Investing in dividend stocks can be a solid investment strategy. These stocks not only allow shareholders to profit from a potential rise in the stock’s share price but also provide a relatively low-risk source of investment income.
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What are dividend stocks?
Dividend stocks are stocks from publicly traded companies that regularly share profits with their shareholders. These shared profits are called dividends. Dividend stocks typically come from well-established companies that are in a financial position to distribute a portion of their retained earnings to shareholders instead of reinvesting everything back into the business.
Dividend payments are typically paid per share and in cash every quarter. However, a company may also pay dividends in additional shares rather than cash — or monthly instead of quarterly.
Why do companies pay dividends?
A company may pay a dividend simply to reward investors and entice shareholders to stick around. Many dividend stocks are from under-the-radar companies or may be household names but not popular, high-flying stocks that draw the attention of the masses. Paying a dividend allows these companies to demonstrate value and give back to shareholders, in addition to any gains they may see in the price of their shares.
Dividend stocks actually play an important role in the market’s overall return. Since 1960, 84% of the S&P 500’s total return can be attributed to reinvested dividends. They’re also less volatile year-to-year compared to non-dividend paying stocks and outperform them over time too. Proponents see dividends as a sign of strength and financial stability.
2 ways to invest in dividend stocks
There are two main ways to invest in dividend stocks: by purchasing individual dividend stocks or through dividend funds — such as exchange-traded funds (ETFs) or mutual funds.
1. Dividend stocks
The most direct way to invest in dividend stocks is to buy the stocks themselves. Compared to an ETF or mutual fund, this gives you direct ownership in the company, which has its benefits and drawbacks as well.
Owning individual dividend stocks gives investors the potential for higher returns than an ETF or mutual fund, where you receive the weighted average performance of the fund’s holdings. When investing in individual dividend stocks, you also have voting rights and don’t have to worry about management fees.
But buying individual stocks comes with increased risk, as it’s harder to achieve the same level of diversification than buying an ETF or mutual fund, especially the less money you have to invest.
Dividend ETFs or mutual funds are designed to invest in a basket of dividend-paying stocks. While you won’t own the underlying company shares in the fund — you own the ETF shares — you can still enjoy regular dividend payments that are passed along from each company within the fund, as well as any appreciation in the fund’s value itself.
Dividend funds are a great way to diversify your portfolio since they invest in a broad range of stocks. Some funds may only hold dividend-paying stocks of specific sectors or industries, while others may focus on stocks of companies characterized solely by high dividend yields. But they sometimes have ongoing management fees that eat into the net yield of any dividend you receive. That said, there are plenty of low-cost funds out there, so just take the time to shop around.
How to evaluate dividend stocks
The dividend amount may be the first thing you look for when choosing a dividend stock, but it’s not the only thing you should consider.
Dividend yield. This financial ratio tells you the percentage of a company’s share price paid out in dividends each year. It shows the percentage of dividends you can expect for every dollar you invest.
Dividend payout ratio. This financial ratio measures the percentage of net income paid to shareholders as dividends. Generally, a high dividend payout ratio means a company is paying out more of its earnings as dividends and reinvesting less into its business. Too high a dividend payout ratio may not be a good thing, though, as the company could struggle to maintain its dividend payout over time.
Dividend growth rate. This shows the dividend growth rate over a period and is often used to measure a company’s long-term profitability.
If you’re investing in dividend stocks through an ETF or mutual, take particular account of the fund’s expense ratio. This is the cost of owning an ETF or mutual fund and includes management and administrative fees. The lower the cost of owning a dividend fund, the higher the net yield of the dividend payment.
Pros and cons of dividend stocks
Pros
Dividend stocks provide a reliable income stream.
Dividend stocks are typically established companies and have less volatility year-to-year than non-dividend-paying stocks.
Investors can benefit from both a stream of income and a potential rise in the stock’s share price.
Cons
Dividend amount can fluctuate and are not guaranteed.
Dividend stocks may not see the same level of growth as other stock types.
While more and more tech stocks are adopting dividends, most dividend-paying companies are limited to certain sectors.
Dividends are automatically paid to your investment account when you invest dividend stocks. All you need to do is buy the stock through a stock broker.
The amount you'll need to invest in dividend stocks depends on the broker you're using. If your broker offers fractional share trading, you should be able to invest in dividend stocks with as little as $1 or $5.
How much you should invest in dividend stocks depends on your investment objectives and strategy. For instance, if your investment strategy is focused on generating income, you may decide to allocate a larger portion of your portfolio to dividend stocks.
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Matt Miczulski is an investments editor and market analyst at Finder. With over 450 bylines, Matt dissects and reviews brokers and investing platforms to expose perks and pain points, explores investment products and concepts and covers market news, making investing more accessible and helping readers to make informed financial decisions.
Before joining Finder in 2021, Matt covered everything from finance news and banking to debt and travel for FinanceBuzz. His expertise and analysis on investing and other financial topics has been featured on Yahoo Finance, CBS, MSN, Best Company and Consolidated Credit, among others. Matt holds a BA in history from William Paterson University.
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