Building up a portfolio of stable and high dividend paying stocks is one of the easiest and sure-fire ways to create a steady stream of truly passive income. Literally – you don’t have to do anything to earn the money except own the stock! How simple is that?
But before you can own them, you have to learn how to invest in dividend stocks if you want to take advantage of the rewards they bring. Just like any type of security, there are good and bad dividend stocks to purchase. In this post, we’ll talk about some of the ways to screen them and select the best ones for your passive income portfolio.
What is a Dividend Stock?
The first step in learning how to get into dividend stocks is first understanding what they are.
A dividend stock is a type of common stock that periodically pays its shareholders (i.e. you) a small payment; usually every quarter (3 months). These quarterly payments are exactly how you can make some extra money right away from owning these stocks.
Where does the money for these dividend payments come from? Generally it comes from the profits that the company has generated. Think of it as a way for the company to reward its shareholders for investing and believing in the company.
This will be a very important detail to remember as you’re doing your research because you will come across many companies that seem to offer high dividend payments despite making little or even no profits. If that’s the case, it could be a red-flag warning that the company is having financial trouble and trying to inflate its dividend yield in an attempt to attract new shareholders. While there might be some possible short-term gain to be had, use caution with these types of companies. A company that doesn’t make profits won’t be able to sustain very high (or any) dividend payments for very long.
Researching Dividend Stocks:
There are many different ways to research dividend paying stocks before you invest in them. For example, a quick Google search will quickly put you into contact with a number of blogs and websites ran by dividend stock enthusiasts.
Personally I like to invest in relatively safe and stable companies. So the first two places I look are at the stocks that compromise the major indices: The S&P 500 and the Dow Jones Industrial Average. You can easily punch in the ticker symbol into your favorite stock screener website and get all the details you’ll ever need about the company and its finances. My favorite ones to use are CNN Money and Yahoo Finance.
Things you’ll want to look for to see if the stock is a good opportunity or not:
- Dividend yield – This metric is a comparison of the dividend payment divided by the price of the stock. Stocks with yields between 3 and 5% are considered pretty high (but not too high that you should be concerned).
- Dividend payout ratio – The dividend payout ratio is a metric is a comparison of the amount of dividends per share against earnings per share. For example, a ratio of 100% would indicate that the company is turning all of its profits into dividend payments. That type of scenario would be in instable and couldn’t continue for very long. Generally stocks in the 30 to 70% range are normal. However this will vary depending on the type of industry the stock is in.
- PE Ratio (Price to Earnings ratio) – The PE Ratio is a classic stock metric that compares the market price against earnings. Generally stocks with lower PE Ratios are thought to be bargain opportunities. I bring it up here because even though a stock may seem like a good opportunity to make some dividend income, it might fundamentally be a poor investment choice. Therefore price should be considered.
A quick shortcut I like to use to keep my risk modest is to select good blue chip dividend stocks from two famous groups called the Dogs of the Dow and The Dividend Aristocrats.
The Dogs of the Dow are the top 10 stocks among the 30 stocks in the Dow Industrial Average with the highest dividend yields. People like to invest in this group because a high dividend yield indicates the price is likely below market average and a good opportunity.
The Dividend Aristocrats are a group of companies that have not decreased their dividend payouts in over 25 years; despite any financial hardships or market conditions (like bull markets or recessions). Imagine that – steady and increasing dividend payments for over 25 years despite the market price of the stock itself!
Purchasing Your Dividend Stocks:
Once you’ve got your list of purchases together, the last step to investing in dividend stocks is by far the easiest one: Go to your favorite discount, online broker (I use Fidelity), setup and fund your account, and then start making your purchases!
That’s really all there is to it. A lot of people think that buying stocks is more complicated than that – as if you have to make several trades per day or time the market. But truthfully it is a much simpler process than that. Just make sure your funds are ready to go and then make your purchase.
Once I purchase my dividend stocks, I like to give them at least a year before I make any changes to the portfolio. This is mostly due to tax reasons. In the U.S., if you hold a stock for less than a year, then it counts as a short-term capital gain and will be taxed at a higher rate. By waiting over a year to sell the stock (if I choose to do so), the stock then becomes a long-term capital gain and gets taxed at a lower rate and can be calculated using a taxcaster’s tool.
As time goes on and you begin to receive dividend payments, the money will passively collect in your core brokerage account. You can decide if you’d like to withdraw these dividend payments or use them to make future stock purchases.
One cool thing most online brokers will let you do with your dividend income payments is to setup a DRIP (dividend reinvestment plan). What this does is automatically take your dividend payments and use them to purchase more shares of the same stock. The advantage is that you can usually do this at no cost and you can purchase fractions of shares instead of whole ones. If you don’t need the money right away, it’s a pretty great way to build your portfolio up even faster!
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