Dividend investing is a strategy that gives you a truly passive income. You buy a stock, and if you choose prudently, you can enjoy a passive dividend income stream for decades. Not everyone’s personality is suitable for managing a rental property or dealing with tenants.
If you invest in dividend-paying stocks for the long term, dividends stream may one day replace your paycheck. And you don’t have to do a thing.
If you don’t find a way to make money while you sleep, you will work until you die – Warren Buffet.
1. Yields Are Not Everything
Looking at yield is an important part of dividend investing. But yield is not everything. While a high yield may be tempting, the stock may be risky. The company’s business may be struggling, for example. Typically, dividend growth (year over year increases) is low in stocks with high dividend yield.
Pay attention to other factors:
Does the company have a moat (sustainable competitive advantage)?
Can the company continue to pay dividends?
Does the company have a cushion to raise dividends in the future?
2. Always Reinvest Dividends
Let’s say you invested $1000 in a stock with a 3% yield. Your annual dividends are $30. If you reinvest those dividends, and the company raises the dividend by 10% to 3.3%, your dividend for next year will be $34. By dollar-cost-averaging into the stock with your dividend distributions, your dividend distributions will increase.
Many brokerages allow reinvesting dividends automatically. Once you set it up, you are done. Every quarter, your dividends will be reinvested in the stock while you sleep.
You may need to pay taxes on your dividend distributions. When you reinvest dividends, plan accordingly.
3. Seek Dividend Growth
It is important to invest in companies that grow dividends over time. Companies like Coca-Cola (KO), Johnson & Johnson (JNJ) and American Express (AXP) have increased dividends every year for many years.
Striking a good balance between beginning yield (yield when you buy) and dividend growth is very important. If you are focused on increasing your passive income, don’t invest in a stock with a high yield but low growth. Find a stock where the dividend yield is between 2-3%, and the dividend growth is between 7-10%.
4. Keep An Eye on The Payout Ratio
Payout ratio is defined as the dividend payout divided by the company’s earnings. That is how much of the earnings that the company pays out as dividends. If the company pays out almost 100% of its earnings, there may not be room to raise dividends in the future. But a company with a low pay our ratio can raise dividends every year for years. A dividend growth investor always looks for stocks with low payout ratios.
5. Don’t Avoid Foreign Stocks But Understand How You Are Taxed
Not all good companies are in the US. As China, India and other developing markets grow, many good companies are overseas. Investing in foreign dividend-paying stocks can be a little tricky. Some companies withhold taxes before they pay dividends, others don’t. Many foreign companies also pay dividends in their own currency, so you are exposed to foreign exchange rate risk.
Do your own research, and understand how you are taxed. You may need to file foreign taxes to get your refund if too much money is withheld.
6. Invest In Non-Dividend Paying Stocks As Well
Don’t put all your eggs in one basket. You should own dividend-paying stocks as well as non-dividend paying stocks. The allocation between the two depends on your need for passive income, your risk tolerance and your ability to tolerate volatility. In general, non-dividend paying stocks are more volatile than stocks that pay dividends.
In the long run, total return matters. The market has plenty of stocks that do not pay dividends. Make sure you have those in your portfolio as well.
Bottom Line
Dividend investing can be sound complicated. But once you understand how it works and put your money to work, you can enjoy the fruits for a long time.