Beginners Guide To Dividend Investing

The idea of collecting checks for the rest of your life and generating passive income can be very compelling. 

Dividend investing is a strategy that offers investors two sources of potential profit: the predictable income from regular dividend payments and capital appreciation over time. Buying dividend stocks can be a great approach for investors looking to generate income or those simply looking to build wealth by reinvesting dividend payments.

It can also be appealing for investors looking for lower-risk investments, which can often be found in dividend stocks. But like all investing there can be pitfalls along the way, and dividend stocks can be risky if you don’t know what you’re doing.

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Why invest in dividend stocks?

Whether you’re looking to generate income from dividends, which are payments a company issues to shareholders, or build long-term wealth for the future, dividend investing can be an excellent way to profit from stocks while also reducing some of the volatility that comes along with stock investing.

Let’s look at an example. Say you buy 100 shares of a company for $10 each, and that company pays a $0.35 annual dividend. You would have invested $1,000, and over the course of a year, and would have received $35 in dividend payments. That works out to a 3.5% yield, not too bad. What you choose to do with your dividends is up to you: some spending money, reinvested automatically into more of that stock or maybe a different stock. Regardless of whether the company’s stock price went up or down, you receive those dividend payments so long as the business is able to support them.

The beauty of dividend stocks is in the predictable nature of at least part of your returns, particularly if you own a diversified collection of dividend stocks across industries and risk profiles. Then you can factor regular dividends into your portfolio and choose how to best utilize them.

When you combine dividends with potential long-term capital appreciation as the companies you own grow in value, the total returns from dividend stocks can rival — and even exceed — the average returns you can expect from the rest of the stock market. Just ensure you buy established companies and don’t get too caught up in chasing the highest yield dividends, more on this later. 

The Power Of Dividends

Dividends make up a significant portion of a stock investor’s total profits in the last 50 years. Taking a look back to 1970, about 78% of the total return of the S&P 500 Index can be attributed to reinvested dividends and the power of compounding.

Historically, dividends have proven themselves a potent source of total return in diversified investment portfolios, particularly during periods of market turbulence.

Look at the table below that shows an analysis of the prior eight decades of the performance of the stock market—that is, from 1930 to the 2000s. You can see that dividends often account for more than two-thirds of the total returns.

If investors avoided dividend-paying stocks during these periods, you can bet that they would have lost most of their overall gains. Without a doubt, dividend investing is an integral element to sustainable wealth building.

Dividend yield and other key metrics

Before buying any dividend stock, it’s important to know how to evaluate them. The following metrics will help you understand how much a stock pays, how safe it is, and whether you should avoid a particular dividend stock. For more general investing terms read: 40 Investing Terms You Need to Know

  1. Dividend yield — The dividend yield, expressed as a percentage, is the ratio that shows how much a company pays out in dividends each year relative to its stock price. For example, if a company pays $1 in annualized dividends and the stock is $10 per share, the dividend yield would be 10%. Yield is also useful as a valuation metric (for instance, by comparing a stock’s current yield to historical levels) and can be useful in identifying red flags. The key thing to note here is, while a higher yield is better, a company’s ability to maintain and grow the dividend payout matters even more.
  2. Payout ratio — The dividend as a percentage of a company’s net income. If a company earns $1 per share in net income, and pays a $0.50-per-share dividend, its payout ratio is 50%. In general terms the lower the payout ratio, the more sustainable a dividend should be. 
  3. Total return — The overall performance of a stock, the combination of dividends and gains or losses from share price change. For example, if a stock rises by 7% this year and pays a 2.5% dividend yield, its total return is 9.5%.
  4. EPS — Earnings per share, is calculated as a company’s profit divided by the outstanding shares of its common stock. The resulting number serves as an indicator of a company’s profitability. In general, a company must earn more than its dividend in order to sustain it, and this metric normalizes its results to the per-share value. The best dividend stocks are companies that have shown the ability to regularly grow earnings per share over time. Companies that consistently grow earnings per share often have strong competitive advantages. The result is a company that can keep paying its dividend and potentially increase it.
  5. P/E ratio — The price-to-earnings ratio divides a company’s share price into earnings per share. P/E ratio is a valuation metric that can be used along with dividend yield to determine if a dividend stock is fairly valued. 

High yield isn’t everything

Inexperienced dividend investors often make the mistake of looking for only the highest yields. While high-yield stocks aren’t bad, in many cases, high yields can be the result of stock price that’s fallen on expectations that the dividend will get cut, and when dividends get cut A LOT of investors get out driving the share price down as well. This is a dividend yield trap!

There are a few steps you can take to avoid falling for a yield trap:

  • Avoid buying stocks based solely on the highest yield. A company that boasts a significantly higher yield than its peers may signal trouble. 
  • Use the payout and cash payout ratios to measure a dividend’s sustainability. 
  • Use a company’s dividend history as a guide. 
  • Study the balance sheet, including debt, cash, and other assets and liabilities. 
  • Consider the business and industry itself. Is the company at risk from competitors or weak demand? Many refer to this as having an economic moat, in other words a competitive advantage that gives them staying power in the their current place in the market.

A yield that looks too good to be true, sadly, often is. It’s better to buy a dividend stock with a lower yield that’s rock solid,than chasing high yield that may crash and burn. Moreover, focusing on dividend growth, a company’s history and ability to raise the dividend, can prove more rewarding than chasing yield. 

How are dividends taxed?

Most dividend stocks pay “qualified” dividends, which, depending on your tax bracket, are taxed at a rate of 0% to 20%, significantly lower than the ordinary income tax rates of 10% to 39.6% (plus a 3.8% tax on certain investment income for the highest earners).

While most dividends qualify for the lower rates, some dividends are classified as “ordinary” dividends and are taxed at your marginal tax rate. There are several kinds of stocks that often pay above-average dividend yields that may also come with higher tax obligations because of their corporate structures. The two most common are real estate investment trusts, or REITs, and master limited partnerships, or MLPs. 

Of course, this doesn’t apply if your dividend stocks are held in a tax-advantaged retirement account such as an IRA, with the caveat that some MLPs can leave you owing taxes even in your IRA. As always refer to your accountant or other tax professional for advice on your specific investments.

Dividend investment strategies

If you’re a long-term investor looking to grow your nest egg, one of the best things to do is use a dividend reinvesting plan, usually called a DRIP. This powerful tool will take every dividend you earn, and reinvest it (at no cost) back into shares of that company. This simple set-it-and-forget-it tool is one of the easiest ways to put the power of time and compounding work in your favor. This is easier than ever with major brokers and new offering DRIP investing.

If you’re building a portfolio to generate income today and won’t be able to reinvest every dividend, the best strategy might be identifying companies that pay an acceptable yield based on your income needs, with a solid margin of safety. Use the payout ratios and their historical results as a guide, as well as other valuation measures like P/E ratio to build a diverse portfolio of dividend stocks you will be able to depend on.

A Step-By-Step Guide to Understanding Dividends

If you’re new to dividend investing or just want a refresher course, my book Beginners Guide to Dividend Investing is the perfect place to start. It explains everything from the basics of terms and dates that matter to dividend holders to the beginnings of buildings your owns dividend stock portfolio. It is a one-stop place for new investors to get a great education. Discover everything you need to know about dividends and dividend investing.

Great place to start on dividend investing for beginners. This book covers all the basics needed to begin building a long term portfolio full of healthy dividend-paying stocks.

A Final Word

Dividend investing is by far one of the best ways to use the stock market to generate passive income and to increase cash flow in your investment portfolio.

Remember that not every dividend-paying stock is useful for this purpose, and you must learn to identify the profitable ones in order to continue to build your wealth.

Before you purchase any investment, you should take the time to become familiar with exactly how it works, and its inherent risks and possible disadvantages. Or seek advice from a financial advisor for more info on that read: When to Hire a Financial Advisor.

If you learn as much as you can about the dividend investing approach before you buy your first stock, you will greatly increase your chances of benefiting from regular, long-term passive income, with as little risk as possible.

The Only 3 Books You Need To Retire Rich

It’s essential to start investing as soon as you can. The earlier you begin, the higher total returns you can earn. But you also have to invest wisely, which is where investing books and knowledge come into play.

Whether you’re a complete beginner, a seasoned professional, or somewhere in between, reading investing books can sharpen your knowledge and deepen your understanding of how the market works. If you’re able to learn one new thing to apply the rest of your life from each book you read on finance and investing, you will reap those rewards throughout your life and you will be sure glad you did when it comes time to retire.

These books were written with the absolute beginner in mind, covering the fundamentals of personal investing. You don’t need any prior investing knowledge or experience to understand these books, only a willingness to learn.

These will provide you the foundation required to place you far ahead of the average investor. The three combined offer actionable steps, that are simple and well laid out. Starting with building a spending plan getting rid of bad debt and investing in dependable albeit conservative investments, likely to match the broad market over the long term allowing you to retire rich. 

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#1. I Will Teach You To Be Rich

Ramit Sethi, the mind behind I Will Teach You to be Rich  which is also the name of his blog — is an entrepreneur with deep understandings of psychology and personal finance. He’s released several online courses covering sales, psychology, business, personal finance and career development.

I Will Teach You to be Rich operates on the premise of you being in charge of your own life to include your finances. It’s written in a humorous and brash style that is aimed at younger investors looking to optimize their finances.

You’ll learn a lot about what drives spending, saving and investing. The book emphasizes the importance of overcoming “analysis paralysis” — the phenomenon where overthinking a situation can lead to a lack of action. He emphasizes how it is more important that you automatically invest in a good fund with low fees rather that stress out and spend all your time hunting and moving money around for that extra 0.2% when that difference isn’t going to make a significant difference.

While he recommends targets date funds that is a choice for you to decide, but index funds or target date will both get the job done with low fees and minimal effort on your part.

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#2. A Random Walk Down Wallstreet

Most proponents of the random walk theory apply it to short- and mid-term trading. They don’t argue that long-term values move unpredictably. they follow trends. However daily, weekly and even monthly stock prices have no consistent basis for prediction. We can see this in practice by looking at the graph on nearly any individual stock as of late, and look at how crazy some of the swings have been in 2020.

Random walk theory says it’s impossible to predict how a stock will move at any given time. In the short- and mid-term, a stock’s price doesn’t have any known relationship with either its historic value or the value of any other assets on the market. The lack of any known pattern means that standard investing tools like market timing and technical or fundamental analysis don’t work.

Most of the book focuses on the many ways used of analyzing the market to find an edge – and goes on to show us how they are largely junk.

This book is very easy to read with a sense a humor within all the great information, and the information itself is presented in a way that’s easily digestible.

If you have any interest in how the stock market works, you should definitely read A Random Walk Down Wall Street. It gives a very critical look at what people are always saying about the stock market – and why a most of it is rubbish. 

Of course, there are many other perspectives on the market, and the truth is that the stock market can be exploited by individuals, but that exploitation requires a lot of work, work that is simply not feasible for most people, and in many cases even professionals.  

The Bogleheads' Guide to Investing ebook by Taylor Larimore,Mel Lindauer,Michael LeBoeuf

#3. The Bogleheads Guide To Investing

The Bogleheads Guide to Investing contains investing advice based on the philosophy of the founder of Vanguard, John C. Bogle — who is also credited with creating the first index fund, a type of investment fund that tracks a particular market index.

This book was written by Taylor Larimore, a prolific reader of investing books and a big believer in Bogle’s long-term, conservative investment philosophy. 

The book starts by instructing you to get your finances in order as well as teaching you the right mindset, (which you already did if you read the first two books) From there, you cover all the basics of investing — from knowing what you’re buying, to allocating your assets, to retirement planning. 

It is a fantastic guide for investing for the long term, minimizing the costs and taxes associated with investing, and most of the basic principles of conservative investment (diversifying your portfolio widely, not betting the whole farm on stocks, and so on).

The book basically moves deliberately from the basics behind investing and what you need to get started, then moves from investment to investment, explaining the ins and outs of each and explaining the fundamentals of an overall investment philosophy.

This book offers a clear beginning to end describing an overall philosophy about what to do with your money. Many other books of this type simply provide a bunch of rules to follow; this one is rooted in the basic idea that you should be an investment conservative: low risk with growth targeting the long haul. It’s an interesting approach – and it makes for a very interesting book.

Summary

These books read and applied in this order can be extremely powerful in building real wealth in the long term. They will help you save more, smash debt,  automate where your money goes, maximize tax advantaged retirement accounts while still doing the things you love. In the end you too can retire rich!

5 Dividend Stocks to Consider During 2020 Market Crash

Since late March, the S&P 500 index has partially climbed back from the coronavirus-driven market sell-off that began in February. However, as of Monday, April 13, the index is still down more than 18% from its all-time high, set on Feb. 19.

During times like these, many investors are looking for rock-solid dividend stocks to help them weather the turbulence, and myself and many others take advantage of lower stock prices to lock in a high long term yield on cost.

When you invest during a bear market in a solid company with a history of increasing its dividend payments, you obtain a degree of comfort that you’ll receive cash flow while you own that stock. Even if the shares lose value during a bear market, you’ll receive income from your dividends.

During uncertain economic times like today, it’s wise to invest thoughtfully. Dividend stock investing during a bear market may reward patient shareholders with long-term profits. Below are stocks I have focused in on for my long term investments, primarily for dividends for the very long term (forever being ideal).

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Coca-Cola (KO) 

When it comes to a tried-and-true dividend stock, it’s hard to beat Coca-Cola (NYSE:KO). And investors can use the argument, if it’s a good enough for Warren Buffett, it’s good enough for you. The potential anchor to the stock has been that soft drinks, particularly of the sugary kind that Coca-Cola is known for, have sort of fallen out of favor. Part of it is due to concerns over childhood obesity and some is because of the changing tastes of consumers who are demanding various options in every aspect of their life. But Coca-Cola is navigating this pivot well. First, they’ve invested in other brands. This strategy is providing an effective hedge against potential revenue losses to the flagship brands.

And the company just released its own energy drink, Coke Energy, in January and the company is looking to get into the caffeinated seltzer and flavored water arena. Analysts are becoming bullish on the company in advance of its earnings which the company reports on January 30.

Sector: Consumer Staples   Industry:Soft Drinks
Recession Return: S&P 500 lost 55% from 2007 – 2009; KO shares lost 31%

Dividend Growth Streak: 55 years

Coca-Cola is the world’s largest beverage seller, marketing over 3,900 products under 500 brands in more than 200 countries and territories via 24 million retail markets. The company owns 21 brands that generate over $1 billion in sales including: Coke, Powerade, Dasani water, Simply and Minute Maid juices. 

Coke’s wide moat is courtesy of the world’s largest distribution network which has taken over 130 years to build up at a cost of tens of billions of dollars in marketing spending. Smaller rivals simply can’t replicate the company’s reach or brand awareness. As a result, Coke enjoys premium shelf space in almost every retail outlet in the world.
Coca-Cola’s plans for the future include continuing to diversify into healthier options where it has less share today, such as teas, juices, and water. These markets continue to grow strongly in both developed and emerging economies. 

Recently this focus on healthier beverages has helped drive mid-single-digit organic sales growth, which is among the best in the industry. Meanwhile, the beverage maker plans to re-franchise its capital-intensive bottling operations (over 900 plants worldwide) which will drastically reduce its annual costs. 

The company has had annual dividend increases for 55 consecutive years (since 1963). Management targets a reasonable 75% payout ratio over time and expects to continue to grow the dividend as a function of free cash flow. 

While the firm does need to invest somewhat aggressively in beverage categories of the future, Coca-Cola should have flexibility to keep its dividend moving higher along the way. From the company’s excellent credit rating to its recession-resistant portfolio (sales declined just under 5% during the financial crisis), support for the payout is solid. 

Meanwhile, investors enjoying Coke’s dividend can also expect below average volatility. During periods of maximum market fear, Coke shares tend to do even better. For example, during the financial crisis shares lost just 31%, outperforming the S&P 500’s slump by about 24%. The bottom line is that Coca-Cola remains one of the safest consumer staple stocks you can own if the economy hits a downturn and brings on a bear market.

Cash out Refinance to Buy Stocks?

A cash-out mortgage refinance allows you to borrow more than you owe, against your homes equity, and keep the difference as cash. Taking out a Home Equity Line Of Credit (HELOC) is another way. 

Normally the most you can borrow from your house is 80% loan-to-value (LTV). So if your home is worth $1,000,000, and you have a $500,000 mortgage, the most you can refinance would be $800,000 and receive $300,000 in cash, and this money is tax free because it’s a loan that you will have to repay but can be very powerful in building a higher net worth or passive income. 

Cash-out Refinance To Buy Stocks

With the coronavirus and other factors, the 10-year bond yield and 30-year bond yield have both fallen to new all-time lows. The 10-year bond yield is now below 1% after the Fed announced a surprise 50 bps Fed Funds cut. More Fed rate cuts in the future are very possible as well.

With many investors cash heavy and unsure how the stock market will perform in the short term, many are turning to other vehicles to hold their wealth. This should help slow any major swings in real estate prices, as investors buy into investment properties. And rental prices even through 08-09 were much less affected than housing prices and the stock market. Some may take this time to do just the opposite and free up money to buy into a depressed market and get stocks while they are on sale. 

If you are thinking of doing a cash-out refinance to buy stocks, here are some of my pros and cons.

Pros Of A Cash-out Refi To Buy Stocks

1) Lock in massive outperformance. Let’s assume the S&P 500 is down 10% for the year when you purchase stocks. You would be able to lock in 10% outperformance on your cash-out capital. No matter whether the S&P 500 continues to go down or up, you will always be outperforming.

Although it’s great to make money when it comes to investing, the next best thing is outperforming the index or your peers. If an active fund manager were to outperform his benchmark by 10%, that would plave him in the top 1% of active fund managers. Given this performance, he’d probably get a huge bonus and attract a massive amount of assets and new investors.

To gain true wealth, you must outperform the average, otherwise, you’ll always be just average. 

Related: How to Passively Invest in Real Estate

2) Take advantage of all-time low interest rates. The Fed cuts interest rates to make money easier to get and increase economic activity. The lower interest rates go, the more people and businesses tend to borrow to buy equipment, property, goods, and services. Doing a cash-out refinance to spend is in line with the Fed’s desires. 

If inflation is running around 2% and you can get a mortgage rate at 2.425%, your real interest rate is only 0.425%. The lower the real interest rate hurdle, the higher the chance of earning a greater return. From a nominal return basis, the 2.425% mortgage interest rate drag on returns is comparable to paying a traditional wealth manager to manage your wealth or investing in a hedge fund which charges 2% of assets and takes 20% of profits. 

Everybody should consider refinancing their mortgage today. But not everybody should be doing a cash-out refinance. 

3) Diversify net worth. If you have a large percentage of your net worth in real estate, you may want to do a cash-out refinance to diversify your net worth. Note that your real estate exposure will only decrease based on your increased exposure in stocks. Your absolute real estate exposure won’t decrease since you haven’t sold any properties. You just have more debt.

4) You could get a tax deduction. The mortgage interest deduction may be available on a cash-out refinance if the money is used to buy, build or substantially improve your home. In general, homeowners who bought houses after Dec. 15, 2017, can deduct interest on the first $750,000 of the mortgage. Claiming the mortgage interest deduction requires itemizing on your tax return. As always, verify your situation with your accountant. 

What to do During a Stock Market Crash.

Are there Benefits of a Bear Market?

Cheap Stocks = Massive Gains Over Time

If you act effectively, by not selling and rather continuing to purchase stocks, the more bear markets you experience as an investor, the higher the probability that you’ll retire with a bigger nest egg. Years of underperformance tend to be followed by years of overperformance and those years of underperformance present a great opportunity to purchase shares inexpensively.

Other Investors Are Scared of the Stock Market

A simple reason why so many investors and even professional money managers are scared of the stock market–in the short term is stock prices can seem arbitrary. Up one day and down the next, watching the ticker every second the market is open can cause one to wonder just what the heck is going on. 

In the short term, stock prices reflect all kinds of noise. The Fed Chairman says this or that, unemployment numbers come out, or more recently a virus spreads across the world, any of these cause the stock market to react in many ways. The point is that in the short term (About one year or less), stock prices are often the result of factors that do not necessarily reflect the long-term value of the enterprise.

When viewed long term, however, the market truly does reflect the underlying value of public companies. By long term, I mean really long term (10+ years). Stocks can be undervalued or overvalued for a decade. But given enough time, stocks will reflect the underlying value of the corporation that issued the security.

Boost your savings rate

A stock market crash can have a ripple effect on other areas of your life. For example, you may get laid off from your job, have limited access to credit or have a tough time getting clients for your side hustle. For these reasons and more, it’s important to be prepared and have cash saved up.

Experts recommend saving three to six months of expenses in an emergency fund, others as high as 12 months. While this may take some time, there’s no harm in starting to save more as soon as you can.

With increased savings, this will help you weather a storm if the stock market should crash. See last weeks post on maximizing savings.