exponential growth in their stock's price, however, these stocks slowly and steadily appreciate over time and if you're reinvesting these dividends, the position can be a very lucrative one. Just ask Warren Buffett.
Last year, his Berkshire Hathaway received around $700 million from their Coca-Cola (KO) position. Now imagine reinvesting all of that into a stock that is trading at around $60.50 at the time of this writing? That means the fund could theoretically buy over another 11,500,000 shares each year, thus increasing the amount they receive in dividends each year.
That's the power of compound interest. That's the power of dividend investing.
These companies use their excess cash as another way to incentivize investors to invest in their stock and to encourage them to continue to hold the stock for a prolonged period of time, thus keeping the stock's price relatively stable. It's a true win-win for everyone.
Investors essentially forgo the massive growth they may find in other stocks, like tech stocks for example, but receive compensation in the form of regular dividends. This constant ebb and flow of money from the company's profits to the investor's pockets is what keeps the volatility of these stocks fairly low.
The idea is that of the excess profits the company does not use for some other purpose, such as growth, they pay that excess to their investors who in turn will most likely reinvest back into the stock.
Examples of Dividend Investments
Examples of Dividend Investments
Stocks that are considered “Dividend Aristocrats” include KO and Verizon (VZ), which have paid investors very well over the past several decades, supporting their businesses and their stock price.
However, dividend stocks like Altria (MO) aren’t the only asset that pays dividends. Investors can use ETFs (Exchange Traded Funds), Mutual Funds, as well as REITs (Real Estate Investment Trusts) to increase their income and utilize compounding interest.
Compound interest is the secret to what makes buying dividend-paying investments such a powerful investing tool. For example, take a 25-year-old who invests $150 a month in something like a Roth IRA for 40 years and earns 12 percent in annual interest. When that person retires at age 65, their investment will be worth just over $1 million.
If the same person were to instead start investing $150 per month only at age 35, they’d only have around $434,000 by the time they reached 65. How does that happen?
The 25-year-old investor’s investment was earning interest on their principal balance—and earning interest on the interest itself. Each year, that earned interest was added back into the principal balance . . . which as a result earns even more interest, the cycle only ends when an investor sells out of the position.
This compounding interest is intensified if the investment pays dividends and you are buying more shares in addition to the dividends paid. This is the growth potential in dividends—and a investor’s wealth.
There are plenty of ways investors can earn dividends as well. Here are a few common examples:
- ETFs - ETFs are among some of the most common ways for investors to gain exposure to dividend-paying investments. Instead of putting a large nest egg into one company for their dividend payment, the investor can better manage their risk by investing in a basket of these dividend-paying stocks. The fund manager picks the stocks based on things like past performance, dividend growth over time, and dividend payout ratios.
- Real Estate Invest Trusts (REITs) - REITs are another common method for this strategy, only instead of paying shareholders from profits of selling a product or service, these dividend payments come from the rent paid by the properties owned by the fund manager. These are a very reliable source of dividend income as they are paid monthly and real estate is a very necessary part of life, so there’s little worry about not receiving these payments.
Why Choose Dividend Investments?
The beauty of dividend investing is that it pays off, no matter your investing strategy. You may choose to pocket the money—helpful for those who need it, like people in retirement—or reinvest and reap the reward of the compounding interest.
When dividends come due, most commonly quarterly but can be monthly in terms of REITs, investors get the option to invest the payment directly back into the stock or to receive the payments directly as income. Depending on your goals as an investor, your decision will be different and specific to your current financial situation.
In it for the long-term? You could choose to reinvest your dividends and build your portfolio. Over time, you will begin to earn returns on those returns, and as your position grows so do the gains on your original investment. Factor in stock splits, and after a few decades you may have a position that rivals that of Warren Buffett himself. (We can only hope.)
For retirees, dividend income built up over a long career can help supplement your loss of income from no longer working. This can make a world of difference in maintaining the same quality of living throughout your retirement. These regularly paid dividends give these shareholders more peace of mind, knowing they can rely on those payments to hit their accounts.
Need the extra income now? You could choose to use periodic dividend payments to help with a house down payment, for example, or contribute to your child's college fund. There is of course a downside to doing this. Not only will you be taxed at the end of the year on the money you received, but if you take the dividends as cash, your original investment will have a hard time growing. Think of the investor that began his investing strategy at 35, instead of 25... a substantial difference in their end result.
As Einstein once said, “Compounding interest is the eighth wonder of the world,” and he was absolutely right, especially when it comes to building wealth over the decades. Dividends can be a key factor in your journey toward the creation of wealth in your life.
Next time you are looking for a way to increase your income, consider investing in funds and stocks that pay dividends as a worthwhile investing strategy to implement.
How You Can Invest in Dividends Today
Investors research ETFs, mutual funds, REITs, and stocks as examples to what investments out there pay dividends. This ultimately brings them to finding the best dividend stocks for them and their portfolio.
Thanks to Magnifi, it’s easy for these investors to now search through thousands of investments to find the dividend-paying stocks and funds and purchase them all in the same place. Check out some of the various searches you can conduct in order to better aggregate a list of potential additions to your portfolio:
- Invest in Dividends
- Invest in REITs
- Invest in Mutual Funds with Dividends
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References:
- "Dividends: Definition in Stocks and How Payments Work," Updated May 23, 2023, investopedia.com, https://www.investopedia.com/terms/d/dividend.asp
- "5 Reasons Why Dividends Matter to Investors," Updated January 31, 2022, investopedia.com, https://www.investopedia.com/articles/investing/091015/5-reasons-why-dividends-matter-investors.asp#:~:text=Studies%20have%20historically%20shown%20that,non%2Ddividend%2Dpaying%20stocks.
- "For Dividend Investors, Time Pays," April 25, 2023, morningstar.com, https://www.morningstar.com/financial-advice/dividend-investors-time-pays
- "Roth IRA Calculator," bankrate.com, https://www.bankrate.com/retirement/roth-ira-plan-calculator/
- "What's a REIT (Real Estate Investment Trust)," 2021, reit.com, https://www.reit.com/what-reit