Dividend investing involves investing in stocks that pay dividends. Dividends can be a source of income for investors, they can also indicate solid, growing companies whose stock might constitute a solid investment.

And dividends have been a popular investment strategy for decades - but it can be hard to do the research, know what companies to invest in, or what products might be worthwhile.

Before getting into what dividend investing is and why it's a smart strategy, you need a platform that you can invest on it on. Check out M1 Finance. They are a commission-free platform that allows you to easily build a dividend investing portfolio. Check out our M1 Finance review here.

What Are Dividends?

Dividends are payments to shareholders of record as a specified date that are authorized by the company’s board of directors. Dividends are a method of returning some of the company’s profits back to shareholders.

Dividends are usually paid in cash and are generally expressed as an amount per share. For example, a dividend payout might be $1 per share. Dividends can be paid at whatever interval the company’s board decides. Quarterly payments are common, especially among established companies.

Besides cash payments, stock dividends can be made. Under this scenario, shareholders will receive a designated number of shares for each share owned.

Dividends Are a Significant Component of Returns

Dividends might seem insignificant at first glance, but historically they have made up a significant part of the total return of the S&P 500¹ and other major stock market indexes.

A study of the impact of dividends on the S&P 500 index from December of 1960 through December of 2018 showed that 82% of the index’s total return was due to reinvested dividends and the power of compounding over this 50-year time horizon.

They assumed a hypothetical² investor had invested $10,000 into the index on December 1, 1960 (note you cannot actually invest in the S&P 500 index, though there are numerous ETFs and mutual funds³ that attempt to replicate the performance of the index).

If all dividends received were reinvested and allowed to compound over time, the hypothetical $10,000 investment would have grown to $2,459,158 through December 20, 2018.

Without the reinvestment of dividends, the $10,000 would have grown to just $431,397 over the roughly 50-year time horizon based solely on price appreciation.

Looking at the percentage contributions of dividends to the index’s total return by decade reinforces the importance of dividends.

*The decade of the 2000s saw a negative total return for the S&P 500 index.

Certainly, the pendulum has swung back and forth between dividends and price appreciation in importance as a source of return on the stocks in the S&P 500 over different periods of time.

For example, the decades of the 1980s and 1990s saw high levels of price appreciation in a number of stocks. The tables were turned during the 1970s and the 1940s. Over the time covered by this study, dividends made up over 40% of the total return of the index.

Dividend Yield Versus Dividend Growth

Dividend investors typically look to dividend stocks for one or both of two reasons.

Dividend Yield

Dividend yield is calculated by dividing the annualized dividend payout of the stock by the current share price. For example, a stock that pays an annualized dividend of $2 per share with a current share price of $50 would have a dividend yield of 4%. If the price rose to $56 per share, the dividend yield would drop to roughly 3.6%. The payout didn’t change, but the increase in the stock’s price would serve to lower the current dividend yield.

The annualized dividend payout that is generally used is the latest quarterly payout times four. The dividend yield will generally change daily with the price movements of the stock.

A high dividend yield can be a function of both an increased payout and/or a decline in the stock’s price.

In reaching for stocks with high yields, it’s important for investors to look beyond the dividend yield to ensure they understand why the yield is high and if the dividend payout is sustainable.

One sector whose stock often has a high yield is utilities. They have stable cash flows and often have a near monopoly in their region. While the share price may not move much unless there is some sort of abnormal event, the dividend payouts are often pretty stable.

This isn’t the case with all stocks with a high dividend yield. Retailer Macy’s (ticker M) recently had the highest dividend yield of all stocks in the S&P 500. The dividend per share has remained constant at $1.51 for the past three years. Yet the price per share of the stock has declined from a high of over $67 per share at the end of July 2015 to a recent price per share of $15.54. Macy’s might represent a good buy at its current price and yield, but certainly has disappointed long-time shareholders.

Dividend Growth

Another take on dividend investing is seeking the stocks of companies with a solid record of increasing their dividend payout per share on an annual basis. Companies that do this are generally well-managed and financially sound.

The ability to sustain and increase the dividend payout each year is a sign that the company is growing its bottom line and is generating solid cash flows.

Whether you invest in companies with a high yield or those with growing payouts, dividend investing can be a solid way to generate a stream of income from your portfolio. This might be a source of passive income as you approach retirement, for example.

S&P 500 Dividend Aristocrats

Prime examples of dividend growth are the S&P 500 Dividend Aristocrats stocks. Dividend Aristocrats are defined as stocks that are included in the S&P 500 index and who have increased their dividend payout at least once annually for at least 25 consecutive years. The first list was published in 1989 and included 26 companies.

According to the site Dividend Value Builder, there are currently 57 companies that qualify as Dividend Aristocrats as of 2019.

If you stop and think about this, the ability to even pay a dividend for 25 consecutive years indicates a company with strong earnings and cash flows. Increasing the dividend payout for 25 consecutive years or more is a sign of a company that is profitable, that is growing, has solid cash flows, and is quite likely a well-managed organization.

A look at the current list of Dividend Aristocrats reveals a who’s who of top companies, including a number of household names.

Dover Corporation (ticker symbol DOV) leads the list with 63 consecutive years of at least one annual dividend increase. Dover is a U.S. diversified manufacturer that makes products divided into three business units: engineered systems, fluids, and refrigeration and food equipment.

Three companies are tied for second place with 62 consecutive years with at least one dividend increase annually:

• Emerson Electric (ticker EMR) is a U.S. multinational and member of the Fortune 500 list. The company manufactures products and provides engineering services for a wide range of customers across the consumer, commercial, and industrial sectors.
• Genuine Parts Company (ticker GPC) is engaged in the distribution of automotive replacement parts, industrial replacement parts, office products, and electrical materials.
• Procter & Gamble (ticker PG) is a major consumer products company with such well-known brand names in areas such as baby care, fabric care, grooming, hair care, shaving, and a host of others.

Rounding out the top five Dividend Aristocrats is another well-known brand, 3M (ticker MMM) with 60 consecutive years of at least one annual increase in their dividend payout. They sell any number of consumer and office products such as Post-it Notes. Beyond this product, they offer products in the areas of worker safety, industrial products, healthcare, and consumer products.

Ways to Invest in Dividend Stocks

For investors who are interested in dividend investing, there are a number of options to consider. Note that none of these are mutually exclusive, investors can mix and match any of these into their overall investing strategy.

Individual Dividend-Paying Stocks

Investors can buy individual dividend-paying stocks. Whether or not this is a good strategy will depend upon each investor’s individual situation and their investment strategy.

A key consideration is whether or not you will be able to build a diversified portfolio of individual stocks going this route.

There are many investors who look to build a stream of income by building a portfolio of individual dividend-paying names. A caution to keep in mind is that even dividend-paying stocks are susceptible to movements in the stock market, though many are less volatile than the market as a whole.

So, let’s say you open an account with M1 Finance to build your dividend-paying stock position, I’d also recommend investing in other asset classes or mutual funds, to diversify your portfolio. 

Mutual Funds and ETFs

There are a number of mutual funds and ETFs that focus on dividend stocks either from a dividend growth perspective or a yield focus. Some examples include the following:

• Vanguard High Dividend Yield Index Fund (ticker VHDYX) attempts to replicate the performance of the FTSE High Dividend Yield Index. The companies held in the fund usually offer higher-than-average dividend yields. There is also an ETF version of the fund. The recent SEC yield of the fund was 3.31% versus a yield of under 2.0% for the S&P 500 index.
• Vanguard Dividend Appreciation ETF (ticker VIG) includes companies that have increased their dividend payout annually for a minimum of 10 consecutive years. This fund is focused on dividend growth versus yield growth. The fund is also available as a mutual fund as well.

There are several funds and ETFs that focus on the S&P 500 Dividend Aristocrats in some form. One example is the following:

• ProShares S&P 500 Dividend Aristocrats ETF (ticker NOBL) invests in an index comprised of 40 S&P stocks. The fund equally weights these 40 holdings, rebalancing the fund four times during the year. The composition of the 40 stocks is reviewed — and if needed, revised — once per year.

Summary

Dividends are an important component of return for stocks. Companies that can continue to pay dividends annually can be excellent investments, especially those that are able to consistently increase their payout levels.

It is important for investors to understand the underlying financials of any stock they might be considering, helping ensure that the company is a solid investment for them. Be sure the dividend is sustainable. It’s also important to realize that even dividend-paying stocks can get hit when the stock market corrects itself.

Mutual funds and ETFs that focus on dividends can be a good alternative. Be sure that you understand the fund’s objectives and its expenses. Make sure that these objectives are consistent with your investing goals.

Notes:

¹ The Standard & Poor's 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general.  It is a market value weighted index with each stock's weight in the index proportionate to its market value. Indices are unmanaged and investors cannot invest directly in an index.

² Hypothetical example(s) are for illustrative purposes only and are not intended to represent the past or future performance of any specific investment.

³ Mutual Funds and Exchange Traded Funds (ETF’s) are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from the Fund Company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.