Luisa Rollenhagen is a journalist and investor who writes about financial planning for Wealthsimple. She is a past winner of the David James Burrell Prize for journalistic achievement and her work has been published in GQ Magazine and BuzzFeed. Luisa earned her M.A. in Journalism at New York University and is now based in Berlin, Germany.
How to invest in dividend stock
Imagine this: You’re 45, sitting by your pool on a random Tuesday at 4pm, casually sipping a margarita you just made yourself from your in-home bar. You feel perfectly at ease, because every couple of months, like clockwork, you’re getting a nice check from all those dividend stocks you so cleverly invested in 20 years ago. That’s the mental image people tend to have when talking about the benefit of dividend stocks. Unfortunately, it’s not quite as simple or glamorous as that. (Financial matters rarely are.)
The one thing the pool fantasy gets sort-of right is that yes, dividend stocks do pay out regular dividends — meaning a part of their profits — to shareholders. Investors pursuing a long-term financial goal tend to favor dividend-paying stock because it can be an important potential step toward finally living off of a regular stream of income.
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Dividend stocks also lend themselves well to DRIPs, where the dividends get reinvested and you earn interest on your interest (thank you, compound interest magic). Either way, dividend stocks can be a suitable investing choice if it aligns with your goals. But before you go Googling the average annual dividend yield of companies on the stock market, you first should know a couple of things about dividend stocks and how to invest in them.
Decide what stock you want to buy
Buying dividend stock is like buying any other kind of stock. You need to choose what trading platform or brokerage you want to use, and then you have to choose your investing style. Do you want to buy individual stocks that pay dividends, or do you want to buy dividend ETFs? There are some pros and cons to each, like the fact that individual stocks tend to be associated with higher risk and higher fees, but also have the potential for higher rewards. Either way, some quick research will help you see which companies pay dividends, and where you can buy shares.
It’s also worth your time to pay attention to the health of the companies paying dividends. What have their historical annual dividend payments looked like? Is the company financially stable? Have they steadily increased dividends over time? While none of these aspects are a guarantee of future results, it will allow you to understand how a company’s dividend performance has been in the past. Companies with a history of financial stability and low volatility are also more likely to pay out dividends, since they have enough capital to do so.
Know what kinds of dividends you’re getting
While most dividends are paid out quarterly, it’s important to know what kind of dividend you’ll be getting. There are three kinds of dividends:
Cash dividends, which are quarterly dividend payments made out to you, the stock owner, and taken from a company’s current earnings or accumulated profit.
Property dividends. This is when a company hands out property—which doesn’t necessarily just include real estate, but can also include other items of value, instead of cash.
Stock dividends, where a company gives you additional shares instead of cash. Stock dividends are usually given out within the framework of a DRIP. And don’t worry: If you’ve chosen to use a robo-advisor to help you manage your portfolio and are worried you’re missing out on DRIPs, there are plenty of platforms that will reinvest dividends for you.
Research the dividend yield
When deciding what stocks to buy, having an idea of the dividend yield can help you refine your search. In broad terms, a dividend yield is shows you how much a company pays in dividends each year relative to the company’s market price per share. High dividend yields can indicate that you’re likely to receive higher dividends, but don’t rely exclusively on that figure when making investing decisions, as a sudden increase in dividend yields can also be the result of a stock’s price rapidly falling.
Do your homework on taxes
Dividends are considered income, so you’ll have to report them in your tax return. However, some dividends are classified as “qualified dividends”—dividends that have been held for a certain amount of time, usually 60 days—which means that they’re subject to capital gains tax.
Pros and cons of investing in dividend stocks
Potentially getting a steady stream of income every couple of months sounds pretty good, right? And in certain cases, it is. Investing in dividend stocks is particularly useful if you’re incorporating them in a long-term wealth-generating strategy. This is particularly true if you take advantage of a DRIP. Thanks to the compound interest your dividends are generating, you’ll be earning interest on that interest as well.
For example, imagine that you own 1,000 shares of Company X. The stock is currently trading at $47 per share, and the annual dividend is $1.56 per share (or 39 cents per quarter). Instead of getting a quarterly cash payment of $390, that amount is reinvested and you’ll now have 1,008.29 shares of Company X instead. That means that your next quarterly dividends would now amount to $393.23, which would be reinvested again, meaning more shares and more dividends. For long-term wealth goals, DRIPs can be an attractive way to potentially generate higher returns than if you just cashed a check every quarter.
However, it’s not all rainbows and pool parties. While dividend stocks can surely be a good addition in a well-balanced portfolio, don’t rely too heavily on them. Focusing too much on dividend stocks usually leads down the slippery slope known as individual stock picking. This means that you’re relying too heavily on a few stocks that you hope are “winners,” but are left vulnerable if those stock prices start falling or something happens to the industry the companies are in. Your portfolio risks being less diversified if you’re focusing exclusively or heavily on dividend stocks, especially since dividend stocks tend to come from a limited range of industries.
If you want to diversify in a wide variety of stocks — including dividend stock — but want to stay away from individual stock picking, then a robo-advisor might be a good option, since an algorithm will set up a balanced portfolio for you and rebalance it to ensure that your money is widely distributed across a variety of assets and fields and is reaping the benefits of the market to its highest potential.
Another thing to keep in mind when considering dividend stocks is that at the end of the day, they’re still stocks. Which means that they’re going to inherently carry more risk than, say, bonds. So while the potential for high dividends is obviously very tempting, it’s important to remember that the higher the potential reward, the higher the potential risk. This is why diversification is so important.
Investing in dividend stock, if done prudently and with a bit of research, can be a great way to set yourself up for a comfortable financial future. If you’re interested in getting your investment goals on track but aren’t sure where to start, Wealthsimple can work with you to create a portfolio that has just as much or as little risk as you’re willing to take on, with the potential to reinvest any dividends you might make along the way. And with low fees and personalized service, any investing newbie can be well on their way to building up a financial future.
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