Let’s be real: there are tons of different financial tools out there that people use to make money from the stock market, and it can be hard to keep them all straight. You might have recently heard your uncle or boss talking about their dividends and wondered what those were and how they differed from just buying shares in the stock market or investing in a mutual fund. This guide will walk you through everything you need to know about what a dividend is, as well as yields and high dividend stocks so you can wisely invest your money. You can also click on one of the links below to jump straight to your question!
What is a dividend stock?
First things first: what exactly are dividend stocks, and how do dividends work?
- Dividend stocks are stocks that pay out regular dividends to shareholders.
- Dividends are sums of money that are paid out of a company’s revenue to its investors.
This is contrasted with capital gains, which is the amount earned after selling shares at a higher value than you bought it. When you hear about someone getting rich off the stock market, it’s usually because they were a savvy investor and made a lot through capital gains. It’s also the more commonly talked-about form of playing the stock market: buying some shares in an up-and-coming company, then selling them once the company gets huge.
In contrast, dividends pay their shareholders quarterly, semi-annually, or annually. Rather than holding out until the right time to sell, an investor putting capital into dividend stocks is hoping for a slow and steady return on investment at a consistent pace. Most companies offer dividends that are maintained at a constant rate, so a portfolio with a solid portion of your assets invested in dividend stocks may be a good way to supplement your cash flow.
Key Terms Demystified
Before we dive deeper into the waters of dividend investment, let’s make sure all the key technical terms are totally clear.
- Dividend: a regular payout from a company to shareholders, usually issued every quarter (so, 4 times a year).
- Shareholders: people who own stock in the company. They’ve put their own money on the line to support the growth of a company, so they expect to be paid back when the company does grow.
- Dividend yield: the ratio describing the annual dividend (that’s the amount paid out to an investor in a year) divided by the share price (the price of one share in the company stock). We’ll see why this is so important in a little bit.
- Stock: essentially pieces of the company that you buy, hoping that the company will grow. If it does, the piece or pieces that you own will also grow in value.
- Capital gains: the money you make when you sell your shares at a higher price than you bought them.
Spotlight: Dividend Yields
Like we covered, the dividend yield is an annual dividend divided by the share price.
Investors tend to prefer higher dividend yields, as this means that the more shares you buy, the more payout you’ll get.
Think of it this way: If you’re spending $1,000 on shares, and one company has a lower stock price but a higher yield, and the other a higher price but lower yield, you’d make more money buying more shares at the lower price, as the total collected from dividend yields will be higher. If that sounds a little confusing, check out the chart for a step-by-step breakdown.
In either case, you’re spending $1,000. However, because Company A has a higher dividend yield than Company B, you end up making more money at each payout. This isn’t the end of the story, however, and there are a lot of other factors that you ought to consider. Let’s take a look at those next.
Why invest in dividend stocks?
Dividends can be a great tool for some situations and not others. Dividends make regular payouts that can supplement your income and increase cash-flow, as you can more or less rely on the fact that you’ll be paid quarterly. This is in contrast with capital gains, with which you only get a return when you sell them—and if the company you’ve invested in actually grows!
Because of their regularity, dividends could be helpful for retirement. You want to make sure that your retirement savings and investment portfolio are growing slowly and steadily; putting all your money on a couple of stocks hoping that they’ll grow by the time you retire is probably not the best way to ensure financial security once you’re done with your career and thinking about retirement.
Dividends may be a better option for long-term savings because they can be more slow-and-steady than waiting for the perfect time to sell a risky short-term stock.
That said, another benefit of dividends is that they offer immediate (although modest) returns on investment. You may have to wait years for the money you put into that fledgling IPO to balloon into a massive capital gains payout. With dividends, however, you might receive a payout four times a year.
NOTE: Consider compound interest.
Compound interest is one of the keys to successful investing, and young investors with a long timeline stand to gain the most from this mathematical structure. Many dividends offer regular payouts, but some also offer payouts in the form of additional shares.
That means every time your payouts are enough to purchase a new share, your investment in the company will grow—and so will the value of your payouts. Over a 20- to 40-year timeline, the compounding effects of reinvestment can be mind-blowing.
Now that you know the benefits of dividends, let’s think about high dividend stocks in particular.
High dividend stocks explained
If you have dreams of living off your passive income, you probably have considered whether you could live off dividends alone. Unless you have hundreds of thousands of dollars to invest right now, that might not be possible just yet. However, high dividend stocks can definitely be a great part of your plan for retirement. Here are some good things to know before you start shopping around for high dividend stocks to invest in.
- Dividend yields higher than 3% are usually considered high. That may not sound like a whole lot, but remember that between the regularity of payouts and the power of compounding interest, 3% can be a solid return on investment, and is better than almost any savings account.
- Dividend stocks higher than 10% are almost always a scam. Do not get lured in by seductively priced dividend yields that seem too good to be true. More than likely, they are. Companies just cannot maintain a sustainable rate of growth if they’re paying out their investors at a 10% rate. Finding out that a company you’re invested in is going into debt to pay its shareholders is not the news you want in the morning.
- The higher the dividend, the more skeptical and discerning you might want to be. Even under that 10% threshold, high dividend yields may be a little risky. If you see something with a 6% yield, you might want to research the company a little more before investing substantial money into it.
- High dividends aren’t a no-brainer. There are always risks associated with higher payouts of any stock, whether it’s dividends or capital gains. Remember that the source of returns on investment is ultimately the risk involved in putting your money in a company’s hands and trusting them to grow. While dividend stocks can certainly be a lower-risk option than playing the stock markets, know that there is always some risk involved with investing. However, the rewards may outweigh that risk — that’s for you to decide!
- Pay attention to the business behind the yield. High yields are great, but you may consider checking out the growth strategy of a company before investing in it. Consider speaking with a professional financial planner if you don’t feel you can adequately assess a company’s growth statistics yourself. Remember that payouts are only possible if the company keeps growing! Check them out on Nasdaq.com to see their history and growth record.
Dividend stocks are corporate stocks that pay out their shareholders regularly. They may be a great option to supplement your cash flow and put money toward your retirement, and deserve a look as you consider your own savings and investment portfolio.