Dividend Investing

Article byRutan Bhattacharyya
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Dividend Investing?

Dividend investing is a technique of purchasing shares of companies that pay dividends regularly to their shareholders. When an individual buys a dividend stock, they get a portion of the organization’s profits. Thus, this method provides passive income while increasing one’s portfolio value over time.

Dividend Investing

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Dividend Investing (wallstreetmojo.com)

Dividend stocks are subject to low volatility compared to growth stocks. Hence, the dividend investment strategy appeals to investors with a low-risk appetite. However, this approach can be risky if one fails to purchase the right stocks. Also, one must remember that this strategy is not ideal for aggressive investors looking to maximize their portfolio returns.

Key Takeaways

  • The dividend investing definition refers to purchasing stocks that pay dividends regularly to the shareholders in exchange for holding them. It enables individuals to earn passive income and can provide them with capital appreciation over time.
  • This investment strategy includes multiple limitations. For example, a company may reduce its dividend or decide not to pay it. Moreover, the maximum one can earn from dividends is restricted, unlike the unlimited return potential of growth stocks.
  • Value investing strategy involves purchasing shares that have a higher intrinsic value. Unlike dividend investing, it is suitable for aggressive investors.

Divided Investing Explained

The dividend investing definition refers to buying shares of publicly traded companies that distribute a portion of their profits to their shareholders from time to time. One can use this method to generate additional income consistently.

Usually, the organizations pay cash dividends every quarter. However, if their profits increase with time, they may decide to raise their dividend payouts. Moreover, a company can pay its shareholders dividends from retained earnings. Individuals should also remember that companies may choose to pay dividends in stock. This means that the companies provide their shareholders with equity shares rather than cash.

Besides providing regular income, the dividend investing strategy can offer capital appreciation through the increase in stock price. Thus, it can help investors increase their portfolio value over time. Usually, dividend-paying stocks are less volatile than growth or non-dividend-paying stocks. Hence, they can be suitable for conservative investors. For example, individuals in or approaching retirement.

Experienced dividend investors usually focus on a high dividend yield or a high dividend growth rate method. In the case of the former, investors primarily choose companies with high cash flow. The strong cash flow position enables companies to pay high dividends, thus providing the shareholders with regular income.

On the other hand, the high dividend growth rate approach involves buying shares of companies paying low dividends but expanding quickly. Thus, when individuals follow this strategy, they can purchase profitable stocks at a low price at earn substantial returns over the long term. Whether an individual chooses the first or second approach depends on their financial goals and risk appetite.

Financial Modeling & Valuation Courses Bundle (25+ Hours Video Series)

–>> If you want to learn Financial Modeling & Valuation professionally , then do check this ​Financial Modeling & Valuation Course Bundle​ (25+ hours of video tutorials with step by step McDonald’s Financial Model). Unlock the art of financial modeling and valuation with a comprehensive course covering McDonald’s forecast methodologies, advanced valuation techniques, and financial statements.

How To Start?

Individuals can start dividend investing for passive income by following these steps. 

#1 – Identify Stocks With A High Dividend Yield

Individuals must focus on choosing shares of established companies with a strong cash flow position. They must avoid companies that primarily focus on growth and have a low dividend yield. Various online platforms allow one to screen for stocks that pay high dividends.

#2 – Evaluate The Stocks

To assess a dividend stock, individuals must start by comparing its dividend yield with its peers. If individuals spot a significantly higher dividend yield than the industry average, they should conduct additional research regarding the company. Then, individuals must check the stock’s payout ratio. The metric tells one how much of the earnings a company pays its shareholders. Typically, the higher the ratio, the lower the cash retained by companies to expand operations and increase dividends.

#3 – Decide How Many Stocks To Add To A Portfolio

Lastly, individuals must decide how many stocks they want to purchase. When purchasing shares, they must remember to build a diversified portfolio to mitigate financial risk. For instance, if a person wants to purchase ten stocks, each stock may account for 10% of the portfolio. If a stock is too risky, they might consider purchasing fewer shares. Another way to implement this strategy is by investing in high-yield or dividend-appreciation mutual funds and exchange-traded funds.

Example

Suppose John Smith invested in the company named Amacon, which offered a 5% dividend per equity share. He purchased 20 shares of the organization, and the total worth of the shares was $2,000. As a result, he received a $5 dividend per share, which means a total of $100 in dividends.

Pros And Cons

Dividend Investing for passive income has certain benefits and limitations. Let us look at them.

Pros

  • The dividend investing strategy is suitable for investors that seek to generate additional income regularly without actively making investment decisions. In other words, it can offer a reliable income stream.
  • Dividend stocks can also offer capital appreciation to shareholders if the price increases over time.
  • This strategy ensures insulation from the stock market as dividends of well-established companies do not fluctuate significantly owing to the changes in the economic environment.

Cons

  • Dividends are not guaranteed. A company may decide not to pay dividends any further. Alternatively, may choose to reduce their dividend.
  • Another con of dividend investing for passive income is the eventual ceiling of returns. Even the most stable companies paying high dividends do not have an annual yield of more than 10%, considering the economic conditions. That said, there are exceptions.
  • Although companies with a very high dividend yield may seem appealing, they are extremely likely to reduce their dividend. Hence, individuals must consider this risk and avoid high-yield dividend traps.

Dividend Investing vs Value Investing vs Index Investing

Dividend investing, index investing, and value investing are different strategies individuals can use to achieve their financial goals. Understanding their meaning can be challenging for someone new to the financial world. To know the concept and eliminate any confusion, they must understand how they differ from one another. In that regard, looking at their distinct characteristics is crucial. So, let us look at them.

Dividend InvestingValue InvestingIndex Investing
It involves buying shares of companies that pay dividends to the shareholders regularly. This strategy involves buying stocks that trade at a price lower than their intrinsic value. It involves investing in an index fund that tracks a particular index. 
The purpose of using this strategy is to build an additional, consistent revenue stream.It aims to maximize portfolio returns over the long term. Individuals using this strategy aim to replicate the performance of the benchmark index.  
This strategy is suitable for conservative investors seeking passive income. It involves higher risk than dividend and index investing strategies. Hence, it is suitable for investors with a high-risk appetite. This passive investment strategy involves lower risk than value investing. Therefore, it is suitable for investors with a long-term investment horizon.  

Frequently Asked Questions (FAQs)

1. Is dividend investing worth it?

Yes, buying dividend-paying stocks can be worth it as the dividends accumulated and the increase in stock price can lead to substantial wealth over the long term. Moreover, dividend income is an additional source of earnings that can help individuals fulfill their financial requirements.

2. Is dividend investing safe?

This strategy is not safe; it involves certain risks. For example, a company may reduce its dividend payments or stop paying them entirely. However, individuals can mitigate financial risk by building a diversified portfolio.

3. What to look for when investing in dividend stocks?

One must consider certain aspects like the payout ratio, credit rating, dividend history, dividend yield, etc., to get an idea of the risk associated with a dividend stock. This will help individuals pick the companies that can enable them to fulfill their financial goals.

4. Is dividend investing good for young investors?

This strategy is not ideal for relatively young individuals. For them, it is better to invest in growth stocks.

This article has been a guide to what is Dividend Investing. Here, we explain how to start it, its pros and cons, example, and comparison with value investing. You may also find some useful articles here –