One of the first things most new investors learn is thatdividendstocks are a wise option. Generally thought of as a safer option thangrowth stocks—or other stocks that don't pay a dividend—dividendstocks occupy a few spots ineven the most novice investors' portfolios. Yet, dividend stocks aren't all the sleepy, safe options we've been led to believe. Like all investments, dividend stocks come in all shapes and colors, and it is important to not paint them with a broad brushstroke.
Here are the three biggest misconceptions about dividend stocks. Understanding them should help you choose better dividend stocks.
Key Takeaways
- Many investors look to dividend-paying stocks to generate income in addition to capital gains.
- A high dividend yield, however, may not always be a good sign, since the company is returning so much of its profits to investors (rather than growing the company.)
- The dividend yield, in conjunction with total return, can be a top factor as dividends are often counted on to improve the total return of an investment.
High Yield is Best
The biggest misconception of dividend stocks is that a highyieldis always a good thing. Many dividend investors simply choose a collection of the highest dividend-paying stock and hope for the best. For a number of reasons, this is not always a good idea.
Remember, a dividend is a percentage of a business’s profits that it is paying to its owners (shareholders) in the form of cash also quoted as its payout ratio. Any money that is paid out in a dividend is not reinvested in the business. If a business is paying shareholders too high a percentage of itsprofits, it may be a sign that management prefers not to reinvest in the company given the lack of upside. Therefore, thedividend payout ratio, which measures the percentage of profits a company pays out to shareholders, is a key metric to watch because it is a sign that a dividend payer still has the flexibility to reinvest and grow its business.
Some sectors of the market have a standard for high payouts and its also part of the sector’s corporate structure. Real estate investment trusts (REIT) and master limited partnership (MLP) are two examples. These companies have high payout ratios and high dividend yield because it is ingrained in their structure.
5 Common Misconceptions About Dividends
Dividend Stocks are Always Boring
Naturally, when it comes to high dividend payers most of us think ofutility companiesand other slow-growth businesses. These businesses come to mind first because investors too often focus on the highest-yielding stocks. If you lower the importance of yield, dividend stocks can become much more exciting.
Some of the best traits a dividend stock can have are the announcement of a new dividend, high dividend growth metrics over recent years, or the potential to commit more and raise the dividend (even if the current yield is low). Any of these announcements can be a very exciting development that can jolt the stock price and result in a greater total return.Sure, trying to predict management’s dividends and whether a dividend stock will go up in the future is not easy, but there are several indicators.
- Financial flexibility: If a stock has a low dividend payout ratio but it is generating high levels of free cash flow, it obviously has room to increase its dividend. LowCapExand debt levels are also ideal. On the other hand, if a company is taking outdebt to maintain its dividend, that is not a goodsign.
- Organic growth: Earnings growth is one indicator but also keep an eye oncash flowand revenues as well. If a company is growing organically (i.e. increased foot traffic, sales, margins), then it may only be a matter of time before the dividend is increased. However, if a company’s growth is coming from high-risk investments or international expansion then a dividend could be less certain.
Dividend Stocks are Always Safe
Dividend stocks are known for being safe, reliable investments. Many of them are top value companies. The dividend aristocrats—companies that have increased their dividend annually over the past 25 years—are often considered safe companies. When you look at the S&P 100, which provides a list of the largest and most established companies in the U.S., you will also find an abundance of safe and growing dividend payers.
However, just because a company is producing dividends doesn’t always make it a safe bet. Management can use the dividend to placate frustrated investors when the stock isn't moving. (In fact, many companies have been known to do this.) Therefore, to avoid dividend traps, it's always important to at least consider how management is using the dividend in its corporate strategy. Dividends that are consolation prizes to investors for a lack of growth are almost always bad ideas. In 2008, the dividend yields of many stocks were pushed artificially high due to stock price declines. For a moment, those dividend yields looked tempting. But as the financial crises deepened, and profits plunged, many dividend programs were cut altogether. A sudden cut to a dividend program often sends stock shares tumbling, as was the case with so many bank stocks in 2008.
The Bottom Line
Ultimately, investors are best served by looking beyond the dividend yield at a few key factors that can help to influence their investing decisions. The dividend yield, in conjunction with total return, can be a top factor as dividends are often counted on to improve the total return of an investment. Looking only to safe dividend payers can also significantly narrow the universe of dividend investments.
Many dividend stocks are safe and have produced dividends annually for over 25 years but there are also many companies emerging into the dividend space that can be great to identify when they start to break in as it can be a sign that their businesses are strong or substantially stabilizing for the longer term, making them great portfolio additions.
FAQs
The stock dividend rewards shareholders without reducing the company's cash balance. It has the adverse effect of diluting earnings per share. Stock dividends may signal financial instability, or at least limited cash reserves.
What are the issues with dividend stock? ›
The stock dividend rewards shareholders without reducing the company's cash balance. It has the adverse effect of diluting earnings per share. Stock dividends may signal financial instability, or at least limited cash reserves.
What are the arguments against dividends? ›
12 The argument against dividends is based on the belief that a company which reinvests funds (rather than paying them out as dividends) will increase the value of the company in the long-term and, as a result, increase the market value of the stock.
What is the downside to investing in dividend stocks? ›
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 circ*mstances.
Why is dividend yield misleading? ›
However, dividend yields can be misleading on their own. Some companies pay out dividends even when they are operating at a short-term loss. Others may pay out dividends too aggressively, failing to reinvest enough capital into their business to maintain profitability down the road.
What to look for when buying dividend stocks? ›
These six tips can help you identify dividend-paying stocks with strong financial health:
- Don't chase high dividend yields. ...
- Assess the payout ratio. ...
- Check the balance sheet. ...
- Look at dividend growth. ...
- Understand sector risk. ...
- Consider a fund.
Not necessarily. Usually, companies adopt a mixed approach by reinvesting part of their profits and distributing the rest as dividend. There is, however, one segment of shareholders that lose out when companies pay dividend. These are investors who buy shares after the company has paid dividend.
Can you live off of dividend stocks? ›
To live off of dividend income alone, you need to receive enough dividend payments each year to cover your expenses. Once you know how much income you need to cover your expenses, you can divide that by the average dividend yield of your portfolio to get a rough estimate of how much you need to invest.
Is dividend investing a bad strategy? ›
Dividend investing can be a great investment strategy. Dividend stocks have historically outperformed the S&P 500 with less volatility. That's because dividend stocks provide two sources of return: regular income from dividend payments and capital appreciation of the stock price. This total return can add up over time.
Do dividends go down when stock price goes up? ›
While a stock's dividend may hold steady quarter-after-quarter, its dividend yield can change daily, because it is linked to the stock's price. As the stock rises, the yield drops, and vice versa.
The 4% rule is easy to follow. In the first year of retirement, you can withdraw up to 4% of your portfolio's value. If you have $1 million saved for retirement, for example, you could spend $40,000 in the first year of retirement following the 4% rule.
What are the 3 main dividend policies? ›
Stable, constant, and residual are the three types of dividend policy. Even though investors know companies are not required to pay dividends, many consider it a bellwether of that specific company's financial health.
What is the free dividend fallacy? ›
Investors caught up in the free-dividends fallacy mistakenly view dividend-paying stocks as bond coupons that produces small, stable gains over time. When investors trade based on a stock's performance, they focus on whether the stock has gained or lost money relative to the purchase price.
Is it smart to buy a stock right before dividend? ›
If you purchase a stock on its ex-dividend date or after, you will not receive the next dividend payment. Instead, the seller gets the dividend. If you purchase before the ex-dividend date, you get the dividend.
How long should you hold a dividend stock? ›
In order to receive the preferred 15% tax rate on dividends, you must hold the stock for a minimum number of days. That minimum period is 61 days within the 121-day period surrounding the ex-dividend date. The 121-day period begins 60 days before the ex-dividend date.
Which stock pays the highest dividend? ›
Comparison Results
| Name | Price & Change | Dividend Yield |
|---|
| CVX Chevron | 170.52 -0.4 (-0.23%) | 3.35% |
| EOG EOG Resources | 119.00 -1.78 (-1.47%) | 7.30% |
| ET Energy Transfer | 12.91 +0.03 (+0.23%) | 7.79% |
| ARCC Ares Capital | 18.26 -0.16 (-0.87%) | 10.41% |
5 more rowsThose who sell before the ex-dividend date will not receive any dividend payments. If an investor decides to sell after the ex-dividend date, they will receive whatever the current dividend payment is, although they are not entitled to receive future payments unless they buy shares again.
How do you make $100 a month in dividends? ›
How To Make $100 A Month In Dividends: A 5 Step Plan
- Choose a desired dividend yield target.
- Determine the amount of investment required.
- Select dividend stocks to fill out your dividend income portfolio.
- Invest in your dividend income portfolio regularly.
- Reinvest all dividends received.
Since dividends are not a function of stock price, market fluctuations and stock price fluctuations on their own do not affect a company's dividend payments.
How much to invest to get $1,000 a month in dividends? ›
The truth is that most investors won't have the money to generate $1,000 per month in dividends; not at first, anyway. Even if you find a market-beating series of investments that average 3% annual yield, you would still need $400,000 in up-front capital to hit your targets. And that's okay.
How To Make $5000 A Month In Dividends In 7 Easy Steps
- Develop a long term perspective.
- Determine how much you can allocate for investment.
- Select dividend stocks that are consistent with your strategy.
- Invest in your selected dividend stocks regularly.
- Keep investment costs and trading to a minimum.
You'll need to build your portfolio up to at least $1 million to make $100,000 each year through dividend investing. Conservative options trading will give you more capital to invest into more dividend stocks and get you closer to the 6-figure goal.
Can you become a millionaire from dividend stocks? ›
Can an investor really get rich from dividends? The short answer is “yes”. With a high savings rate, robust investment returns, and a long enough time horizon, this will lead to surprising wealth in the long run. For many investors who are just starting out, this may seem like an unrealistic pipe dream.
What is a good average dividend yield? ›
What Is a Good Dividend Yield? Yields from 2% to 6% are generally considered to be a good dividend yield, but there are plenty of factors to consider when deciding if a stock's yield makes it a good investment.
How to make $500 a month in dividends? ›
To build a dividend portfolio that pays you $500 in monthly dividends, you need at least 3 different stocks. One in each of the quarterly payment patterns. If you have 6 stocks, select 2 from each payment pattern. 9 dividend stocks, then choose 3 from each payment pattern.
Are stock dividends hurt by inflation? ›
Unlike many bonds and other investments that pay a previously determined rate of interest to investors who own them, stocks' dividends can—and often do—rise when inflation does. Companies typically pay dividends each quarter and they often adjust them based on a variety of factors.
How many dividend stocks should I own? ›
There is no hard and fast rule for how many dividend stocks to start a portfolio, but a good starting point is to aim for a minimum of 10. This will give you a good mix of different companies and sectors and help to diversify your risk.
Is it better to buy before or after ex-dividend date? ›
If you're a long-term investor and receiving income from holding dividend stocks is your top priority, buy the stock before the ex-dividend date. This qualifies you to receive the upcoming dividend payment. However, be very aware that the stock price tends to drop by the dividend payout amount on the ex-dividend date.
Are dividend stocks still worth it? ›
Dividend investing can be a great investment strategy. Dividend stocks have historically outperformed the S&P 500 with less volatility. That's because dividend stocks provide two sources of return: regular income from dividend payments and capital appreciation of the stock price. This total return can add up over time.
What happens to dividend stocks when market crashes? ›
Dividend Safety Still Matters
That being said, during most recessions the market's dividends do tend to fall. Companies that maintain or even increase their payouts during these times mask some of the drag caused by businesses that significantly cut or completely eliminate their dividends.
Look for $12,000 Per Year in Dividends
To make $1,000 per month in dividends, it's better to think in annual terms. Companies list their average yield on an annual basis, not based on monthly averages.
What is the largest dividend ever paid? ›
Apple's dividend is the largest new dividend ever paid by a company, beating the $1.3 billion record previously set by Cisco Systems, says S&P Capital IQ. Apple's dividend further extends the record dividends being paid by S&P 500 companies this year. Just Apple's dividend alone increases the S&P 500's payment by 3.9%.
What is the highest dividend yield stock? ›
Comparison Results
| Name | Price & Change | Dividend Yield |
|---|
| EOG EOG Resources | 119.00 -1.78 (-1.47%) | 7.30% |
| ET Energy Transfer | 12.91 +0.03 (+0.23%) | 7.79% |
| ARCC Ares Capital | 18.26 -0.16 (-0.87%) | 10.41% |
| HESM Hess Midstream Partners | 28.45 +0.03 (+0.11%) | 7.65% |
5 more rowsBest Dividend Stocks of All Time: McDonald's (MCD)
McDonald's (NYSE:MCD) has a 10-year annualized total return of 13.69% through Dec. 30, 2022. In 2021, it paid out $3.92 billion in dividends and currently yields 2.30%.
