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By adding a collection of dividend stocks to your portfolio, you have the chance to grow your money in two ways. This is because, on top of quarterly dividend payments, you also have the opportunity to increase the value of your investment via share price gains.
In this guide, we explain how to invest in dividend stocks as a beginner. We’ll walk you through the process step-by-step alongside some handy tips on what to consider before you proceed with an investment.
How Do Dividend Stocks Work?
If you’re new to dividend stocks, it’s best to understand how this share type works before investing your capital. Put simply, dividend stocks are public companies that distribute some of their profits to shareholders.
This is often the case when a company has excess profits that it does not plan to reinvest back into future growth. The general rule of thumb is that companies will pay a dividend every three months. Some, however, choose to do this bi-annually instead.
Irrespective of the frequency in which distributions are made, dividend payments are usually evaluated in terms of a yield. This lets you as an investor know how competitive the dividend stocks are. For example, ExxonMobil — which is one of the best dividend stocks to own in terms of yields — stands at well over 5% as of Q2 2021.
Although ExxonMobil has increased the size of its dividend for 18 consecutive years, companies that have achieved this feat in excess of five decades. This includes Federal Realty Investment Trust, Sysco, Stanley Black & Decker, and several others.
Not all companies pay dividends, so you’ll need to do some homework to find suitable stocks that meet your financial goals.
Some of the biggest and most successful companies in the world choose not to pay dividends at all. This includes the likes of Alphabet, Facebook, and Amazon, which to date, have never paid a single cent in dividends.
Nevertheless, in terms of receiving a dividend, the company’s board of directors will initially meet to decide how much to pay. They will also announce a record date. The ex-dividend date is usually one business day before the record date.
If you are in possession of the stock before the ex-dividend date, you are entitled to a payment. The dividend payment is then distributed to all shareholders on the payable date, at an amount proportionate to the number of shares held.
- Let’s suppose that you are holding 1,000 ExxonMobil stocks
- ExxonMobil announces that it is paying a dividend of $0.87 per share
- This means that you will receive a payment of $870
In most cases, the payment will be distributed to the brokerage that you are holding the shares with. This means that you will see the payment reflected in your trading account. You can then withdraw the money back to your bank account or reinvest the dividends into other assets.
Note: Most companies in North America pay dividends quaterly, but some pay monthly. Generally, these are companies with legal structures aimed at generating a consistent distribution of income to shareholders — for instance REITs and energy companies.
How to Invest in Dividend Stocks (7 Steps)
If you’re wondering how to invest in dividend stocks as a beginner, there are several core steps that you need to take.
We are now going to walk you through the process in simple terms.
Step 1: Research Companies That Offer Dividends
The first step is performing some independent research. After all, there are thousands of public companies that pay regular dividends.
If you are looking to purchase dividend stocks on a self-directed basis, then you’ll likely only be adding a handful to your portfolio. To get the ball rolling, it might be worth using a stock screen. This allows you to filter stocks down so that you are only viewing companies that pay dividends. You can often sort the results by the dividend yield, too.
Another way you can find suitable dividend stocks is to look at Dividend Aristocrats. These are companies that have increased the size of their dividend every quarter for at least 25 consecutive years. You then have Dividend Kings, which have achieved this goal for at least 50 years.
Step 2: Evaluate the Stock
Once you have made a shortlist of potential dividend stocks to invest in, you then need to perform some research on the company itself. After all, just because a stock pays an attractive dividend yield, it’s not necessarily a viable investment.
On the contrary, you also need to consider the share price of the stock and whether it has the potential to rise over time or at least in the medium term. For example, let’s suppose that you invest in a dividend stock that is currently yielding 7%.
Sure, this offers an above-average yield, but if the share price itself declines by 15%, then the value of your investment is now worth less.
With this in mind, there are several key metrics that you need to consider before proceeding. A good starting point is to focus on key accounting ratios such as the price-to-earnings (P/E) ratio .
This looks at the current share price of a company against that of its earnings per share. Once you have obtained the P/E ratio, you then need to compare this to the sector average. If the dividend stock in question has a P/E ratio that is higher than this average, it could mean that the shares are overvalued.
Other accounting ratios that are worth considering when researching a potential dividend stock include the earnings-per-share (EPS), cash dividend payout, debt-to-equity, price-to-book, and operating profit margin.
Pro Tip: Companies with payout ratios above 100% should raise a red flag and need to be properly analyzed. It may not be sustainable for a company to pay out more than what it earns.
Step 3: Decide How Much to Invest in Dividend Stocks
Once you have decided which dividend stocks you wish to add to your portfolio, you then need to think about how much to invest. This is always an important part of the investment process, as diversification is key.
That is to say, while dividend stocks should always play a part in your wider portfolio, other share types should be considered too. For example, you might decide to allocate some funds into growth stocks.
A well-diversified portfolio should also allocate funds to asset classes other than just stocks. Think along the lines of bonds and commodities like gold. The specific split between each financial instrument should be based on your financial goals and tolerance towards risk.
For example, a conservative portfolio might have a stronger focus on Dividend Aristocrats or Kings. Those with a higher appetite for risk might decide to allocate more towards growth stocks.
Either way, you will also need to come up with an investment strategy. For example, some investors will look to purchase dividend stocks by making a one-off lump sum capital injection.
However, perhaps the more risk-averse option is to invest small amounts but on a more frequent basis. For instance, if you were to commit to an investment of $200 per month, you would be able to benefit from dollar-cost averaging.
This means that upon making each investment, you will get a different cost price. As such, when your dividend stocks go through a downward period, you get to purchase the shares at a lower price.
Step 4: Open a Brokerage Account
At this stage of our guide on how to invest in dividend stocks, you should now know which shares you wish to buy. If so, you will now need to head over to your brokerage platform and complete the investment.
If you don’t have a brokerage account, there are plenty of options available to those based in the US. Many online brokers now allow you to invest in US-listed stocks on a 0% commission basis.
Choosing a brokerage with low or zero trading fees, is ideal for the previously discussed dollar-cost averaging strategy.
Step 5: Place Your Order
You can complete the dividend stock investment process by placing an order with your brokerage. If you’re completely new to the world of online investing, placing an order doesn’t have to be difficult.
This is because you can elect to place a market order, which means the brokerage will execute your trade at the next best available price. If you want to enter the market at a specific price, you might consider a limit order.
For example, Johnson & Johnson might be priced at $164 per share, but you might not want to invest until the stocks drop to $160. You might also consider a stop-loss order, albeit, this is more conducive for short-term trading.
This order type allows you to automatically sell an investment when it goes down by a certain amount. For example, you might elect to cut your losses if the dividend stock drops by more than 10% in value.
Step 6: Keep Reinvesting Your Dividends (DRIP)
One of the most attractive aspects of investing in dividend stocks is that you have the potential to benefit from the long-term impact of compound interest. This is essentially where you earn interest on your interest.
This can be achieved by creating a dividend reinvestment plan (DRIP). This means that every time you receive a payment, you reinvest the dividends back into another stock. Preferably, this should be another dividend stock so that you can continuously reinvest your dividends over time.
Here’s a simplistic example of how a DRIP can be beneficial:
- Let’s suppose that you buy $5,000 worth of dividend stocks;
- Over the first year, you have received an average annualized dividend yield of 5%;
- This means that on an investment of $5,000, you’ve received $250 in dividends;
- You decide to cash out your $250 dividends, so you are still left with $5,000;
- At the end of year two, you again make a dividend yield of 5%;
- On an investment of $5,000, that’s another $250; and
- You again decide to withdraw your dividend payment, so you are left with $5,000.
Of course, the above example does not take into account share price changes. But, for the purpose of this basic explainer, now let’s look at what can happen when a DRIP strategy is utilized.
- At the end of year one, you decide to reinvest your $250 payment into other dividend stocks;
- This means that you now own $5,250 of dividend stocks;
- At the end of year two, you receive a dividend yield of 5%;
- This time, the 5% is calculated again $5,250 and not $5,000 as in the previous example;
- As such, instead of receiving a payment of $250, it’s higher at $262.50; and
- By again reinvesting your dividend payment, you now own $5,512.50 worth of stocks
As noted above, the above figures do not take into account the fact that the share price of your dividend stocks will rise and fall in value. The key takeaway with a DRIP strategy is that by avoiding withdrawing your dividends, you can grow your wealth much faster as you will continuously be building your stock position.
Step 7: Monitor Your Dividends
An additional consideration you need to make when investing in dividend stocks is to regularly keep tabs on how each company is performing. After all, there is no guarantee that your chosen stocks will continue to pay dividends.
For example, when the coronavirus pandemic came to fruition in 2020, many S&P 500 companies decided to either cut or outright suspend their dividend policy. You also need to look beyond just the dividend payment itself.
As noted earlier, the share price action of your chosen dividend stocks is just as, if not more important than the actual yield. If at any point some of your dividend stocks are no longer aligned with your financial goals, it might be time to rebalance your portfolio.
Examples of Dividend Stocks
Remember that not all companies on the market offer dividends. Generally, more mature and established companies offer dividends to their shareholders. Here are a few examples of well-known companies that have a history of paying dividends:
|3M Co.||NYSE: MMM||Industrials||2.94%|
|McDonald's Corp.||NYSE: MCD||Consumer Cyclical||2.12%|
|PepsiCo Inc.||NASDAQ: PEP||Consumer Defensive||2.75%|
|Procter & Gamble Co.||NYSE: PG||Consumer Defensive||2.49%|
|AT&T Inc.||NYSE: T||Communication Services||7.40%|
|Walmart Inc.||NYSE: WMT||Consumer Defensive||1.55%|
|Exxon Mobil Corp.||NYSE: XOM||Energy||5.95%|
Benefits of Investing in Dividend Stocks
Here’s a breakdown of the main benefits of investing in dividend stocks:
Perhaps the most obvious benefit of investing in dividend stocks is that you have the opportunity to earn regular income.
In many cases, you will receive a payment every three months — which you can then invest into other stocks to benefit from the previously discussed compound interest.
Often Established Companies
For a company to pay dividends, it will need to have sufficient cash flow levels. In addition to this, you will often find that dividend-paying stocks are well beyond their growth stage and as such are now established companies.
This means that in theory, there is slightly less risk involved with such stocks as they have firmly established themselves in their respective sectors. For example, by sticking with Dividend Kings, you know that the stock in question has increased the size of its dividend-paying for at least 200 consecutive months.
Such a long-standing data set speaks volumes about the strength of the firm. More specifically, you know that it has gone through several stock market recessions and has always bounced back.
If you have your heart set on building a portfolio of dividend stocks but can’t quite decide which companies to choose, there are now plenty of ETFs that can streamline the process for you.
For example, the Dow Jones contains 30 established companies from a variety of sectors and markets — all of which pay dividends. You then have the likes of the Vanguard High Dividend Yield Index ETF (NYSEARCA: VYM).
Through a single investment, this ETF will give you access to more than 400 dividend-paying stocks. Some of the largest contributors to this ETF include JPMorgan Chase & Co, Johnson & Johnson, Home Depot, Procter & Gamble, and Bank of America.
By investing in a dividend ETF, you will likely receive a payment from the provider every three months. Plus, the ETF provider will take care of rebalancing and reweighting the portfolio, so you can sit back and allow your money to work for you.
Pro Tip: Dividend stocks, specially those that increase dividends regularly, can be a better hedge against inflation than bonds. Research by Richard Schiller from Yale University shows that dividends from the S&P 500 have grown at an annual rate of 4.2% since 1912, while the CPI (Consumer Price Index) has risen by 3.3% over the same timeframe.
Downsides of Investing in Dividend Stocks
Here’s a breakdown of the main drawback of investing in dividend stocks:
Fixated on Yield
One of the biggest drawbacks when investing in dividend stocks is that it’s all too easy to fixate on yields. That is to say, you might overlook the fact that the stock is potentially overvalued simply because it is paying an above-average dividend.
Crucially, an attractive dividend will still lose you money if the value of its share price drops by a larger amount than the yield itself.
Upside Potential Will Be Limited
In the section above, we mentioned that a popular Vanguard dividend ETF contains the likes of JPMorgan Chase & Co, Johnson & Johnson, Home Depot, and Procter & Gamble.
These companies all have one thing in common: they are hugely established firms that are dominant players in their respective industries. What this means for you as an investor is that your upside potential will be limited.
Sure, you might enjoy a consistent dividend payment, but there is only so much that these companies can grow year-on-year.
At the other end of the scale, you have tech stocks like Amazon, Facebook, and Tesla — all of which saw double-digit percentage gains in 2020. Like many tech stocks, the aforementioned companies do not pay dividends.
Cuts and Suspensions
As we briefly discussed earlier, there is never any guarantee that your chosen dividend stock will continue to payout. At any given time, a firm’s board of directors can decide to cut or even suspend its dividend policy.
If this is the case, the motivating reason is usually down to poor performance. As a result, it’s a double-whammy insofar that a dividend cut or suspension is also likely to result in a declining stock price, at least in the short-to-medium term.
FAQ About How to Invest in Dividend Stocks
We’ve found some of the most frequently asked questions with regards to dividend-paying stocks. Here are our answers.
What Are Dividend Stocks?
In a nutshell, dividend stocks refer to public companies that share some of their retained profits with shareholders. Not all companies pay dividends, but when they do, this is usually every three or six months.
Why Do Companies Pay Dividends?
In most cases, companies pay dividends when they have excess cash. This motivates shareholders to remain invested in the company, as the dividend is a form of income that increases wealth. When a company has a consistent track record of paying dividends, this sends a message to the wider markets that it is in a strong state of financial health.
How Are Dividends Taxed?
How dividends are taxed in the US will depend on several factors. For example, if you hold your dividend stocks in a tax-efficient retirement account, then the payments might not be taxed at all. If the dividend stocks are held in a standard investment account, the tax rate will follow that of your long-term capital gains bracket.
Due to the complexities involved in stock-related taxes, it’s best to speak with a qualified advisor.
What Is the Best Strategy for Investing in Dividend Stocks?
There are many strategies that you might consider when investing in dividend stocks. At the forefront of this should be a DRIP — which we covered earlier. To recap, this will see you reinvest your dividends into other stocks (or other financial instruments) as soon as you receive a payment.
Additionally, it’s important to ensure that you are well diversified. This means not only investing in dividend stocks from different sectors and industries but alternative assets altogether. A great strategy to achieve instant diversification is to consider investing in an ETF that focuses exclusively on dividend stocks.
What Is The Difference Between Dividend Stocks and Growth Stocks?
There are many types of stocks to consider when building a portfolio. Two, in particular, are dividend stocks and growth stocks. The former relates to companies that pay dividends. The latter concerns stocks that are still in their early stages of growth.
Dividend stocks will allow you to earn regular income payments, but share price growth is likely to be more modest. In the case of higher-risk growth stocks, you likely won’t earn any dividends for some time. But, the upside potential in terms of share price growth will be significantly higher than that of dividend stocks.
Are Dividend Stocks Safe?
On the one hand, dividend stocks are often established companies with a solid track record in their respective sectors.
As such, the general consensus is that dividend-paying companies are a safer bet than growth stocks. However, no stock is immune from risk, so do remember that even stocks with a long-standing history of paying dividends can lose you money.
In summary, this guide has walked you through the process of how to invest in dividend stocks. On top of covering the basics of how to complete the investment process, we have also explained the many considerations that you need to make in choosing the right dividend stocks for your portfolio.
We also have explored the many risks that need to be considered before proceeding. Ultimately — and irrespective of which dividend stocks you decide to invest in — just make sure that you are well diversified and that you consider a long-term DRIP strategy.
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Kane is a highly-skilled researcher and writer with expertise in finance, trading, and cryptocurrencies. Academically, Kane holds a Bachelor’s Degree in Finance, a Master’s Degree in Financial Crime, and he is currently engaged in a Doctorate. He is passionate about researching the money laundering threats of the virtual economy — notably, cryptocurrencies and blockchain technology.