Some companies distribute a portion of their profits to their stockholders 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.
When you own stocks that pay dividends, you can count on receiving a regular income from your investments—in addition to any growth in your portfolio as stocks gain value over time.
For people who want to invest in the market but are concerned about its ups and downs, buying dividend stocks may be a viable strategy. “Although dividend paying stocks won't protect against market volatility, they will provide some type of positive return through income,” says John Conlon, chief equities strategist at People’s United Advisors in Burlington, Vt.
Also, owning stock in companies that pay dividends usually means you’re investing in strong, stable companies. “Companies with the cash flow to consistently pay and grow dividends through time tend to have stronger and more durable business models, as well as healthy balance sheets,” says Christopher P. O’Keefe, CFA, managing director at Logan Capital Management in Newtown Square, Penn. “These companies are more likely to survive and thrive post market volatility.”
Historically, companies with consistent growth in dividends have outperformed non-dividend growth companies. Since 1972, dividend-paying companies have outperformed non-dividend payers by over 600 basis points annualized and dividend growers by an even larger margin, according to Ned Davis Research.
As social distancing and temporary shutdown measures to limit the spread of the coronavirus are sending global economies into a steep recession, and there’s no immediate vaccine or cure yet available, “it’s very possible market returns could be low for the next 12 months if not longer,” O’Keefe says. As a result, dividends may end up providing a significant portion of investor returns this year, he says.
You can purchase individual dividend stocks, or you can purchase funds that include dividend-paying stocks. Acorns offers several dividend funds.
When choosing dividend investments, be careful. “Researching and knowing what you're buying is always important, but it is especially critical in the current market,” Conlon says. “With the economy being stalled intentionally, many companies are feeling pressure on cash flow, which puts pressure on the ability to pay dividends.”
For instance, real estate investment trusts (REITs) typically pay attractive dividends. But in the current market, many businesses are distressed financially due to the economic shutdown and are not paying their rent and mortgage payments. As a result, the yields of some REITs are strained.
In the current market, more dividend companies are also cutting, suspending and eliminating their dividends to cope with overburdened balance sheets, O’Keefe says. So be sure to do your research before purchasing stock in a company that traditionally pays dividends.
Yes, dividends count as income, so you have to pay taxes on them. Ordinary dividends, the most common type, are taxed at your normal tax rate. Each January or February, you should receive a Form 1099 from your investment firm that includes the total you earned in dividends during the previous tax year. You should include that amount with your taxable income when you file your tax return.
If the dividends are “qualified dividends,” they are taxed at the lower capital gains tax rate. However, it’s safe to assume that most dividends you earn are ordinary (and taxed at your regular tax rate) unless your investment information says otherwise.
When you purchase stocks or funds that pay dividends, you have a choice to keep the dividends in cash or automatically reinvest them into your portfolio. By reinvesting dividends, you’re “automatically in the mode of dollar-cost averaging,” Conlon says, which allows you to take advantage of stock prices at all levels of the market, never buying only at high prices.
“Reinvesting allows for a consistent dollar-cost averaging as you add to shares over time and helps grow your total investment value,” O’Keefe says. “If you are lucky enough to have your dividends paid in stock, these are not taxable if you reinvest them.”
Acorns reinvests dividends in its portfolios to fuel growth faster. “Long-term investors find that their potential income increases every year from that dividend growth and the increase in shares from the reinvestment,” O’Keefe adds.
However, if you need the dividend as a source of income, you can have those dividends flow to cash.
While dividend stocks can be important tools for boosting investment income, it’s also smart to add other types of investments to your portfolio.
A diversified portfolio that includes a variety of stocks and bonds is important for ongoing growth and to build value. For instance, if dividend stocks are down, other parts of a diversified portfolio may still be growing. During the first quarter of 2020, non-dividend paying stocks have significantly outperformed dividend paying stocks, O’Keefe says. While this is not typical during market drawdowns, it shows that a variety of different types of companies can make a stronger portfolio.
An easy way to build a diverse portfolio of both stocks and bonds is to purchase shares in exchange-traded funds (ETFs) and index funds, as these funds contain a variety of holdings. Acorns portfolios are built with ETFs, offering investors exposure to thousands of stocks and bonds.
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