Dividends: What are they and how can you make them a part of your investing strategy?

The purpose of investing your money is to grow it into more money over time, and you can do that in many different ways. One option is to invest in stocks with a strong history of paying dividends.

Here, we’ll review what dividends are and how you can use them to meet your financial goals.

What is a dividend?

A dividend is a portion of a company’s profits that the company shares with stockholders. When a company earns a profit, it can use that money as it pleases, the same way you get to control how you spend your paycheck. Some companies choose to reinvest all their profits so their businesses grow. Other companies may opt to share their profits by paying dividends to shareholders.

Why would they do that? For one thing, dividends can help keep investors happy. And sometimes, when a company is stable, it can afford to pay dividends while continuing to grow the business. Companies in this position might consider paying dividends to encourage loyalty among stockholders and build confidence in the business.

Remember, companies issue stock in the first place to raise money for the business. For that same reason, companies want shareholders to continue investing in their stock. Consistently paying dividends to shareholders can be an effective way to encourage them to keep investing.

What are the types of dividends?

Dividends fall into several categories, including cash and stock. With cash dividends – which are the most common – shareholders receive a certain amount of money per share. That cash is generally deposited directly into investors’ brokerage accounts where the shares are held.

With stock dividends, companies distribute additional shares to stockholders according to the number of shares they currently own.

How do dividends work?

Companies can choose how often they want to pay dividends, though they’re generally paid on a quarterly basis. (Some companies, however, may pay dividends monthly, twice a year or annually.)

Let’s say a company’s annual dividend is $2 per share, and you own 100 shares. If the company pays dividends quarterly, then you’d get $50 per quarter – or $200 per year.

There are also special dividends, which are one-time payments companies choose to make when they have extra cash on hand. A company may opt to pay a special dividend following a particularly strong quarter.

What are the benefits of dividend paying stocks for investors?

There are plenty of benefits to holding dividend-paying stocks in your portfolio, including the following:

What are the risks and considerations of dividend paying stocks for investors?

Though investing in dividend stocks can be rewarding, they are subject to the same risks as other stocks, along with some other impacts. Here are just some of the items you may want to consider before investing in dividend stocks.

How can you make dividends a part of your investing strategy?

Now that you understand more about how dividends work, let’s talk about how to make dividend-paying stocks a part of your investment portfolio.

Finding the right dividend-paying stocks

While plenty of companies pay dividends, investors should remember that companies can stop paying dividends at any time – either because they choose to or because they can no longer afford to. For this reason, it’s important to select companies whose dividends you believe are both consistent and sustainable if you’re looking to invest in a dividend-paying stock in particular.

Additional factors to consider when choosing dividend stocks include dividend yield and payout ratio. The dividend yield is a ratio of a company’s annual dividends per share divided by its stock price: A company whose stock is trading at $100 per share with a $2 annual dividend has a 2% dividend yield. It’s worth noting that dividend yield and stock price have an inverse relationship: When a stock increases in value, its dividend yield will decrease – and vice versa – assuming the company maintains a stable dividend payout through the shifting market conditions.

Payout ratio, which measures the percentage of a company’s earnings that are paid to stockholders as dividends, is calculated by dividing dividends per share by earnings per share. If a company’s annual dividend per share is $2 and earnings per share equal $5, you’d take $2 divided by $5 to get 0.4, then multiply that by 100 to get 40%.

A higher dividend yield means a company is paying a large dividend relative to its stock price. While that could be considered a good thing, a company sharing too much of its profits with stockholders is also reinvesting less money in the business. If that leads to less growth over time, a higher dividend yield may become unsustainable. A higher payout ratio could indicate something similar, as distributing an excessive portion of earnings to stockholders could drag on growth and make future dividend payments less viable.

Rather than chasing the highest dividend yields or payout ratios, you may want to focus on companies that have consistently paid dividends. It also can be advantageous to look for companies that have consistently increased their dividends over time.

Building a diversified portfolio

One of the most important things you can do as an investor is to ensure your portfolio is diversified. Dividend-paying stocks can help you build a diversified portfolio, as the companies that pay them are likely in a more mature stage of growth.

This type of investment can help balance out growth stocks in a portfolio, which generally don’t pay dividends, or they pay very small ones, because they’re focused on expanding the business. With growth stocks, what returns you forgo in dividends you could realize in share price gains.

Reinvesting dividends

Once you collect dividend payments, that money is yours to use as you see fit. One option is to use dividends to boost income. Another strategy is to reinvest.

Many brokerage accounts offer dividend reinvestment plans (DRIPs). With a DRIP, dividend payments that land in your account are automatically reinvested in that same dividend-paying stock. You can also reinvest your dividends manually if you want to branch out into other stocks.

The benefit of reinvesting your dividends – as opposed to cashing them out or letting them sit in your brokerage account as cash – is realizing compound returns. When you use your dividends to buy more stock, those shares can then generate their own dividends, perpetuating a cycle of growth that can lead to higher returns over time.

The bottom line

Investing in dividend-paying stocks can be a great way to generate income for your portfolio. If you’re looking to put money into dividend-paying stocks, though, make sure to research potential investments carefully. It’s also important to consider them a part of your investing strategy, not your only strategy. With the right approach, you may find that dividend stocks can help your portfolio grow over time, ultimately advancing your long-term financial goals.

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