If you want to build long term wealth by investing in the stock market, you should consider a dividend investing strategy. While most any investment plan will build wealth if you stick with it over the long term, a dividend investing strategy has added benefits.
In fact, by investing in dividend-paying stocks, you can potentially earn a higher return with less risk.
And who wouldn’t want this?
5 Reasons to consider Dividend Investing
In this post, I’ll walk you through 5 great reasons to seriously consider dividend investing as well as the best way to get started!
1. Higher Return
Historically, dividend-paying stocks have outperformed the market as a whole. This is simply because, in addition to the growth of the stock itself, you get the added benefit of dividends. When you combine these two, you can achieve higher than average growth.
For example, let’s look at two hypothetical stocks, ABC and XYZ. We will assume ABC pays a 3% dividend, and the stock price grows at 5% a year.
XYZ doesn’t pay a dividend and returns 7% a year.
Which investment do you think provides the highest long term growth (assuming they continue to grow at these rates)?
The answer is ABC. When you add the 3% dividend to the 5% stock growth, you have an 8% rate of return. And if ABC company increases the dividends over the years, your rate of return will only continue to go higher.
This hypothetical example plays out in real life too.
Below is a chart from Morningstar. It shows the growth of $10,000 from 1960 through 2017 invested in the S&P 500 Index.
Growing the initial $10,000 into more than $460,000 is pretty darn good. But look at what happens when you take into account dividends. In this case, dividends are reinvested to buy more shares.
The result is your $10,000 grows into more than $2.5 million!
As you can see, the impact of dividends makes a difference over time.
Note: Past performance does not guarantee the same or similar performance in the future. This chart is for illustration purposes only.
2. Passive Income
When you invest in dividend-paying stocks, you earn income every time the stock pays you a dividend. In most cases, this means you get paid four times a year. This is money you earn no matter what you are doing. Think about it this way.
To earn money from your job, you have to show up five days a week and perform tasks. You have to work to earn an income. Even if you have a side hustle, odds are you are doing work, and in return for that work, you earn an income.
But with dividend investing, you aren’t doing any work. You could sleep in and still earn an income. You could play with your kids, binge watch your favorite show, or even play golf. No matter what you are doing, as long as you own the shares of stock, you are earning an income. And to increase your income, you would buy more shares.
3. Secure Future
Let's take this one step further. I mentioned how you earn more income when you invest more money into dividend-paying stocks. While this is true, there is another way you can make more dividend income. This is done by simply holding on to these stocks for the long term.
Many dividends paying stocks increase the amount they payout regularly. So even though you might own the same number of shares, you could earn more money every year, assuming the company increases its dividend payout. And many companies do this. There is a name for the companies who have increased their dividend payments each year for the last 25 years or more.
They are called dividend aristocrats.
Why is increasing the dividend payment important to you? As you retire, inflation isn’t suddenly going to stop. Prices will continue to rise every year. By owning dividend-paying stocks, you may be able to offset this rise in prices by earning larger amounts of dividend income.
4. Lower Volatility
Do you want to find investments that don’t fluctuate wildly in the price? In general, dividend stocks are less volatile than stocks that don't pay or don't grow their dividends.
There are two reasons for this.
- Dividend-paying stocks tend to be larger, more mature companies. As a result, they often don’t have as wild a price movement as the market as a whole.
- Investors in stocks that pay dividends tend to be ‘buy and hold' investors. They typically don't sell frequently. That adds a layer of stability to the stock.
While dividend aristocrats generally don' have the wild price movements, you will still see movement. Don’t think that investing in these stocks means you will never gain or lose money. These stocks do experience gains as well as losses. The difference is the movement is often much less than it otherwise would be.
For example, look at a company like IBM. They are a large business with proven revenue streams. As a result, investors know what to expect when the company reports earnings. Are there surprises from time to time? Sure there are. But for the most part, you know what you are getting when you invest here.
On the other hand, if you invest in a small biotech company, you have no idea when it comes to revenue. So when they make a discovery, the stock prices take off like a rocket. But the reverse is also true. When they have to scrap a study, the stock price can drop like a rock.
5. Long Term Focus
One of the significant flaws most investors face is impatience. When the market is rising, it is easy to stay invested. But when the market starts to fall, many investors panic and sell their holdings. Oft times their fear keeps them out of the market for a long time, sacrificing returns along the way.
Investing in dividend stocks may lower the urge to want to sell when the market is falling. The reason? You're earning an income stream by holding onto your investment.
If you own a stock that doesn’t pay a dividend, all you have to consider is the loss of principal. With a stock that pays a dividend, you are still losing principal, but you are receiving an income every quarter. That reduces the drop in value to the extent of the dividend. This income stream gives you a reason to stay invested in the stock. When you do this, you benefit when the market turns around, and you experience the gain from the start.
How To Get Started With Dividend Investing
There are a handful of ways to get started with dividend investing. Two of the best options are investing in mutual funds and exchange-traded funds (ETFs) that invest in dividend-paying companies.
Keep in mind, though, that you cannot control the stocks they buy. As a result, the dividend yield may be less than if you built your dividend portfolio yourself. To do that, you pick and choose stocks to make up your portfolio and then invest in these companies.
The problem with this strategy had been you needed a lot of money to invest because you could only buy whole shares of stocks.
For example, if AT&T was trading for $30 a share, you needed to invest $30 to buy one share. If you wanted 100 shares, that means $3,000. It's never a good idea to own just one stock. You have to buy many more to have a diversified portfolio.
But thanks to technology, you can now get started with fractional investing. Fractional investing allows you to buy a fraction of a share of stock. In this case, if you had $3,000 to invest, you could divide it among all the stocks that make up your portfolio and be instantly diversified and start collecting dividends.
If you're someone who wants total control over what you own, this strategy is a good option. You have 100% control of the stocks you own, and you don’t need a lot of money to start investing. You could start at just $100. The only catch to dividend investing this way is to not focus only on the dividend. If possible, look for stocks with an overall dividend yield of 3% or higher. That's above what the S & P 500 pays.
That dividend income should help you keep up with inflation. While there are lots of dividends paying stocks that yield more than 3%, not all are worth investing in. The best strategy is to only invest in high-quality stocks that pay a healthy dividend.
A dividend investing strategy is might be a good strategy to consider. It allows you to earn a passive income every year and potentially reduce the volatility of your stock investments. Of course, it isn’t all great news. When the market drops, so too will the value of these stocks. But the chances are that their values won’t fall as much as other non-dividend paying stocks.
Implementing a dividend-paying stock strategy requires taking some time to research the best stocks to buy. Another downside is diversification. Mutual funds, ETFs, and fractional investing allow you to diversify your dividend stocks. However, if all you own is these stocks, you're missing out on much more extensive parts of the market (small and mid-cap stocks, international, etc.). Though bonds are currently paying less than some dividend-paying stocks, high quality, short to intermediate-term bonds provides some protection in a falling stock market.
If you're looking for ways to increase the passive income you get from your investments, a dividend strategy as part of a properly allocated portfolio makes sense. Be sure you understand the risks. Don't time the market. Stay invested over the ups and downs of the market.
Following these steps offer you the best chance for long term investment success
Fred started the blog Money with a Purpose in October 2017. The blog focused on three primary areas: Personal Finance, Overcoming Adversity, and Lifestyle. During his time at Money with a Purpose, he was quoted in Forbes, USA Today and appeared in Money Magazine, MarketWatch, The Good Men Project, Thrive Global and many other publications.
In April 2019, Fred, along with two other partners, acquired The Money Mix website. To focus his time and energy where he could be the most productive, Fred recently merged Money with a Purpose with The Money Mix. You can now find all of his great content right here on The Money Mix, along with content from some of the brightest minds in personal finance.