Dividend investing allows investors to profit from both regular dividend payments and capital appreciation. If you are seeking ways to supplement your income or expand your wealth, you should look into high-yield dividend stocks.
However, before settling on dividend investing as a source of passive income, you should understand the dangers associated and the best technique for mitigating those risks.
This article will explain what dividend investing is, its benefits and pitfalls, how to become a successful dividend investor, and which stocks to buy for high returns.
Let’s dive right in!
Table of Content
What Does Dividend Investing Entail?
Most novice investors are unfamiliar with the concept of a dividend as it pertains to investment, especially for an individual stock or mutual fund.
A dividend is a payment made to shareholders by a publicly-traded company as part of its earnings returns for a specific period.
The process of approving dividend payouts begins with a meeting of the company’s board of directors, who analyze financial reports to determine whether or not to pay dividends. When the board authorizes and declares the dividend stock payment, it announces the size and date of payment.
Dividends are often paid to stockholders in the form of cash payments on a monthly, quarterly, or annual basis.
Are Dividends Beneficial to Investors?
Given that not all companies pay dividends, and since the board of directors must decide whether or not a payout is appropriate for their particular company (depending on various factors), there may be concerns regarding the benefits of dividends to investors.
Dividend investing can be profitable since it provides investors with recurrent payments. Some shareholders want dividends for income or to reinvest in additional shares of the company.
Dividend payments that are consistent and growing can be a sign that a company is financially stable and strong.
Dividend investing is also worthwhile because it rewards investors through capital appreciation. Capital appreciation is the rise in the price or value of a company’s assets that allows investors to profit from a consistent flow of revenue.
Investing in dividend stocks for retirement is also a good idea because many companies gradually increase their dividend payouts. This gradual increase helps to counterbalance the negative impacts of inflation on income.
A dividend investing strategy preserves and grows your principal amount injected over time, something certain annuity arrangements may not provide. This is a benefit that many people wish for, especially if they want to leave a legacy for their family or community.
This strategy also allows investors to sell assets to fund other investments or retirement activities.
Despite these advantages, there are significant risks associated with investing in dividend-paying equities. They are nevertheless subject to fluctuating market pricing.
When a firm’s market performance deteriorates, there is always the possibility that it will lower or eliminate its dividend completely.
In fact, as illustrated above, newer enterprises, technology, and growing firms usually prefer to spend their profits on growing the business and pursuing new prospects. Thus, they do not pay dividends.
However, because of growth prospects, they may instead refund capital gains when share prices rise. This is all feasible with a well-diversified portfolio of dividend companies that guarantees you returns on a consistent basis.
Also Read: 10 Useful Ideas to Propel You Towards Financial Independence
How Much Do I Need to Invest to Live off Dividends?
Many of us would like to be able to live off dividends when we retire. Is it, however, practical?
I would argue yes and no. Diversifying your portfolio is usually a good idea to reduce risk exposure. If you have a high-risk tolerance, you can survive off dividends, but in reality, most people invest in more than one investment market.
Focusing on a company that pays stable and growing dividends over time, rather than the dividend stock’s price volatility, can protect you from the emotional risk of investing.
You can certainly live off dividends if you diversify your portfolio to avoid the shocks caused by market value volatility. This dividend investment approach might provide you with a steady stream of money.
But how much is enough, and how long will it last?
Assuming you had $1 million at retirement, you could earn up to $40,000 in annual income after adjusting for 2% inflation.
To do so, we would estimate that stock dividends will grow at a 3.0% annual rate – you would then invest $400,000 in treasury bonds (which correspond to the inflation rate) and $600,000 in stocks. Dividend income from the stocks might be worth $18,000 (3% *600,000) per year.
Within 21 years, dividend stock profits could have reached $24,000 per year (after inflation), while bond interest gains are used to cover other expenses or to divest.
This dividend investment calculator can be altered based on your profits target by dividing or multiplying the results by 10 or 100. It indicates that you can live off dividends if you diversify your portfolio and invest in safe, growing dividend payouts.
Dividend Investing Strategy
Now that we’ve set a common ground and clarified the basics let’s take a deeper look at the recommended dividend investing strategy.
The recommended dividend investing strategy requires the investor to identify the best investment opportunities by reviewing select well-financed companies.
According to AAII Dividend Investing, the following are some of the characteristics to look out for when selecting companies to invest in:
- A long record of earnings and dividend growth
- Positive free cash flow
- Reasonable valuations, preferably “low.”
- A reliable outlook for price appreciation and dividend growth in the future
Once you’ve decided on the sort or nature of the company to invest in, you should evaluate the dividend investment options listed below:
1. Diversify Your Stock Portfolio
Established investors, such as Warren Buffet, run concentrated portfolios.
However, not all of us have the same resources, insights, and connections as Buffet to give us the courage to run a concentrated portfolio successfully.
Instead, I recommend you go for a reasonable range of different stocks. Indeed, the American Association of Individual Investors (AAII) warns that investing in a single dividend stock rather than diversifying heightens the annual volatility (or risk exposure) by approximately 30%.
The AAII study also indicates that holding 25 stocks decreases dividend investing risk by around 80%, while holding 100 equities reduces risk by about 90%. This data implies that a higher number of equities are required to diversify your dividend investment stocks in times of financial hardship.
Therefore, it is reasonable to hold between 25 and 100 stocks while considering other factors, such as your financial situation and portfolio size.
2. Diversify Across the Industry
Holding a large number of dividend stocks that are focused on one or two industries is not a safe bet.
These investments are risky due to their comparable qualities. For example, if the price of oil falls during an economic downturn or interest rates rise, equities in the same industry will perform roughly identically since they are correlated.
When you buy equities from companies in multiple industries, you diversify your risk – when certain sectors struggle, others thrive.
Therefore, it is advisable to use the 5 percent rule of investment allocation.
The 5 percent rule of investing is a broad investment concept that states that an investor should not allocate more than 5% of their portfolio to one investment security.
This guideline encourages investors to diversify properly across the industry, which can help them achieve respectable returns while limiting risk.
Also Read: 5 Tips on How to Invest Money Wisely
3. Review the Capital Structure or Leverage
When evaluating prospective companies for dividend investing, financial leverage is a crucial factor to consider because it signifies the amount of returns equity holders are likely to receive.
The more a company is financed through debt, the more its dividend stock is exposed to unfavorable business conditions, such as changes in interest rates and credit conditions.
When constructing your dividend investing portfolio, it is advisable to go for firms whose debt-to-equity ratio (Debt to Equity Ratio = Total Debt / Shareholders’ Equity) is not more than 50%.
You should also look out for a strong grade credit rating and interest coverage ratio.
4. Small-Cap or Large-Cap Stocks?
Market capitalization (market cap) measures the market value of the outstanding shares of a publicly-traded company.
It is calculated by multiplying the price of a stock by its total number of outstanding shares (Market cap = share price x # shares outstanding).
It shows how much a company is worth at market value and what investors are willing to pay for its stock. A firm with 20 million shares selling at $50 per share, for example, would have a market cap of $1 billion.
As a dividend investor, it is advisable to go for large-cap companies rather than small-cap firms.
The former is more liquid than the latter because they have more buyers and sellers, making it easier to buy and sell dividend stocks at reasonable margins.
Businesses making up small-cap stocks are also less diversified, making these kinds of dividend stocks more volatile.
How to Start Dividend Investing
In case you’re wondering where to start in dividend investing, here is a simple guide that you can use with the help of an investment advisor:
- Screen high dividend-paying stocks – you can use financial sites or online broker websites.
- Evaluate and select specific stocks – you can compare the dividend yields. For instance, you can choose companies with a high dividend payout ratio, as this measure indicates how much of the company’s earnings are spent on dividends. Learn how to research stocks here.
- Decide the percentage to invest in each stock – for instance, you can diversify by injecting 5-10% of your portfolio in each of the 25 stocks selected.
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When looking for firms with the highest dividend payouts, keep in mind that high yields are risky.
High payouts can be unsustainable in the long run and may indicate that investors are selling the shares, lowering the share price, and boosting the dividend yield.
Remember, the dividend yield is a factor of the dividend per share and the price per share – the lower the share price, the higher the return.
Dividend yields within the 4% mark are safe, but factors such as your risk tolerance can allow you to be flexible.
The following are the top 10 high-dividend stocks to invest in as of 2022:
- Coca-Cola Co: This is the best dividend stock to invest in right now in general.
- Chevron Corporation: This is a dividend aristocrat as well as an American oil and gas producer. Dividend Aristocrats are companies that are both members of the S&P 500 Index and have paid and increased their basic dividend for at least 25 years in a row.
- Philip Morris International Inc.: PMI is a large-cap dividend stock that may be underpriced.
- Exxon Mobil Corp: This is a high-yielding dividend stock in the energy industry.
- Apple Inc: Apple is a low dividend yield with massive share price growth.
- Johnson & Johnson: The American multinational corporation is a reliable stock that has raised its dividend for the past six decades.
- Walgreens Boots Alliance Inc: It is a low-cost dividend stock to consider for long-term investment.
- Dover Corp: This is the US stock market’s longest dividend.
- Verizon Communications Inc.: The company has a high dividend yield and a low price-to-earnings ratio.
- Bank of America Corp: It is a solid dividend stock that tends to outperform the banking sector as a whole.
Conclusion
Dividend investing is a good long-term goal because it enables you to generate recurring income and is a source of capital appreciation by accumulating the principal amount invested.
If you are looking for a sustainable way to live during retirement, you can diversify dividend-paying stocks with other sources of income, such as treasury bonds.
Stock and industry diversification, coupled with a reasonable selection of target companies, can help keep your portfolio safe from risky industry conditions.
Author Profile
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Victoria is a seasoned SEO content writer and copywriter with proven experience in creating unique, insightful, and engaging content for a wide range of audiences that ranks high on search engines.
She is also a personal finance coach who will help you manage your money better by reducing wastage and identifying opportunities to grow your income. Follow her on her social media pages where she talks about personal finance and business growth strategies.
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