One of the best ways to build wealth for the long term is to invest.
Over time, your investment can grow through compounding returns. And when you start investing early, you have a better chance of reaching your retirement and financial freedom goals.
Dividend investing is one way to help you work toward your income goals over time. It essentially takes the idea of compounding returns and super-charges it. Here’s how you can grow your own wealth with dividend investing
What is a stock dividend?
Sometimes, a company pays a portion of its profits to shareholders. This is called a dividend.
A dividend can be paid one time, as a special circumstance, or regularly. It depends on the company in question, and its practices.
Your dividend payment is money you receive on top of any capital appreciation that comes as a result of owning a stock. You don’t have to sell any shares to receive a dividend. In fact, it’s better not to if you are involved in dividend investing.
A dividend payment formula is based on how many shares you own, and the amount per share a company pays.
For example, Coca-Cola Company (KO) last paid a dividend of 35 cents a share in November 2016. So if you owned 200 shares of KO, you received $70. That money represents a portion of Coca-Cola’s profits, and they decided to distribute it back to company owners (stockholders).
Dividend investing is all about choosing companies or funds that pay regular dividends in the hopes of building your portfolio quicker. You may even eventually be able to create an income stream based on dividend payouts.
Building a dividend investing portfolio
When I first began dividend investing, I looked for a fund specializing in dividend stocks. Diversity is an important part of investing, even with dividend stocks. One of the easiest ways to achieve diversity when you don’t have much money is to invest in funds.
Figure out how much you can put toward your dividend portfolio each month. Search for a fund that pays dividends regularly, and put your money there. Some robo-advisors, like Betterment, make it easy to set up an automatic plan to invest in funds that pay dividends.
At first, you might be a little discouraged with your dividend payouts. When I first start my dividend portfolio, I received perhaps $1.45 a month from my fund. Over time, though, as you add more shares to your portfolio, your payouts get bigger.
Reinvesting your dividends
The real money-maker for your portfolio is reinvesting your dividends.
The goal is to build a dividend portfolio that eventually provides you with a reasonable income. That’s not going to happen immediately — unless you have a huge windfall that you can invest in one swoop.
Most of us have to start small and reap small dividends. The key to dividend investing is to reinvest what you get during the early years of your portfolio. You take whatever you receive in dividend payouts and buy more shares (or partial shares) of the dividend fund or stock.
The more shares you have, the bigger your dividend. You can use your dividend to buy more shares, and the cycle continues. Plus, you should still be using dollar-cost averaging to invest each month.
Let’s say you decide to invest in the dividend ETF VIG. You invest $200 each month. Right now, you have 50 shares. The last dividend payout was $0.3930 per share, so with your 50 shares, you end up with $19.65.
Instead of spending that money, you take it and buy more shares of VIG. Your next month’s investment will be $219.65. It’s not a huge boost, but it can help. Now you can buy two and a half shares of VIG at $86.25 next month, instead of just two shares.
VIG pays dividends quarterly, so you keep making your regular investment of $200 a month. Let’s say you buy two more shares each month for the remaining two months of the quarter. That’s four more shares added to the two and a half bought the month after the dividend payout.
Now, when the next dividend is paid, it’s based on 56.5 shares. Your new payout is $22.20. Once again, you use that money to boost your ability to buy extra shares the following month.
Of course, in the stock market prices vary regularly, and dividend payouts can go up or down. However, when you use dividend reinvesting as part of your plan, it’s like getting free shares.
Over time, the number of shares you have in your portfolio continues to grow, and that means higher payouts down the road.
Using DRIPs to grow your portfolio
One of the easiest ways to reinvest your dividends is through a dividend reinvestment plan (DRIP).
Many companies and funds offer these plans. With a DRIP, your payouts are automatically reinvested in the stock or fund. You don’t have to do a thing. Most brokerages that offer DRIPs won’t charge transaction fees for dividend reinvestment.
Over time, using a DRIP has the added advantage of growing your portfolio value over all. The more shares you have in your portfolio, the bigger your potential appreciation later.
Whether you decide to sell some of your assets, or you want to use the income stream, a bigger portfolio means more money in your pocket.
Eventually, you are likely to reach a point where you want to invest in individual dividend stocks.
Funds are a good way to get started, but many dividend investors eventually branch out. Once you’ve used dollar cost averaging to build your portfolio, you can sell shares and use the proceeds to build your dividend portfolio with individual stocks.
One way to begin your experiments with individual stocks is to start with dividend aristocrats. These are companies that raise their dividends each year.
A dividend aristocrat must increase its dividend payout each year for 25 consecutive years to make the list. There might only be a tiny increase, but it’s an increase nonetheless. If a company misses a single year, it’s off the list until reaching the 25-year threshold again.
There are companies on the dividend aristocrat list that have been increasing dividends every year for more than 40 years.
Dividend aristocrats are attractive because you can be reasonably certain dividends will go up. It’s not a sure thing, but it’s a fairly good bet.
Plus, these are companies that kept raising dividends and paying out portions of profit to shareholders even during recessions. Some investors feel that indicates overall health and staying power for a company.
What about yield?
When you talk about dividend investing, you are going to hear about yield. After becoming comfortable with individual dividend stocks, some investors move away from the aristocrats in search of yield.
Dividend yield is a ratio that illustrates how much the company pays out in dividends each year in relation to its share price. You take the annual dividend amount paid and divide it by the current stock price.
Let’s take the example of KO from above. If KO pays 35 cents a share quarterly, that’s a total annual dividend of $1.40. The current stock price is $41.32. Take 1.40 divide it by 41.32, and you get 0.0338, or 3.38 percent. That’s your yield.
Of course, the yield can vary. The stock price can go up or down. If KO goes higher, up to $50 a share, the yield drops to 2.80 percent. But if it goes lower, down to $35, it results in a yield of four percent.
Another consideration is that dividends can rise. So if KO increases its dividend, that means a different yield situation.
It can be tempting to look for dividend stocks with higher yields. After all, a higher yield means a bigger payout, right?
Before you get too excited about high-yield dividend investing, it’s important to understand a couple of things about higher yields:
They might not be sustainable
Not all high dividend yields are sustainable. Sure, there are companies with yields of 13 percent. But how long can these companies pay out at that level? You could see a cut fairly soon.
Dividend aristocrats don’t offer the most amazing yields, but at least you can be reasonably sure they’ll keep increasing their payouts over time.
It could mean a dramatic stock price drop
Sometimes the yield is high because the stock price has dropped recently. If you see a high yield, you might want to dig into the price history a little bit for that stock.
Long-term dividend investing is more about building a foundation for stable returns and potential income. That is less likely if a company is faltering.
What else is wrong?
Some companies temporarily boost dividend payouts to attract investors. They announce an increase, or that a special, one-time dividend will be paid. The hope is that investors will flock to the company and offer an infusion of cash.
However, that could be a sign that there is something wrong. Look into the company to see whether or not it will be around to pay that big dividend.
High yield dividend stocks have their purpose, and some investors have success with them. They search for yield, and take advantage of it, and then move on before something happens.
Always consider your own situation and goals, and your risk tolerance, as you plan your dividend investing portfolio.
Dividend investing can be one way to build your long-term portfolio and income. It’s a way to use extra money to bulk up your holdings.
And, eventually, you might even grow your portfolio to the point where your dividends can be part of your income.
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