Investors are constantly searching for new ways to invest their money. Often, the average investor won’t get the best or a desired return from traditional investing approaches. Here I break down both pro and cons of dividend investing for you.
In such times, they need to think beyond the basic rules of stock trading; they need to think of an alternative.
One of the best alternatives to the traditional stock trading is dividend investing.
Read more about the pros and cons of dividend investing below and see how to earn more within your portfolio.
Today, dividend investing is one of the most popular ways of generating income from stocks.
What is dividend investing? My Accounting Course defines it as investment strategy that involves the buying of stocks that pay out a dividend to generate a steady passive income stream.
If you are new to dividend investing, then you may want to understand the concept of dividends first.
It would be a huge mistake to get into dividend investing without understanding dividends first. The simplest way to define dividends would be a percentage of company’s income that is paid out to shareholders.
This means that if you own hundred shares of a company that pays an annual dividend of 5 cents, then you will receive 5 dollars a year ($0.05*100).
Companies pay out the dividend from their earnings and do not consider it as an expense.
This essentially means that the dividend paid out to shareholders has no effect on a company’s profitability whatsoever.
Another important thing to note is that dividend stock at paid at the discretion of the management.
If the management decides to minimize or eliminate a dividend at any point, it can do so without any warning.
The return on the investment relative to share price is represented by a dividend yield.
For instance, if the value of a stock is $10 and it pays a 40-cent dividend, the yield on the stock is 4% (0.4/10=4%).
As the share price changes, the yield will also change. If the share price increases, then the yield will decrease and vice versa.
There is also an extra income stream or investing strategy that I recommend while dividend investing, and that is the covered call writing on your shares.
The strategy enables you to make money on at-least 100 shares worth, so if you’re investing in stock dividends, why not covered calls too?
What Is Dividend Investing?
Now that you understand what dividends are and how they work, you can start thinking about dividend investing. It’s a process that aims to create a diversified portfolio of stocks.
Dividend investing targets companies that can pay a dividend for long periods.
Since dividends are an important indicator of a stock’s value, a company with a consistently rising dividend is generally a company that with consistently growing revenues and profits.
Investing in the dividends stock of such a company is a good idea, as the company is likely to have stable and growing revenue for a long time to come.
With the above in mind, the best companies for dividend investing are those that increase their dividend every year.
When choosing candidates for your dividend investing portfolio, look at companies with rising cash flow, stable business models, reasonable valuations, and quality balance sheets.
The Pros and Cons of Dividend Investing
We now have a basic idea about dividends and dividend investing. However, this information may not be enough for you to decide if investing in dividend stocks is right for you.
To make an informed decision, you must consider the pros and cons of dividend investing. Following are some advantages and disadvantages of investing in dividend stocks.
Pros of Dividend Investing
There are many advantages of investing in dividends. Following are some of them:
1. Generating Passive Income
One of the best things about investing in dividend stocks is that you ‘get paid to wait.’
You can generate a steady income stream without putting in any real effort or work for it. In a way, it is like earning an interest from a bank. However, the ROI potential is far greater with dividend investing.
You can use your dividend earnings to generate even more earnings. This process is referred to as compounding.
By reinvesting your dividend earnings, you can grow both your number of shares and the dividends per share.
The price of the stock increasing or not is inconsequential here; you will get a competitive return regardless of what happens with the stock price.
3. Preservation of Capital
Compared to the average company, companies that pay out a quality dividend are generally more mature and stable.
If you compare the stocks of these companies to the more speculative stock, then you will find that they hold up better in down markets.
In addition to the above, some other advantages of dividend investing include varied fluctuations and the ability to take advantage of bear markets and corrections.
Cons of Dividend Investing
Investing in dividend stocks comes with its fair share of cons. Following are some of the disadvantages of investing in dividends:
1. Double Taxation
Yes, you heard that right. Your earnings from dividend investments will be taxed not once, but twice.
The first-time tax is paid on the dividend is before you even receive the dividend.
This tax is paid by the dividend issuer on its annual earnings; these earnings generate the dividend payments made by the company.
The second tax has to be paid by you, the investor, as personal income tax on your dividend earnings over the course of a year.
2. Dividend Cut
I have mentioned this earlier as well; a company can minimize or eliminate its dividend at any time without any warning. This is because they are under no obligation to pay the dividend.
So, if you must huge investments in a dividend stock and issuer decides to cut the dividend, then you could find yourself in a great deal of trouble.
Some other cons of investing in dividend stocks include high dividend payout risks, low growth companies, and adverse effects of changes in a company’s dividend policy.
Although it is a great alternative to traditional stock trading, dividend investing comes with its fair share of pros and cons as seen above.
Therefore, you’d do well to compare the pros and cons of dividend investing before deciding to invest in it or not. Following this advice will serve you well.
Comment down below if you invest in stocks with dividends and which ones. We love to help one another so share those awesome paying dividend stocks.