Dividend investing is popular with many types of investors, but especially with older investors, many of whom are looking for a reliable income stream to finance their golden years. The best dividend stocks can pay a solid dividend and grow it over time. And with inflation still a priority for investors, this could be an especially good time for dividend stocks.
“Dividend-paying stocks tend to be more defensive and outperform growth stocks during periods of high inflation, high interest rates and economic uncertainty,” says Elizabeth E. Evans, CFP, managing partner at Evans May Wealth, an asset management firm in the United States. Indianapolis area.
But how can you best benefit from dividend stocks? Top investors use many tricks to get the most out of it. Here are some secrets to successful investing in dividend stocks.
Top tips for investing in dividend stocks
The five tips below are both things to do and things not to do. When investing, it is often just as important to avoid doing unwise things as it is to actively do smart things.
1. Find sustainable dividends
Finding a sustainable dividend is one of the surest ways to avoid loss, which is legendary investor Warren Buffett’s No. 1 (and No. 2) rule. When it comes to dividend investing, one of the best ways to avoid losses is to look for a company that can maintain its payouts even if revenue declines in the short term.
Why is a sustainable dividend so important for an investment? If investors think a company has an unsustainable dividend, they will push the share price down in anticipation of a dividend cut. If and when a dividend cut actually happens, stocks could be in trouble again as investors flee. Many large investors, such as mutual funds, will trim their positions or may be forced to sell entirely if the company cuts its dividend completely.
A quick check of whether a dividend can be sustainable is to look at what percentage of the company’s profits are going towards the dividend. Companies that pay out less than 50 percent of their profits as dividends are more likely to weather a downturn in their business without making cuts. Still, some companies, like REITs, can safely pay out more cash flow without much hassle.
Investors can also check out stocks included in lists such as Dividend Aristocrats to see which companies have long-term track records of maintaining and increasing their payouts.
2. Reinvest those dividends
Getting a cash payout from your shares is valuable, but if you spend that money, you won’t benefit from the compounding effect of reinvesting your dividends. Reinvesting your dividends can give your portfolio a needed boost and boost your investment gains.
“Since the 1930s, more than 40 percent of S&P 500 returns can be attributed to dividend income,” says Evans, who says dividends play an especially important role when market returns are low. “Dividend income tends to absorb stock price volatility, thereby smoothing the overall volatility in a portfolio.”
Many brokers will automatically reinvest your dividends if you tell them to, and they will even buy fractional shares so you can put all that money to work immediately. When the next dividend is paid, you will make even more money on your payout. At best, you create a virtuous cycle where your wealth continues to grow with each quarterly payout.
It’s worth noting that dividends are taxable even if you reinvest them. So dividend reinvestment may work best in tax-advantaged accounts, such as an IRA or a 401(k). Within these accounts, you won’t owe taxes immediately (or perhaps ever, if you use the Roth versions).
3. Avoid the highest yields
When you look at the lists of the highest-yielding dividend stocks on the market, it can be tempting to pick the stocks with the highest dividends. After all, that seems like the fastest way to compound your money. But often those high yields are dangerous. They are a sign that the market does not trust the sustainability of a dividend, and so the market is pushing the share price down to compensate.
Buying the highest yields “can be harmful because these high yields are often transient and can consist of one-time distributions that temporarily increase yields,” says Brian Robinson, CFP, financial advisor and partner at SharpePoint, an asset management firm . company in Phoenix. “These types of securities also tend to have extremely high price volatility.”
So unless you’re an expert at analyzing investments, it’s best to avoid the highest-yielding stocks on the market. If you buy the highest yields, you can quickly lose a lot more money than you would ever make with that tempting but illusory 8 or 9 percent yield.
4. Look for dividend growth
“Dividend growth is much more important than dividend yield,” says Evans.
Many investors get caught up in looking at a stock’s current high returns and don’t think about how much a company can grow its payout over time. But a growing payout will help you mitigate the effects of rising costs on your portfolio, and that’s critical if you’ve been investing for decades.
“Don’t forget about inflation,” says Robinson, who advises that a good dividend portfolio should “track the average annual increase in the cost of goods.”
Investors can run a number of checks on their company to see what dividend growth could look like in the coming years:
- Dividend payout ratio: This is the ratio between the dividend and the total profit. The lower the number, the more the company could safely increase its dividend.
- Dividend Growth Rate: This is how quickly the company has increased its dividend in the past. Higher growth may indicate that management is willing to pay shareholders more.
- Earnings growth rate: A company that continues to grow its profits will also have more capacity to grow its dividend. For example, a company that grows its profits at 10 percent per year could potentially also grow a sustainable dividend at that rate.
“If a company can generate strong and sustainable free cash flow from operations, it is more likely that the company can grow its dividend and continue to deliver strong shareholder returns over time,” says Evans.
5. Buy and hold for the long term
If you really want to turn your portfolio into a dividend dynamo, you need to invest for the long term. That means finding a solid dividend payer and sticking with it over time. That time element is absolutely crucial, but it’s easy to stumble when there’s bad news.
Look at the experience of Warren Buffett and his purchase of Coca-Cola shares from his holding company Berkshire Hathaway. Berkshire bought 400 million shares of the beverage company for about $1.3 billion nearly three decades ago. The stock has naturally risen and is worth approximately $22.4 billion as of September 2023. But look at what Berkshire earns in dividends.
Coca-Cola currently pays a dividend yield of about 3.1 percent – not particularly high – but Berkshire’s return on its investments is huge. Coca-Cola must pay out more than $700 million to Berkshire this year. So the company earns more than half of its original investment every year from dividends alone.
And that is the power of dividend investing with a buy-and-hold mentality.
In short
All too often, many people view dividend investing as the domain of the dour investors, but dividend investing can be one of the most stable and lucrative forms of investing. Use these five secrets above to improve your dividend investing strategy, and remember to always think long term.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making any investment decision. In addition, investors are advised that the past performance of investment products does not guarantee future price increases.
