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What Is Dividend Investing? Understanding How It Works

What is dividend investing? A dividend investment strategy focuses on stocks that distribute dividends. Learn more about dividend investing, its benefits and risks, and how to avoid making common mistakes.

6 min read

Dividend investing is an investment strategy that focuses on stocks that distribute dividends. Dividends are payments made by companies — in the form of stock or cash dividend — typically on a quarterly basis.

When investing in dividend-payers, investors can potentially profit in two ways:

  1. from dividend payments 
  2. from any price appreciation of the underlying stock

Dividend Stocks: What They Are and How They Work

Every company makes a capital allocation decision on how much of their net income to reinvest towards growth versus returning to shareholders. A dividend is the portion of income that the company decides to return to shareholders. Companies can issue dividends in the form of additional stock or cash.

Companies that issue consistent dividends provide returns to investors in the form of steady income. By contrast, many growth companies believe in their ability to generate higher value for shareholders by using proceeds for expansion or capital investments. The board of directors decide whether to pay out the company’s profit in dividends.

Mutual funds and exchange traded funds (ETFs) also issue dividends. This usually is the result of underlying stocks held by the fund issuing a dividend, which are then passed to shareholders of the fund.

Quick Quiz

Are higher dividends always better than lower dividends? If ETF A issues a dividend of $4 per unit and ETF B issues a dividend of $3, is ETF A better?

You are right! Higher dividends are not necessarily better than lower dividends. Read the section "What is Dividend Yield?" to learn more.

Higher dividends are not necessarily better than lower dividends. Read the section "What is Dividend Yield?" to find out why.

What is Dividend Investing?

Dividend investing is an investment strategy focused on instruments that issue regular dividends. You can invest directly in stocks that have a history of issuing regular dividends or in ETFs or mutual funds that invest in a portfolio of dividend-yielding stocks.

What is Dividend Yield?

Not all dividends are created equal. To judge the comparative attractiveness of a dividend, you need a measure that normalizes for underlying stock price to provide an equal footing for evaluation.

One such measure is the dividend yield. To calculate dividend yield, divide a company’s annual dividend per share by the current share price. Dividend yield is the measure of dividend you have earned for every dollar invested.

Dividend Yield = (annual dividend received per unit or share)/(price per unit or share)

For example, imagine ETF A issues a dividend of $4 per unit and ETF B issues a dividend of $3 and that each unit of ETF A costs $40 and each unit of ETF B costs $20. The dividend yield of ETF A works out to be ($4/$40) 10%, whereas the dividend yield of ETF B works out to be ($3/$20) 15%. If all else is equal, ETF B with its higher dividend yield would provide a higher return than ETF A.

Types of Dividend Investing Strategies

Broadly, dividend investing strategies fall into one of two categories based on the criteria being followed and the investment goals targeted.

High Dividend-yield Strategies target companies with high levels of dividend yield. These strategies have the potential to offer a high level of dividend income and the opportunity for capital appreciation.

Dividend Growth Strategies focus on investing in companies with a history of consistently growing their dividends. The ability to grow dividends consistently over long periods of time demonstrates qualitative attributes, such as fiscal discipline and operational efficiencies, and can potentially lead to growth from dividend income as well as capital appreciation. ETFs built with this strategy usually track indices of stocks that have grown their dividends over consistently long periods of time.

Benefits of Dividend Investing

Investing in stocks that provide high dividend yields helps investors to:

Risks of Dividend Investing

When considering where and how to invest, consider:

Tax Implications
Some dividends may be taxed as income, unless they are in tax-advantaged accounts like 401(k)s or an IRA. Thus, dividend investing may increase your tax liability. This is true of reinvested dividends as well.

Low Growth Potential
Companies that pay regular dividends are naturally reinvesting less into growing the company, which could impact the total return.

Possible Policy Changes
Even companies that have a history of offering regular dividends may decide not to issue dividends in a particular year in reaction to changing economic conditions or company-specific factors. As companies are not obligated to distribute dividends, dividend income is not guaranteed.

Dividend Investing Mistakes to Avoid

When implementing any investing strategy, investors run the risk of overlooking factors that can end up having a large impact on returns.

The Dividend Value Trap
Relying solely on dividend yield as a metric for investing often leads investors to chase high yields at the cost of high risk to their capital. A high dividend yield may not always signify high total return. The average dividend yield from S&P 500 companies fluctuates between 3% and 5%.2 It’s prudent to be wary of very high payout ratios that are funded by debt and declining cash flows.

Choosing Dividend over Company Fundamentals
Chasing dividend payouts without considering the quality and durability of a company can lead to issues like shrinking dividend yields, loss of capital, and volatility in total returns. Therefore, look for companies with competitive strength, long-term expected earnings growth, strong cash flow, and a low debt-to-equity ratio.

How Do Dividend ETFs Benefit Investors (and Limit Risks)?

The ETF structure itself provides some potentially useful benefits. The following benefits can enable dividend investors to:

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