What are dividend stocks? How do dividends work? Do you need them in your portfolio? Today we take a look at this sometimes-confusing asset class and what investment portfolios it works best in.

What are dividend stocks?

Dividends are payments made to shareholders based on the incoming profits of a business, a kind of profit share for participating stakeholders. It’s through having dividend-paying stocks that you become eligible to receive your ‘cut’ of this profit share.

Not all shares have the expectation of dividends attached to them. Many companies offer stock on the stock market to generate funding to reinvest in their business, using the capital to grow the business and make it a more valuable concern.

Over time this should lead to appreciation of the stock price, and you can resell the share for more than you paid (thus earning a profit), but you are never actually receiving a dividend for that stock. You pay at your entry price, and receive profit (or loss) based on your exit price.

A dividend stock, on the other hand, may not appreciate as much over time, but you receive these incremental ‘payouts’ based on the profit generated.

What types of dividends are there?

By far most dividends are cash dividends, where actual cash is returned to you. Of course, the company doesn’t come around and cut you a check personally! Mostly, you will see the dividend paid into your stock account, and you can reinvest it or authorise its payout accordingly. Dividend reinvestment is a simple yet effective strategy. Small amounts reinvested can grow into much bigger sums if an investor use them to buy even more shares that pay dividends as well.

‘Ordinary’ dividend stocks are taxed at your income tax rate, while ‘qualified’ dividend stocks are taxed as capital gains.

While much rarer, however, there are other types of dividend stock, namely:

  • Asset dividend– you receive an asset in lieu of cash, like part of a property
  • Stock dividend– your receive more stock as ‘payment’

There’s also ‘special dividends’. These are a one-time payout you may receive as a shareholder, with no expectation of quarterly repeats. Some non-dividend stocks may offer special dividend payouts at key moments in their life cycle.

What is dividend yield?

One of the benefits of dividend stocks is that regular income is paid out to you. Dividend yield is the dividend rate as a percentage of the stock price. For example, a stock trading at £200 paying out a £4 dividend, makes for a 2% dividend yield.

It’s important not to get too dazzled by the dividend yield. Seeing a big percentage figure is beguiling, but it matters what it is a percentage of. 20% of a low-value stock may not yield as much actual money as 5% of a high-value stock.

How do you find stocks that return great dividends?

It’s nice to think that you could find a few high-yielding dividend stocks and simply live on that. In fact, this is a key strategy leveraged in many pensioners’ portfolios. Don’t quit your day job just yet, however. The average dividend yield on the S&P 500  is 1.5%, and realistic expectations on individual stocks currently sit at about 1%- 3%.

On the other hand, UK stocks usually offer better dividend yields. FTSE 100’s dividend yield is currently around 3.5%  and is expected to rise 4.2% by the end of 2022.

Remember, you want your dividend stock company to thrive, too, and they need to stay profitable as well as invest in the business to grow over time, so dividend payouts are rarely massive on a per-stock basis.

When evaluating dividend stocks, you will see the terms ‘common’ and ‘preferred’. Preferred is not always the best choice. Usually, it means higher dividends but typically has a fixed redemption price too. The company may also have a ‘call option’, where you can be forced to sell back those shares after a period of time (typically 5 years). It’s usually not wise to buy a preferred stock whose call date is approaching fast.

Common stock may have a lower dividend, and if earnings fail you are behind nearly every other interested party in the pay-out queue, so may not get a dividend if earnings fail. As these can be more freely traded, the stock price tends to be more volatile than with preferred shares, too. However, should the company do well, there is no cap on the redemption price you can make, and you can never have your stock called, either.

Should you invest in dividend stocks?

They may seem safer than most of the other stocks, but they are not without risk. In the short term yes, you have income coming in, and that’s what makes them very attractive for older people’s portfolios. Many rely on dividend shares for their annual income. However, choosing dividend stocks means you are ‘betting’ on the performance of the individual stock over time, and that always comes with increased risk. A dividend-focused mutual fund can reduce this risk a little, as it gives you built-in diversification without too many fees. People like the quarterly payout of cash until they sell their shares, but don’t let that distract from the potential risk.

Dividend stocks can be part of a balanced portfolio at any age. However, they’re not really preferred by younger investors. Typically, the younger you are the more you focus on growth, not income, and stocks that are surrendering part of their profits as dividends are rarely in a growth phase.

How to invest in dividend stocks?

Dividend stocks, dividend-focused ETFs, and dividend mutual funds can all be bought and traded the same way as any other financial product. If you’re using a stock platform like Robinhood, you can simply log into your account and purchase them the same as any other product. They differ only in the focus of the packages or stocks on offer.

Dividend stocks can play a valuable role in a diversified portfolio, and while they aren’t suited to all investors, they could be the right choice for you. Especially if you are looking for a diversified portfolio. Many younger investors will also incorporate some dividend stocks to diversify their portfolios over time. Dividend payouts could be an important part of relatively risk-averse portfolios.

Do dividend stocks sound like the right match for your portfolio, or do you prefer a more aggressive approach? Be sure to let us know in the comments!

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