There are few strategies as tried and true as dividend investing. For decades, everyday investors and seasoned professional portfolio managers have scoured the universe of stocks in search of the strongest yields that can generate significant income. At the core of dividend investing is developing a robust process to select reliable companies to own while avoiding potentially dangerous, high-risk stocks. Additionally, with so many exchange-traded funds (ETFs) available today, you can also mold a portfolio of funds with a focus on dividends. 

Dividend investing remains a popular way to allocate capital, even after the recent prolonged period of outperformance from many high-flying tech stocks that do not pay dividends at all. The notion that you can live off dividends paid out from shares in companies is appealing to both retirees and those on the path toward financial independence. Typically, a US company will distribute cash to shareholders once per quarter, while many non-US firms pay dividends semi-annually. But did you know there are also stock dividends and special dividends? Furthermore, there are high-yield strategies as well as dividend-growth methods of investing. There’s a lot more to dividend investing than you probably thought!

Unlike many hot investment fads, dividend investing goes back decades. In fact, the majority of US stock market returns since the 1970s have come just from dividends. Think of it like the tortoise and the hare – simply owning companies committed to paying back shareholders via dividends has proven to beat out investors seeking to score big profits from quick price appreciation. You see, some of the best dividend-paying companies are those that are more financially stable and at low risk of going out of business – they tend to earn steadily rising profits and keep their debt in check. 

Big picture, investing in firms that return capital to shareholders by way of dividends can be an effective and lucrative way to manage a long-term portfolio while not getting over your skis when it comes to risk. Let’s outline some key terms, detail dividend investing strategies, and go through the risks and benefits of dividend investing. We’ll also talk taxes. The goal is to figure out if dividend investing works for you.

What is Dividend Investing

Dividend investing is simple. You scan the world of stocks in search of companies that pay reliable dividends. With today’s research tools, it is easier than ever. Before we dig into how to go about selecting individual stocks, let’s run through some key terms. 

Dividends are an elective distribution of profits from a company to its shareholders. Established firms that are growing profits and generating free cash flow are more likely to pay dividends, whereas up-and-coming young companies or those lacking profits might not have a dividend yield. 

On that note, a dividend yield is just the annual dividend payout divided by the stock price. You might see the dividend yield stated on a “trailing” basis, meaning the sum of dividends paid over the previous 12 months, or on a “forward” basis, projecting ahead the next year’s dividend distributions.

Dividend investing is popular with a range of investor types. While there is never a one-size-fits-all solution, owning a portfolio of a few dozen companies with a history of focusing on shareholders through steadily increasing dividend payouts has worked for many investor types. Dividend investing is common among risk-sensitive investors who want to avoid high-risk companies in favor of steady-eddy blue-chip stocks. It’s also a method that can complement a broader portfolio of stocks and bonds in order to form a well-diversified investment mix. Over the long haul, though, investing in reputable companies paying recurring dividends has been shown to earn strong returns. Dividend-paying companies, according to some studies, have even outperformed non-dividend-paying stocks. 

Types of Dividends

Most large-cap US companies pay quarterly cash dividends from excess earnings and cash flow. The dollar amount is often announced within an earnings report, and a dividend increase headline is commonly met with cheer among the investment crowd. A firm has several options when it comes to allocating its capital: reinvest in the business through high-growth projects to grow earnings per share, reduce debt to shore up its balance sheet, buy back stock to reward shareholders and reduce potentially costly equity financing, or distribute dividends. The dividend payout itself can be small, as little as a penny per share, or very large depending on the number of shares outstanding and the distribution’s dollar amount. Moreover, there are four types of dividends to know about:

1. Cash dividends: Cash dividends are the most common, and they are what investors think about when they research various dividend investing strategies. With a cash dividend, a company takes a portion of its profits and pays it out to its owners. The amount of the distribution is expressed as a dollar amount per share. 

2. Stock dividends: Stock dividends are sort of like little stock splits. Instead of receiving cash, you get more shares of stock. Of course, if you want to live off your dividends, you would have to then sell those additional shares to generate cash.

3. Property dividends: In rare instances, a capital-intensive business might distribute physical assets to its owners, or a conglomerate company could pay out stocks and bonds, or other securities, to its shareholders. 

4. Special dividends: Some businesses prefer to have more flexibility with their dividend payout policy. A special dividend helps them do that since it is paid out on a non-recurring basis, usually after a period of strong operating performance and high earnings. It can also be paid following the sale of significant assets. Special dividends are often made on top of an existing dividend policy.

The Dividend Timeline

It's important to understand the sequencing of dividends. First, there is a dividend announcement date, next is the dividend ex-date, then the date of record, and finally the dividend pay date. Shareholders owning the stock on the ex-date are entitled to receive the dividend on the pay date. 

Finding Dividend Stocks and Developing a Strategy

The easiest way to find dividend stocks is to use stock screens whereby you can filter for dividend-paying companies with yields within a certain percentage range. Some prudence may be needed, as selecting stocks that simply have the highest yield could lead to owning overly risky companies. An extremely high yield is considered a warning flag, suggesting that the company might not be able to continue distributing such a large amount to shareholders. Such investments could be “dividend traps.” What’s more, the reason a yield might be so lofty is that its stock price might have declined sharply in a short time, another danger warning. So, many experts suggest discarding those mega-high-yielders, and focusing on the next tier of high-dividend stocks to maintain a robust long-term strategic asset allocation.

Along with scanning stocks by dividend yield, you should also review other fundamental indicators to ensure that the companies you consider owning are healthy. Digging into a firm’s profit trends, debt levels, and free cash flow metrics may be useful. You can also dig into the list of so-called “dividend aristocrats” - companies that have increased their dividends every year for at least 25 years. This is what is known as a “dividend growth” strategy since it aims to only identify and invest in firms that are raising their dividend, not just paying one out. You can piece together your own dividend growth allocation or select from the world or dividend-theme ETFs for a more hands-off approach.

With today’s technology and slick tools, is that it’s easy to create a high-quality portfolio of dividend stocks. Just take a look at some of the world’s largest companies – you will see that many of them have dividend yields of 3% or more. Forming a portfolio from stocks of various sectors can help ensure diversification and an investment strategy that can endure for decades. Quality dividend companies may be better able to weather economic downturns than riskier ones, and when bear markets strike, dividend growers may have the ability to provide a steady income stream during tumultuous times. 

Reinvesting dividends is also quite common. While a retiree might prefer to live off the dividends they receive, younger investors focused on growing their wealth may be better served to buy more shares rather than let cash build in their accounts. Most brokerage firms allow you to reinvest dividends in the security – that goes for individual stocks, ETFs, and mutual funds. A dividend reinvestment plan (DRIP) commonly has no commission attached and it can be an effective way to dollar-cost average into a portfolio that meets your needs and makes compounding returns your friend.

The Dividend Timeline, What Happens on the Ex-Date & Tax Implications

It’s also important to know that dividends are not a free lunch. On the ex-date, the company’s stock price drops by approximately the amount of the dividend. And that makes sense because the dividend itself is part of shareholders’ equity on the balance sheet until it is  distributed. Furthermore, the company is taxed on the dividend and then you are taxed when you receive the payout. This is what is known as the “double taxation” of dividends. For that reason, more companies elect to repurchase shares in the open market rather than pay big dividends. 

The good news for investors is that you can always own high-dividend stocks in a tax-sheltered Individual Retirement Account, 401(k), or Health Savings Account (HSA) to bypass having to pay tax each year on your dividends. Uncle Sam favors long-term holders of dividend stocks – there are what’s known as “qualified” dividends which are generally dividends paid by US corporations or qualifying foreign firms and those that have been held for more than 60 days during a 121-day window starting 60 days before the ex-date. A qualified dividend is taxed at the more favorable long-term capital gains tax rates and not at higher ordinary income tax rates.

The Bottom Line

Dividend investing is a time-tested way to manage a portfolio of stocks and ETFs. By focusing on high-quality, high-yielding companies, you have the opportunity to allocate capital that meets your unique risk and return objectives. Beware of dividend traps and consider dividend growth strategies such as investing in dividend aristocrats. Being a tax-aware investor is wise, too. No matter how you go about it, maintaining a diversified portfolio is key, and being able to stick with it through the thick and thin is crucial.