If you want to build long-term wealth by investing in the stock market, you should consider adding a dividend investing strategy for your investment plan. While most investment plans will build wealth if you stick with it over the long term, a dividend investing strategy has added benefits.
There are only a few savings options that pay a reasonable rate.
Interest rates on savings accounts are close to zero. You might find an online back or two that pays close to 1%. My wife and I recently opened an account with one of those banks. When we opened the account, the rate quoted was 1.20%. Within a matter of a couple of weeks, the rate dropped to 0.95%. That's still better than most brick and mortar banks, which pay rates as low as .20%. Let me break that down for you.
If you have $20,000 in an account paying .20%, you earn $40.00 per year in interest. That's almost like keeping it under your mattress. However, 0.95% isn't a high rate either. Compared to the 0.20% rate, though, it's almost five times better, paying $190.00.
In this post, I'll walk you through six great reasons to seriously consider dividend investing as well as the best way to get started!
6 Reasons to Consider Dividend Investing
1. Favorable Tax Rates
In contrast to the savings account interest rates, the dividend rate on the S & P 500 currently is 1.95%. So that same $20,000 investment would pay you $390 per year in dividend income. Plus, the vast majority of that income is from qualified dividends. That means you enjoy the favorable dividend tax rate.
If you are in the 10% or 12% tax bracket, you pay zero tax on your dividend income. If your tax rate is greater than 12% up to 35%, your tax rate on qualified dividends is 15%. For those whose tax rate is above 35%, you will pay 20% on qualified dividend income.
What makes a dividend qualified? There are three factors.
- The dividend must have been paid by a U.S. company or a qualifying foreign company.
- The dividends are not listed with the IRS as those that do not qualify.
- The required dividend holding period has been met.
Now before the CPAs and financial planners out there jump on me, let me make something clear. I'm not suggesting you move your money out of savings accounts into dividend-paying stocks or any stocks for that matter. I am suggesting that as part of your overall investment plans, which includes emergency funds, retirement accounts, taxable investment accounts, and any other investments, having a portion invested in companies that pay dividends makes sense.
Read on for further details.
2. Higher Returns
Historically, dividend-paying stocks have outperformed the market as a whole. That is simply because, in addition to the growth of the stock itself, you get the added benefit of dividends. When you combine these two, you can achieve higher than average growth.
For example, let's look at two hypothetical stocks, ABC and XYZ. We will assume ABC pays a 3% dividend, and the stock price grows at 5% a year.
XYZ doesn't pay a dividend and returns 7% a year.
Which investment do you think provides the highest long-term growth (assuming they continue to grow at these rates)?
The answer is ABC. When you add the 3% dividend to the 5% stock growth, you have an 8% rate of return. And if ABC company increases the dividends over the years, your rate of return will only continue to go higher.
This hypothetical example plays out in real life too.
Below is a chart from Morningstar. It shows the growth of $10,000 from 1960 through 2017 invested in the S&P 500 Index.
Growing the initial $10,000 into more than $460,000 is pretty darn good. But look at what happens when you take into account dividends. In this case, dividends get reinvested to buy more shares.
The result is your $10,000 grows into more than $2.5 million!
As you can see, the impact of dividends makes a difference over time.
Note: Past performance does not guarantee the same or similar performance in the future. This chart is for illustration purposes only.
3. Passive Income
When you invest in dividend-paying stocks, you earn income every time the stock pays you a dividend. In most cases, this means you get paid four times a year. That is money you make no matter what you are doing. Think about it this way.
To earn money from your job, you have to work to earn an income. You have to show up five days a week and perform tasks. Even if you have a side hustle, odds are you are doing work, and in return for that work, you receive income.
But with dividend investing, you aren't doing any work. You could sleep in and still earn an income. You could play with your kids, binge-watch your favorite show, or even play golf. No matter what you are doing, as long as you own the shares of stock, you are earning an income. And to increase your income, you would buy more shares.
Dividends are one of the best forms of passive income out there.
4. Secure Future
Let's take this one step further. I mentioned how you earn more income when you invest more money into dividend-paying stocks. While this is true, there is another way you can make more dividend income. You accomplish this by simply holding on to these stocks for the long term.
Many dividends-paying stocks increase the amount they payout regularly. So even though you might own the same number of shares, you could earn more money every year, assuming the company increases its dividend payout. And many companies do this. Companies that have increased their dividends over the last 25 years or more are called dividend aristocrats.
Why should having an increased dividend payment be important to you? As you retire, inflation isn't suddenly going to stop. Prices will continue to rise every year. By owning dividend-paying stocks, you may be able to offset this rise in prices by earning more significant amounts of dividend income.
And in today's world, it seems no one's job is safe. Amid a global pandemic, millions of people have discovered that unfortunate truth. Unemployment skyrocketed within a couple of months. At the time we wrote this post, jobs and the economy seem to be recovering. However, it's far too early to say we are out of the woods yet.
Having multiple sources of income, like dividend-paying stocks, is a great way to provide a cushion in an economic downturn, whether from the usual business cycle or another event outside our control.
5. Lower Volatility
Do you want to find investments that don't fluctuate wildly in price? In general, dividend stocks are less volatile than stocks that don't pay or grow their dividends.
There are two reasons for this.
- Dividend-paying stocks tend to be larger, more mature companies. As a result, they often don't have as wild a price movement as the market as a whole.
- Investors in stocks that pay dividends tend to be ‘buy and hold' investors. They typically don't sell frequently. That adds a layer of stability to the stock.
While dividend aristocrats generally don't have the wild price movements, you will still see change. Please don't get the idea that investing in these stocks means you will never gain or lose money. Dividend-paying stocks do experience gains as well as losses. The difference is the movement is often much less than it otherwise would be.
For example, look at a company like IBM. They are a large business with proven revenue streams. As a result, investors know what to expect when the company reports earnings. Are there surprises from time to time? Sure there are. But for the most part, you know what you are getting when you invest here.
On the other hand, if you invest in a small biotech company, you have no idea about revenue. So when they make a discovery, the stock prices take off like a rocket. But the reverse is also true. When they have to scrap a study, the stock price can drop like a rock.
6. Long Term Focus
One of the significant flaws most investors face is impatience. When the market is rising, it is easy to stay invested. But when the market starts to fall, many investors panic and sell their holdings. Often, their fear keeps them out of the market for a long time, sacrificing returns along the way.
Investing in dividend stocks may lower the urge to want to sell when the market is falling. The reason? You're earning an income stream by holding onto your investment.
If you own a stock that doesn't pay a dividend, all you have to consider is the loss of principal. You are still losing principal with a stock that pays a dividend, but you are receiving an income every quarter. That reduces the drop in value to the extent of the dividend. This income stream gives you a reason to stay invested in the stock. When you do this, you benefit when the market turns around, and you experience the gain from the start.
How To Get Started With Dividend Investing
There are a handful of ways to get started with dividend investing. Two of the best options are investing in mutual funds and exchange-traded funds (ETFs) that invest in dividend-paying companies.
Keep in mind, though, that you cannot control the stocks they buy. As a result, the dividend yield may be less than if you built the dividend portfolio yourself. To do that, you pick and choose stocks to make up your portfolio and then invest in these companies.
The problem with this strategy had been you needed a lot of money to invest because you could only buy whole shares of stocks.
For example, if AT&T was trading for $30 a share, you needed to invest $30 to buy one share. If you wanted 100 shares, that means $3,000. It's never a good idea to own just one stock. You have to buy many more to have a diversified portfolio.
But thanks to technology, you can now get started with fractional investing. Fractional investing allows you to buy a fraction of a share of stock. In this case, if you had $3,000 to invest, you could divide it among all the stocks that make up your portfolio and be instantly diversified and start collecting dividends.
If you're someone who wants total control over what you own, this strategy is a good option. You have 100% control of your stocks and don't need much money to start investing. You could start at just $100. The only catch to dividend investing this way is to not focus only on the dividend. If possible, look for stocks with an overall dividend yield of 3% or higher. That's above what the S & P 500 pays.
That dividend income should help you keep up with inflation. While many dividends-paying stocks yield more than 3%, not all are worthy of your investment. The best strategy is to only invest in high-quality stocks that pay a healthy dividend.
A dividend investing strategy might be an excellent strategy to consider. It allows you to earn a passive income every year and potentially reduce the volatility of your stock investments. Of course, it isn't all great news. When the market drops, so too will the value of these stocks. But the chances are good. They won't fall as much as other non-dividend paying stocks.
Implementing a dividend-paying stock strategy requires taking some time to research the best stocks to buy. Another downside is diversification. Mutual funds, ETFs, and fractional investing allow you to diversify your dividend stocks. However, if all you own is these stocks, you're missing out on much more extensive parts of the market (small and mid-cap stocks, international, etc.). Though bonds are currently paying less than some dividend-paying stocks, high-quality, short to intermediate-term bonds provide some protection in a falling stock market.
If you're looking for ways to increase the passive income you get from your investments, a dividend strategy as part of a properly allocated portfolio makes sense. Be sure you understand the risks. Don't time the market. Stay invested over the ups and downs of the market.
Following these steps offer you the best chance for long-term investment success.
As a financial advisor for almost 30 years, Fred shares his expertise on personal finance, investing, and other relevant topics on Your Money Geek and many other financial media. He has been quoted or featured in Money Magazine, MarketWatch, The Good Men Project, Thrive Global, and many other publications.