Many types of investors, but particularly older investors searching for a steady income stream to finance their retirement years, find dividend investing appealing. The top dividend stocks can both pay a sizable dividend and increase it over time. Additionally, since investors are still concerned about inflation, this could be an especially favorable period for dividend stocks.
In times of high inflation, high-interest rates, and economic uncertainty, “dividend-paying stocks tend to be more defensive and outperform growth stocks,” according to Elizabeth E. Evans, CFP, managing partner of Evans May Wealth, an Indianapolis-based wealth management company.
However, what is the best way to benefit from dividend stocks? Here are a few tips from seasoned investors to help you make the most of your dividend stock investments.
Top tips for investing in dividend stocks
The following five tips include both things to do and things not to do. When investing, avoiding foolish decisions is frequently just as crucial as actively making wise ones.
1. Find sustainable dividends
Warren Buffett, the renowned investor, has stated that the best way to prevent loss is to find a sustainable dividend, which is his first (and second) rule. Finding a company that can continue to pay out dividends in the event of a short-term decline in business is one of the best ways to protect your investment from loss when it comes to dividend investing.
Why is an investment so dependent on a sustainable dividend? Investors will drive down the price of a company’s stock in anticipation of a dividend cut if they believe the payout is unsustainable. The stock may then suffer another round of losses as investors depart if and when a dividend cut is implemented. If the company completely reduces its dividend, a lot of big investors, including investment funds, will likely reduce their positions or maybe have to sell them all.
A simple way to determine if a dividend is sustainable is to look at the percentage of the company’s profit that is used to pay the dividend. Businesses that distribute less than half of their profits as dividends have a greater chance of withstanding a downturn in the industry without making any cuts. However, some businesses, like REITs, can easily and safely distribute more cash flow.
To determine which companies have a history of consistently increasing their payouts over the long term, investors can also look at stocks that are featured on lists like Dividend Aristocrats.
2. Reinvest those dividends
While receiving a cash payout from your stock is nice, you will miss out on the compound interest that comes from reinvesting your dividends if you spend that money. Reinvesting dividends can increase the value of your investments and provide a much-needed boost to your portfolio.
According to Evans, dividend income has accounted for over 40% of the S&P 500’s returns since the 1930s. Evans emphasizes the significance of dividends in times when the market has produced low returns. “Dividend income tends to reduce overall portfolio volatility by absorbing the price volatility of stocks.”
If you ask them to, a lot of brokerages will reinvest your dividends automatically. They’ll even purchase fractional shares so you can start using all that money right away. You will then profit even more from your payout when the subsequent dividend is distributed. When everything works well, you’ll establish a positive feedback loop where your money keeps growing with every quarterly payout.
It’s important to remember that dividends, even when reinvested, are subject to taxation. Reinvesting dividends may therefore be most effective when done through tax-advantaged accounts like 401(k)s and IRAs. You won’t owe taxes inside these accounts right away (or perhaps at all if you use the Roth versions.)
3. Avoid the highest yields
It can be alluring to choose the stocks with the highest dividends when perusing lists of the top-yielding dividend stocks on the market. That seems to be the quickest way to compound your money, after all. However, those large yields are frequently risky. They indicate a lack of confidence in a dividend’s sustainability on the part of the market, which drives down the price of stocks to make up for it.
Purchasing the highest yields “may be detrimental because these high yields are oftentimes transitory and may consist of one-time distributions that temporarily raise the yield,” according to a financial advisor and partner Brian Robinson, CFP, of Phoenix-based SharePoint, a wealth management company. “The price volatility of these securities is also typically very high.”
Therefore, it’s advisable to stay away from the highest-yielding stocks on the market unless you are an expert at investing analysis. Purchasing the highest yields may cause you to lose far more money than you would ever make from that alluring but deceptive 8 or 9 percent yield.
4. Look for dividend growth
According to Evans, dividend growth is far more significant than dividend yield.
A common mistake made by investors is to focus only on a stock’s current high yields, rather than taking into account the potential growth of the payout over time. However, if you plan to invest for decades, a growing payout will help you offset the effects of rising costs on your portfolio.
A solid dividend portfolio “should keep up with the average annual increase in the cost of goods,” says Robinson, adding, “Don’t forget inflation.”
To get an idea of how their company’s dividend growth may pan out in the upcoming years, investors can perform the following checks on it:
Dividend payout ratio: The proportion of total profits to dividends. The more securely the company could increase its dividend, the lower the number.
Dividend growth rate: The rate at which the business has historically increased its dividend. A management’s willingness to pay shareholders more could be indicated by higher growth.
Rate of earnings growth: An organization with steady earnings growth will be better able to increase dividends. For instance, a business that grows its profits at a rate of ten percent per year may be able to grow its dividend at a sustainable rate as well.
“There is a greater likelihood that a company will be able to grow its dividend and continue to deliver strong returns to shareholders over time if it can generate strong and sustainable free cash flow from operations,” says Evans.
5. Buy and hold for the long term
Investing for the long term is necessary if you truly want to turn your portfolio into a dividend dynamo. That entails selecting a reliable dividend payer and being committed to it over time. That time factor is very important, but when bad news comes in, it can be difficult to stay focused.
Examine Warren Buffett’s experience buying Coca-Cola stock at Berkshire Hathaway, his holding company. Almost thirty years ago, Berkshire paid approximately $1.3 billion to acquire 400 million shares of the beverage company. Naturally, the stock has increased and, as of September 2023, it is valued at roughly $22.4 billion. However, take a look at Berkshire’s dividend income.
Today, Coca-Cola yields a dividend of roughly 3.1 percent, which is not particularly high, but Berkshire has received an enormous return on its investment. Berkshire is expected to receive more than $700 million from Coke this year. Thus, the company’s annual dividend income exceeds its initial investment by a significant margin.
And that’s the power of dividend investing with a buy-and-hold mentality.