Dividend Investing: What is it & How it Works

Some publicly-traded companies distribute a portion of their profits to their shareholders in the form of dividends, or payments made on a regular basis (usually quarterly). Dividend investing is an investing strategy that focuses on buying stock in companies that pay dividends, in an effort to create income. 

What is dividend investing? 

Dividend investing is an investing strategy that emphasizes purchasing stocks, exchange traded funds (ETFs), or mutual funds that pay significant dividends to their stockholders. By owning stocks that pay dividends, investors can count on receiving regular income from their investments, in addition to any growth in their investment portfolios if they gain value over time. 

For people who want to invest in the stock market but are concerned about its ups and downs, investing in dividend stocks may be a viable strategy. While dividend-paying stocks can’t protect investors from market volatility, they can provide a return through income, as long as the company continues to disburse dividends. 

That’s because dividend stocks can provide two sources of returns—regular income from dividend payments, as well as capital appreciation of the stock price. Over time, the double returns can add up. Historically, dividends have played a significant role in total returns, especially during periods when average annual returns for equities were lower than 10%, according to Hartford Funds research. 

Also, companies that pay significant dividends are often strong and stable, as they must have adequate cash flow and healthy balance sheets to consistently pay and grow dividends over time. 

How dividend investing works

When you purchase shares of a dividend-paying company, you can often expect to receive a percentage of the company’s profits as a dividend on an annual or quarterly basis. For example, if you purchase 100 shares of a company for $10 each, you’d invest $1,000. If each share pays a dividend of $.50 annually, you would receive $50 in dividends during the first year. Your dividend payments would represent a 5% yield on your investment, aside from any growth in the stock’s value. 

As an investor in dividend-paying stocks or mutual funds, you can choose whether to keep the dividends in cash or have them automatically reinvested into your portfolio. By reinvesting dividends, you take advantage of dollar cost averaging, which allows you to regularly purchase stock at various levels of the market, avoiding buying only at high prices.

Reinvesting dividends can help fuel faster growth in an investment portfolio, and Acorns Invest accounts reinvest dividends by default. However, if you need the dividend as a source of income, reinvesting may not be the right move for you. Instead, you can have those dividends flow into a cash account. Keep in mind that investment income is typically taxed. 

What is dividend yield? 

Dividend yield is a metric that helps investors understand how much return they are getting on their investment. A stock’s dividend yield is the ratio that shows how much the company pays out in dividends each year compared to its stock price. Expressed as a percentage, the dividend yield shows how much you can expect in future dividend income, based on the price of a stock today.

For example, if a company’s stock price is $100 per share, and its dividend yield is 5%, an investor can expect to earn about $5 per year, per share through dividend payments, assuming the dividend amount remains the same. Understanding the dividend yield of a stock before purchasing can be helpful for determining income expectations from that investment. 

Dividend payout ratio explained 

The dividend payout ratio is also a helpful metric for investors to consider when assessing the return on their investment (ROI) in a dividend-paying company. The dividend payout ratio is the proportion of a company’s earnings that is paid out to shareholders via dividends. It is usually expressed as a percentage.

For example, if a company’s payout ratio is 15%, that means the company pays 15% of its earnings to shareholders as dividends, and retains 85% of its earnings for ongoing operations or debt payoff.

Dividend payout ratios vary by industry and by company stage. For instance, younger companies in the development stage may add more value to shareholders by investing their earnings in new products, in order to build future revenues. More established companies may not need to invest as much in research and development and may be expected to pay out a higher percentage of earnings to their shareholders. 

How to invest in dividend stocks

Step 1: Choose form of dividend stock

You can purchase individual dividend stocks, or you can purchase funds that include dividend-paying stocks. Acorns offers several dividend-paying exchange-traded funds (ETFs) through its Acorns Invest accounts. 

Step 2: Do your research

Careful research is important when choosing any investment, but if you’re counting on the income from dividend investments, research is especially crucial. Some companies decrease or increase their dividends based on market conditions, and when cash flow pressures increase, some companies have less ability to pay dividends. Consider looking for dividend-paying investments that are expected to remain strong even if the economy contracts. 

Step: 3 Purchase the dividend stock 

While some investors prefer to select specific dividend-paying companies to purchase, it can be wise to purchase shares in mutual funds or exchange-traded funds that pay dividends instead. By purchasing dividend-paying funds, you can have exposure to a variety of dividend companies and rely on a fund manager to maintain portfolio diversification. With dividend funds, you can pursue a dividend investing strategy without the risk of choosing all the right companies yourself.