Updated November 11th, 2021
This is a guest contribution by Ethan Holden, with updates from Ben Reynolds.
Investing in dividends allows an investor to take advantage of many aspects of investing while moving away from reliance on inherently volatile stock market prices.
Dividend investing consists of a strategy which emphasizes stocks that pay significant dividend payments to create income.
These dividends are the (typically) quarterly payments that companies offer to their shareholders, partially as an enticement to keep their shares. Dividends are paid based on a per share basis (each share is entitled to a dividend payment), with an ex-dividend date being the deadline for making the stock purchase.
Many stock trading platforms offer numerous metrics and tools available to help with a dividend-focused approach. FSNB’s online portal allows prospective traders to study dividends, analyze the yield of dividends relative to their stock price, and track the performance of their dividend-earning stocks over time. FSNB and other platforms also offer a dividend reinvestment plan, known as a DRIP, that automatically reinvests any money earned from a dividend into the stock account.
Pro #1: Insulation From The Stock Market
One of the many advantages of investing based on dividends is the insulation from the stock market. The stock market can hardly be predicted with any accuracy. Stocks fluctuate based on the fickle demands of investors and the actions of massive hedge funds and other large companies.
Famous investor Warren Buffet believes that the movements of these actions cannot be predicted by anyone. He once argued that no investor could outperform the general market over a period of ten years using technical analysis.
Stocks rise and fall due to people trying to predict which events will tip the stock market and which events will make securities more profitable.
The average investor does not have the same technology and access to information that many institutional investors have and is at a disadvantage in these guessing games as well. Also, they do not have the same ease of liquidity in their stock purchases. Most brokerages make money with every stock trade. An investor may have to pay a few dollars every time they buy or sell, cutting into any returns that they hope to receive from buying low and selling high.
Pro #2: Varied Fluctuation
Dividends do not fluctuate in the same way. At its heart, dividend investing is based on a handful of presumptions that are baked in every quarter.
A company’s dividend can be predicted based on a variety of factors. Companies that are young and in a growth phase expect that their rapidly increasing stock price will woo investors and that they will not need to offer any enticement to keep those investors. As a result, those dividends will be small.
In addition, weaker companies of any size will not have the resources to offer a dividend.
Instead, an investor can look at a company with safe, reliable cash flows and a history of paying dividends and conclude that they will offer a reliable dividend into the future.
Pro #3: Dividends Can Provide A Reliable Income Stream
A dividend investor can use the reliability of dividends to pursue portfolio growth in a different way than the traditional stock market. Traditional stock market gains are often a fluctuation that cannot be easily predicted. Gains will often be punctuated by eventual losses.
In the case of dividends, the magic of compounding is much more important. Compounding refers to the way interest increases, especially when dividends are reinvested as part of a DRIP plan.
The compounding effect is most clearly displayed in the rule of 72.The rule of 72 is a heuristic used to find the approximate time in years it will take an investment to double given a certain interest rate.
Investors who use a DRIP can find the approximate time an investment will double from dividends alone, without factoring in any growth, by dividend 72 by the current dividend yield. As an example, a stock with an 8% yield – like Dividend King Altria (MO) – would double from its reinvested dividend alone approximately every 9 years.
During times of uncertainty and savings accounts that only yield a few tenths of one percent per year, an approach to investing that can double an investor’s money that quickly will be particularly fruitful and attractive as an investment opportunity.
In addition, blue chip dividend stocks can provide a reliable income stream similar to other forms of investing such as real estate or bonds. Dividends pay a set number of benefits on a date that can be predicted months in advance. They can provide tidy sums of income for people who may be interested in living on investment income over an extended period of time. These individuals do not want a massive lump-sum payment or the periodic selling off of stock. Rather, they want to keep their stock’s initial investment value while also bringing in a source of income that can either augment or replace their employment income. This form of investment payment can even be tailor-made to be more regular.
One approach to investing in dividends is called a “check a month” strategy. This strategy is tailor-made for those who want a regular income from their investments and do not want to take advantage of DRIP programs. The “check a month” refers to how stock purchases are structured. Companies declare and pay dividends at different times throughout each of the four quarters during a year. If properly set up, a fund can be structured where the investor receives a different set of dividend checks each month, meaning a constant stream of income.
Separately, the webinar replay below covers how to generate rising passive income from dividend investing in detail.
Con #1: Less Potential For Massive Gains
One downside to investing in stocks for the dividend is an eventual cap on returns. The dividend stock may pay out a sizable rate of return, but even the highest yielding stocks with any sort of stability don’t pay out more than ~10% annually in today’s low interest rate environment, except in rare circumstances.
A high-growth stock strategy could lead to massive losses, but the ceiling on gains is much higher. For instance, an individual who was picking stocks and bought Apple in the 1980s at a significant level would be incredibly wealthy by now.
Buying a number of high-dividend stocks will not lead to growth at a similar level. It is also incredibly easy for a dividend to go down over time as a company’s growth model changes. Even if a company has the highest dividends manageable, they still will not have the kind of yield that most growth investing approaches will have, along with all the other risks to principal that stock investing may have.
Con #2: Disconnect Between Dividends & Business Growth
Another potential downside of investing primarily for dividends is the chance for a disconnect between the business growth of a company and the amount of dividends the company pays.
Common stocks are not required to pay dividends. A company can cut its dividend at any time. Typically, dividend cuts occur when a company is struggling and cannot pay its dividend with its cash flows.
But that’s not always the case…
Sometimes a company will reduce its dividend because it changes its capital allocation policy. A company may believe it has better uses of cash than to pay a dividend to shareholders. Instead, the company may invest more in the growth of the business, fund an acquisition, pay down debt, or repurchase shares.
In all of the above examples, the company could very well be seeing underlying business growth and still decide to reduce its dividend. A con of dividend investing is that dividends from common stocks are not legally required, and therefore can be discontinued at management’s whim.
Con #3: High Yield Dividend Traps
Exceptionally high yielding dividend securities may look appealing… But they often carry outsized risks of a dividend reduction. Ultra-high yield securities with a high risk of reducing their dividend payments are called dividend traps.
An investor must do his homework in order to figure out the true nature of a company’s stock yield. Since yield is a fraction dependent on both dividend and price, a dividend may seem incredibly high even though it is about to be cut the next time an investor is eligible for a dividend payment.
For an extreme example, say a company’s dividend is $1 and the share price is $50. The initial yield would be 2%, not particularly attractive for a dividend-based strategy. But if the stock price dropped to $10, the yield on the stock would then be 10%, prime territory for a yield hungry investor.
However, it is clear that the company did not intend to pay a dividend that was five times the yield it had originally believed it would be. Therefore, if there were no compelling reason for the share price to increase closer to $50, the company would probably drop the dividend significantly for the next ex-dividend date, making the investment not nearly as lucrative as it would otherwise be.
Investing in dividends should not be an approach investors take without first doing their due diligence. This approach requires a considerable amount of time and research – especially when investing in individual stocks.
Knowing about the positives and negatives of dividend investing is a good first step to figuring out if this approach to investing is right for you.
Further Reading: The 8 Rules Of Dividend Investing.