Many investors want to make investments and then collect a paycheck every month, few months or year for the rest of their lives. If investments that help you generate such a passive income with little to no work on your end interests you, then you are a great candidate for dividend investing. This article is designed to help you understand what dividend investing is and everything else you need to know about it.
What Are Dividends?
When a company makes a profit, it can do several things with the extra income. The company may decide to invest in assets, hire additional employees or even acquire other businesses. It is also quite common for businesses to distribute some of their profits to their shareholders through dividend payments.
The management decides the portion of their profits that the company will distribute to its shareholders as dividends as well as when these dividends will be paid out. Once shareholders receive their dividends, they can decide to take the cash or reinvest it by buying additional shares.
Many companies pay dividends four times a year but there is no agreed timeline across various industries for when the payments go out. It all depends on when a company deems its financial year to start or end. Many companies end their financial years in December, some end it in April while others end it in July. You can use a company’s end of financial year date to follow company announcements to know when dividend payments will be distributed.
Dividend investing is building an investment portfolio that contains high-value stocks that pay a regular dividend. The reason why dividend investing is so attractive is that you only buy the shares once and they will keep paying you a regular income as long as the companies you are invested in honour their dividend agreements.
Dividends are paid out into your brokerage or bank account and the best thing you can do is to reinvest these dividends by buying additional dividend stocks. Doing this allows you to take advantage of the compounding effect of additional investments.
Buying Dividend Stocks
As mentioned, you need a brokerage account to purchase stocks of any kind, including dividend stocks. It is always best to go with a broker who offers you advice on the best dividend stocks to buy. Alternatively, you should consider automated investing platforms that manage your investments for you or commission-free investment platforms such as Wealthsimple. Wealthsimple makes it simple to buy dividend stocks, other types of stocks and exchange-traded funds. Wealthsimple’s finance and investment tools make it easy for investors to make money and build wealth, with their human agents standing by to answer any questions you may have. Wealthsimple also gives you a free stock once you register on their commission-free trading platform.
Key Dividend Terms to Understand
There are various dividend investing terms you should understand before you start investing. The first one is the dividend yield. The dividend yield is the percentage of the share price paid off as dividend. To work out the dividend yield, you divide the dividend per share by the price of a single share and multiply by a hundred.
The dividend yield is so important because it helps determine if a stock is worth investing in. A dividend yield of around 10% is great but you should not bother with shares that have dividend yields of below 3% unless you know that the dividend will increase in the future.
The ex-dividend date is the date when a company commits to paying dividends to its shareholders. It is on this day that money starts getting distributed to shareholders. Once things are in motion, shareholders only need to wait for a month or two for the payment date. This is the actual date that money gets into brokerage and bank accounts. Once the money arrives, some people prefer to have automatic reinvestment orders set up so they do not receive the dividends but instead receive additional shares.
Dividend Investing Vs. Growth Investing
It is important to understand that not all stocks pay a dividend and not all companies are interested in increasing their dividend payments. These companies feel that it would be better if their profits were reinvested to keep growing the company.
Some investors see growth stocks as a better alternative to dividend stocks because they have the potential to offer bigger payments. If you want to buy growth stocks, you need to consider how much the stocks will grow in a year and compare that to the dividend yield of stocks of a similar company. If the gains are higher than the dividend yield, then the growth stock would be great for you.
Why Investors Should Be Careful About Dividend Yields
Investors are always looking for stocks that have a high dividend yield. Remember that a yield of 2-3% is average, 6-10% is great and anything higher is incredible. When you find a stock with a dividend yield of above 5%, you should examine it closely to find out why that is.
The two main reasons why a dividend yield would be so high are that the company is doing great and is offering such a high return on investment. The second reason is that the stock may have fallen in price recently.
For a stock trading at $75 with a dividend of $1.50, that is a dividend yield of 2%. This is an average return. Now, consider a case where the share price falls to $25 and the dividend payout remains the same. In this instance, the dividend yield will have jumped to 6%. This is a great return but, upon further examination, you will see that this is not a great share to hold for its dividend yield.
Dividend Mutual Funds are a Great Option
The whole point of dividend investing is having a portfolio of strong dividend stocks. For new investors, this may be challenging because they may not know how to find or choose the stocks to include in their portfolios. The good news is that there are lots of high-yield dividend mutual funds that you can invest in.
The stocks in these mutual funds are carefully chosen to ensure only high-yield stocks are included. These mutual funds have a massive advantage over individual stocks. Investors benefit from the accumulation of gains from all the individual stocks in their mutual funds because each of the underlying securities pays a dividend.
The one difference between these mutual funds and individual stocks is that the mutual stocks are mandated to pay their investors at least once a year. Remember that individual dividend stocks pay up to four times a year so you should pick what works for you in that regard.
Dividend Stock Income is Taxable
Dividends are subject to what is known as capital gains tax. Capital gains tax is applicable to the profit you make on stocks. Capital gains in Canada are only paid on 50% of the profit made according to the taxation law in the province or territory you reside in. Because capital gains tax is only charged when you sell the stocks, you can keep enjoying the growth until it is time to sell them.
One thing to note is that 100% of your interest income on your stocks is taxed every year. Even though the interest does not benefit from tax credits, the dividend itself does. This means that once these tax credits are applied, you will find the dividend is taxed at a much lower rate than interest income.
Pros and Cons
If you would like to start investing in a dividend stock, you need to weigh the pros and cons carefully. The first benefit you get with dividend stock is that they provide a predictable income stream for investors. You can receive payments at least once a year without selling your stocks.
Dividend stocks are also so stable that they can provide some protection against market volatility. When the share price falls, the dividend prices of these companies’ shares do not fall at the same rate and so investors can be shielded this way.
Another benefit is that investors can take advantage of compounding to grow their portfolios without adding additional funds. All they need to do is reverse their dividends through their brokers or automated systems.
The one downside of dividend investing is that the dividend sometimes underperforms growth stocks over the long term. Also, the dividend yield of some dividend stocks can be misleading. This happens in cases where the share price falls, and the dividend remains the same.
Lastly, dividend payments are taxable. Depending on where you live, you may be able to apply tax credits that lower the overall taxation rate but the bottom line is that you will still have to pay some tax once you sell.
Dividend stocks are a great option for investors who want to create a passive income stream without selling off their stocks. Investors can buy individual dividend stocks or buy mutual funds that allow them to invest in numerous stocks at the same time.