Would you be interested in an investment that provided income on a regular basis, in addition to its potential to increase in value over time? That regular income would be passive, earned simply because you own the investment, with no additional effort required on your part.
If this type of investment sounds appealing, you may want to consider investing in a stock that pays dividends. Curious? Here’s a guide to help you figure out whether this kind of investment could be right for you, and how to get started.
What is a Dividend?
A dividend is “a distribution of a portion of a company’s earnings, decided by the board of directors, to a class of its shareholders,” according to Investopedia.
Dividends are often paid out quarterly and can be paid in cash, stock or property. Cash dividends are most common, so I’ll focus on those in this post.
Who Might Want to Invest in Dividend-Paying Stocks?
Because they are a form of income, dividends are particularly attractive to investors looking for regular income, like retirees. This group can use the cash dividends that a stock pays to help cover living expenses, while keeping the original stock investment intact.
But retirees aren’t the only investors interested in dividend-paying stocks. Younger investors can reinvest the cash dividend back into more shares of the stock. This practice can then result in greater future dividends for the investor since he or she owns more shares of the stock. Over time, this benefits the investor much like compound interest benefits the saver.
How to Choose Stocks That Pay Dividends
There’s no shortage of dividend-paying stocks to choose from. In 2013, 81% of the S&P 500 companies paid a dividend. With all those options available, how should an investor choose?
It’s natural to want to focus on the stocks that pay the highest dividend, but another, more conservative strategy is to consider stocks that have most consistently paid a dividend. This strategy is especially useful for long-term investors who want to make sure the stocks in their portfolios continue paying dividends year after year.
These investors will want to pay attention to the Dividend Aristocrat list, made up of S&P 500 companies that have:
1. Paid a dividend in each of the last 25 years
2. Increased the dividend in every one of those years
The list is updated each year, and the 2014 edition lists 54 companies, including such well-known names as McDonald’s, Wal-Mart, and Coca-Cola.
How to Buy Dividend-Paying Stocks
Individual shares of dividend-paying stocks can be bought the same way other stocks can: either through a broker or in some cases directly from the company itself. But buying individual shares is not the only — or in some cases even the best — route to take.
Investing through a mutual fund can help you diversify your portfolio by spreading your investment across a number of different stocks, and can possibly keep brokerage fees to a minimum at the same time. Many stock mutual funds contain dividend-paying stocks, but some of those funds are designed specifically to maximize dividends for the investor.
While I’m not going to recommend specific stocks or mutual funds, you could start by checking out some of the dividend-specific mutual funds at low-cost brokerages, like Vanguard or Schwab.
What Else Should You Know?
Investing in stocks is inherently risky and dividend-paying stocks are no exception. While you can reduce your risk (and potentially your return) by choosing more conservative stocks, there is no guarantee that any stock will increase in value or that the company will continue to pay a dividend.
Ready to start exploring dividend investing? Become familiar with these terms, and do your research before jumping in:
• Dividends per Share: The dollar amount each share of stock receives
• Dividend Yield: The dividend amount stated as a percentage of the market price of a share of the stock
• Declaration Date: The date on which a company announces its intention to pay a dividend
• Ex-Date or Ex-Dividend Date: An investor needs to own the stock before this date in order to be eligible to receive the dividend
• DRIP (Dividend Reinvestment Plan): A company that offers a DRIP allows investors to automatically reinvest their dividends back into additional shares of the stock
Your turn: Are you a dividend investor? What strategies have worked for you?
Julie Mayfield is a freelance writer and blogger specializing in personal finance and lifestyle topics. She is the creator of two blogs: The Family CEO and Creating This Life.