Dividend stocks can be a great asset for investors looking for regular income. Most American dividend stocks pay a set amount on a quarterly basis, and the top ones increase their payouts over time, so investors can build an annuity-like cash stream. Plus, they tend to be less volatile than growth stocks, so they can help diversify your overall portfolio and reduce risk.
So how do you invest in dividend stocks? There’s an easy way and a hard way.
Let’s start with the easy (dividend ETFs) before we discuss the more complex way (doing it yourself).
Dividend ETFs are a great path for those who know little about investing. Like much in the world of exchange-traded funds, dividend ETFs offer a simple and straightforward solution to getting exposure to a specific investing niche — in this case, stocks that pay a regular dividend.
A dividend ETF typically includes dozens, if not hundreds, of dividend-paying stocks. That instantly provides you with diversification, which means greater safety for your payout: Even if a few of the fund’s stocks cut their dividends, the effect will be minimal on the fund’s overall dividend. A safe payout should be your top consideration in buying any dividend-paying investment.
Here’s how you buy a dividend ETF:
- Find a broadly diversified dividend ETF. You can find a list of dividend ETFs on a site such as the ETF Database, a research firm that covers the ETF industry.
- Analyze the ETF. Make sure the ETF is invested in stocks (also called equities), not bonds. You’ll also want to check the following:
- The dividend yield. This is how much a company pays out in dividends each year relative to its share price, and is usually expressed as a percentage. Generally, higher is better, though anything above 3.5% should be examined more closely to assess the safety of the investment.
- 5-year returns. Generally, higher is better.
- Expense ratio. Look for a low expense ratio.
- Stock size. Dividend ETFs can be invested in companies with large, medium or small capitalization (referred to as large caps, mid caps and small caps). Large caps are generally the safest, while small caps are the riskiest.
- Buy the ETF. You can buy ETFs just like you’d buy any stock, through an online broker. A good approach is to buy them regularly, to take advantage of dollar-cost averaging.
Probably the safest choice is a low-cost fund that picks dividend payers from the Standard & Poor’s 500 stock index. That offers a broadly diversified package of America’s top companies.
Why you should buy an ETF: The biggest advantage for individual investors is that you can buy just one ETF and don’t have to track dozens of companies, which is what you’d have to do if you buy dividend stocks yourself. Buy your dividend ETF and then add money to it regularly.
Buying individual stocks
While this is the more complex way, if you’re really committed to investing right, you may not find it so hard. In fact, you may find investing to be an enjoyable hobby. And you get the added potential of finding higher dividends than in an ETF.
Finding individual dividend stocks does take more work, however, than selecting a dividend ETF. You’ll need to analyze the company and industry, evaluate the safety of the dividend and then determine how much to buy. And since an individual stock is riskier than a diversified dividend ETF, you’ll want to buy a portfolio of dividend stocks, not just one stock.
Here’s how to buy a dividend stock:
- Find a dividend-paying stock. You can screen for stocks that pay dividends on many financial sites and broker sites.
- Analyze the company. This step is probably the hardest but the most important. To make sure you choose a healthy company that can sustain its dividend for years, you’ll need to spend a lot of time understanding the company’s financial statements and industry, including:
- How well is the company positioned competitively?
- Does the industry have a strong future?
- Is the balance sheet strong and are earnings likely to grow?
- How good is management and is it aligned with outside shareholders?
- Do you see indications the company will continue to grow earnings in the future?
- Analyze the safety of the dividend. What is the payout ratio? That is, what percentage of income does a company pay in dividends? The lower it is, the safer the dividend and the faster the dividend can grow over time. A payout ratio over 80% is generally a red flag, but even that is just a rough benchmark. In some industries, you don’t want a payout ratio above 50%.
- Decide how much stock you want to buy. You need diversification if you’re buying individual stocks, so you’ll need to determine what percent of your portfolio goes into each stock. If you’re buying 20 stocks, you could put 5% of your portfolio in each (or buy 25 stocks at 4%, 30 stocks at 3.3%, etc.). However, if the stock is riskier, you might want to buy less of it and put more of your money toward safer choices.
The No. 1 consideration in buying a dividend stock is the safety of its dividend. So when buying a dividend stock, it’s absolutely crucial that you not be a “yield pig,” focusing only on the highest dividend yields. A high yield often signals that investors are skeptical of the company’s ability to sustain the dividend and that it may be in danger of being cut. That skepticism drives down share price, and a lower share price pushes the yield ratio higher.
If the market thinks the dividend will be cut and it is cut, the stock will go down and you’ll lose money. Plus, you’ll have a smaller dividend. So you get hit two ways.
Why you should buy individual dividend stocks: You like the challenge of combing over the market for attractive stocks and don’t mind — even enjoy — spending the time to do it. If you’re good, you’ll likely be able to build a portfolio of dividend stocks that offers a higher yield than what you could find in a dividend ETF.