Read on to learn more why M1 Finance is my favorite online broker for getting started with dividend investing.
I started learning how to invest in dividend stocks in 1995 when my uncle gifted me one share of Chevron stock for my 20th birthday. Since then, I’ve built a portfolio of 50+ stocks in my that pays me more than $7,000 every year.
Dividend stocks are only one portion of my overall investment strategy. I also invest in index funds, growth stocks, high yield savings, a few managed mutual funds, and real estate through REITs and crowdfunding sites.
But dividend stocks remain a core investing tool. The income generated will help fund my living expenses in retirement without having to draw down my savings.
In this article, you’ll learn the step-by-step process for how to start investing in dividend stocks.
My intent with this article is twofold; to help determine if dividend investing the right strategy for you, and, to give you the basics for getting started.
Dividend investing is not a perfect strategy. You need to consider both the benefits and downsides as compared to other strategies if you’re thinking about building yourself a portfolio. However, it is an elegant and intuitive strategy, one that can help create freedom in your life if deployed with discipline and persistence.
This article will be updated and refined as a cornerstone article on my site. Contact me with suggested improvements.
This article is long (6000+ words), so utilize the table of contents to skip around (click to expand). Sponsored links are in bold.
For guidance on where to invest, check out this guide: Best Online Brokers for Dividend Reinvestment.
Before getting started with the how-to portion of this article, it’s essential to understand some basics about dividends. You should also carefully consider if dividend investing is the right strategy to achieve your investment objectives.
Why Do Companies Pay Dividends?
Publicly traded companies are owned by the shareholders, which consist of employees, institutional owners, short-term traders, and ordinary investors like you and me. Each shareholder owns a small piece of the company by owning the stock.
Company management may choose to share profits with shareholders in the form of a dividend. Companies usually pay dividends quarterly, but can also be monthly, semi-annually, or one-time payments.
The practice of paying dividends to shareholders was first done back in the 1600s by the Dutch East India Company.
Many companies do not pay dividends to shareholders, and the ones that do are under no obligation to continue paying them.
Profit-sharing is the primary reason why companies pay dividends. But there are other reasons.
Corporations ultimately answer to the shareholders. If a majority of shareholders want something to happen, it will happen. For example, shareholders can hold votes to reduce or increase executive compensation.
Dividends are, in part, paid to shareholders to keep them happy. When a dividend payment is cut or eliminated, the executive leadership has to answer to the shareholders.
Unable to invest for growth
Some corporations pay dividends because there is no better use for the excess cash flow. Utilities, for example, have historically paid dividends to shareholders because their growth potential is limited.
One criticism of corporate dividends is that paying them handcuffs the company from investing for growth.
When a portion of profits is paid to shareholders, what remains becomes more valuable to management. Companies are forced to be more prudent with their employee compensation and capital investments.
High-growth companies that do not pay a dividend, such as Facebook and Google, are often criticized for frivolous spending practices and lack of financial discipline.
Attract Long-term Investors
Historically, dividend stocks tend to attract longer-term investors, such as retirees investing for income. A typical income investor has a different profile than a Tesla or Netflix investor.
These days, with the prevalence of ETFs and passive investing, this is less of a consideration.
Are Dividend Stocks the Right Investment for You?
Dividend investing is not the right strategy for most people.
If you’re not willing to put time into research or don’t know how to evaluate a stock, you’re better off in index funds or ETFs.
Do not invest in individual dividend stocks instead of maxing out your employer-sponsored retirement accounts (401(k), 403(b), TSP, etc.). Max out those accounts first.
Then, eliminate all high-interest consumer debt, and put a cash emergency fund of 3-6 months of living expenses in a high yield savings account
If there’s excess cash flow left over each month after completing those milestones, dividend investing is one strategy to consider. Compare a dividend strategy to accomplish your investment objectives against growth stocks, real estate, bonds, commodities, side businesses, and alternative investments.
Investing in individual dividend stocks carries a higher risk than investing in the broader market with index funds, ETFs, or managed mutual funds because of limited diversification.
Therefore, you should build a portfolio of several stocks over time, performing due diligence on each stock purchase. This requires two critical components:
- Enough time to perform stock analysis
- A thorough understanding of dividend stock evaluation practices
Another essential consideration is your investment objective.
Do you want to beat the market? Or are you interested in building an income stream?
Though studies have shown that a disciplined dividend growth strategy has outperformed the market over various long-term investment horizons, beating the market as an individual investor takes a tremendous long-term effort no matter how you invest.
Dividend stocks can be a useful vehicle to build an income stream, either to supplement your salary or to fund retirement expenses.
But using stocks to build an income stream in taxable accounts will create a taxable event (the dividend income taxed). To eliminate the burden of taxation, invest in tax-advantaged accounts. Think about your investment strategy in the context of your overall tax planning.
Remember, any time you invest in the stock market, you may lose money. Don’t invest money you can’t afford to lose.
How to Invest in Dividend Stocks (Step-by-Step)
Step 1: Choose a Dividend Stock Investing Strategy
The right dividend strategy for you depends on your age, risk tolerance, and willingness to research stocks. Here are the four basic strategies (with several overlapping qualities):
- Dividend Growth Investing
- Dividends for Current Income
- Dividend Reinvestment Plans (DRIPs)
- Pie Investing (aka Diversified Dollar-Cost Averaging)
Dividend Growth Investing
The dividend growth strategy focuses on buying stocks that have a long history of paying and growing the company’s dividend. The goal is to invest in high-quality stocks, each with a wide economic moat (i.e., a strong competitive advantage) that are expected to grow earnings above the rate of inflation over time.
Within the pool of these stocks, the investor aims to buy those stocks which are currently undervalued based on historical valuation metrics.
Investors typically buy a diversified portfolio of stocks with varying attributes, including sectors, dividend yields, and dividend growth rates.
Sectors are the different categories of companies, such as utilities, energy, technology, consumer, financial, etc.
The dividend yield is like an interest rate. If a company’s stock yields 3%, a $1,000 investment will earn $30 ($1,000 x .03) over the next four quarters ($7.50 per quarter).
The dividend growth rate is the annual percentage increase in the dividend payment. For example, if a company paid a $1.00 dividend per share in 2018 and $1.10 in 2019, that’s a dividend growth rate of 10%.
High-yielding companies usually have a slower dividend growth rate (AT&T, for example), while faster-growing companies with lower yields often have a higher dividend growth rate (Visa, for example).
A diversified portfolio of stocks with different attributes will return good current income and future dividend growth.
With this strategy, dividends are usually ‘pooled’ into a cash account within a low-cost brokerage. When enough money is available to buy another stock, the investor chooses the most undervalued dividend growth stock currently on a watch list, then makes a purchase.
Dividends for Current Income
Older investors who are looking to create an income stream in retirement use dividends stocks for current income. That means they are more interested in higher-yield stocks rather than the dividend growth rate. Typically, these investors look for stocks that yield higher than 4% and have a strong balance sheet for sustainable payments.
Certain types of companies, such as utilities, telecoms, real estate investment trusts (REIT), and master limited partnerships (MLPs), are common investments for those seeking higher yields.
Dividend Reinvestment Plans (“Dripping”)
What is DRIP investing?
Dripping is an old-fashioned way to invest in stocks. Instead of investing through a broker (in “street name”), you invest through a transfer agent that enables direct investment in a company’s stock (in “shareholder name’). Learn more about street name vs. shareholder name here.
In the old days, you’d receive a stock certificate, then be automatically enrolled in the dividend reinvestment plan, or DRIP. Back then you invested by sending checks in the mail and you’d receive a statement every month. Now it’s mostly done online through transfer agents such as Computershare.
DRIPs are a suitable way to dollar-cost average into a single stock if you make regular contributions of equal amounts. A benefit of DRIP investing is the ability to own fractional shares.
Certificates are less common these days, but most dividend-paying blue-chip companies still have DRIPS, also known as direct stock purchase plans (DSPPs).
Before easy access to online brokers, DRIPs were the only way to invest small dollar amounts into stocks because most advisers and brokerages required large minimum investments.
With the increase in low-cost online brokers and smartphone applications, DRIPs are no longer a good choice because you can only invest in one stock at a time.
Multiple DRIPs create a headache at tax time, and dripping makes it more difficult to diversify your portfolio.
Pie Investing (aka Diversified Dollar-Cost Averaging)
Pie investing is a strategy similar to dripping in that the investor can make regular contributions of an equal amount on a set day every month or week. However, with a pie, you can invest in several stocks with a small amount of money.
M1 Finance is a no-fee online broker that made this method possible, taking the best of DRIP investing combined with easier diversification and consolidated tax statements.
To invest with pies, the investor selects a group of dividend growth stocks and chooses the percent allocation for each stock. For example, if you choose eight stocks, each one would be 12.5% of the pie (or whatever percentage you set).
When you contribute to the account, the dollar amount invested is allocated to the stocks to match the set percentage of each. Stocks that have appreciated since the last investment will get less of the new investment, and the companies that have recently decreased will get more.
Fractional share ownership is permitted.
By investing equal amounts at regular intervals, you’re dollar-cost averaging into the total portfolio. Dollar-cost averaging is a valid strategy that takes the emotion out of investment timing.
To learn more pie investing, read my M1 Finance review, which explains the strategy in detail.
Step 2: Select the Best Account Type and Online Broker for your Objectives
Tax-advantaged accounts such as a traditional IRA or Roth IRA are the best place to create a dividend stock portfolio. Dividend income is not taxed in these accounts. However, there are limitations on contributions and eligibility.
The other option is to invest in an individual or joint taxable account. If there’s money left over after maxing out retirement accounts, you can put it here to invest in dividend stocks or other investments. But the dividends are taxed.
Some brokers also offer custodial accounts for minors.
When looking for an online broker for your dividend investment account, there are several factors to consider.
- Fees – What is the cost to make a trade?
- Tech platform – Do the desktop and mobile fit your needs?
- Reputation – Is the company legitimate and like by its customers?
- Investment selection – Is there access to most stocks and low-cost mutual funds and no-fee ETFs?
- Existing relationship – Do you already have an employer-sponsored retirement account? You may be able to use the same broker for other account types.
Over the years, I’ve used a few different online brokerages, but have ultimately consolidated to just two: Fidelity and M1 Finance. I conduct the bulk of my dividend growth investing in my Fidelity account and dollar-cost average into a pie of ten stocks at M1 Finance.
I chose to consolidate to Fidelity because that is where several of my retirement accounts were already held, including my employer-sponsored plan, and my former 401(k) rollover at Vanguard. My wife also has two accounts there.
For nearly two decades, I used TD Ameritrade as my primary account but moved it to Fidelity to consolidate and simplify. I was pleased with TD Ameritrade, especially the dividend projection tool.
But trades are a bit pricier at $6.95.
Big news, on October 1st, 2019 in response to Charles Schwab, TD Ameritrade announced it is now commission-free.
I like and recommend all three.
Most online brokers are sufficient for the needs of dividend investors. So the broker you chose is a personal preference, combined with the bullet points outlined above.
Other brokers I’ve evaluated and recommend include:
- Robinhood – The original no-fee broker, primarily a smartphone app
- Ally Invest – Full-service online broker, trades as low as $3.95
- Interactive Brokers – Low-cost trading and the best margin rates in the industry; recently added an no-fee trading option
- TradeStation – Solid full-service online broker geared toward active traders. $5 trades
Step 3: Research Stocks
Stock research is a critical component of dividend investing. If you don’t have the time or knowledge to do appropriate stock research, find another investment strategy.
Free Research Tools
The internet is home to many free research tools to perform due diligence on potential dividend stock investments.
My favorite free resource for researching dividend stocks is available on the website Dripinvesting.org. Go there and download the free Dividends Champions, Contenders, and Challengers list (the “CCC” list).
It’s a monthly compilation of stocks that have paid and increased their dividends for 25 years (Champions), 11-24 years (Contenders), and 5-10 years (Challengers). The spreadsheet has a ton of cool data if you’re into awesome spreadsheets full of stock data.
Another source that I’ve used for more than two decades is Yahoo Finance. Yahoo Finance is still the leading investment site on the internet. I use the portfolio tool to track my investments. I love the Key Statistics page that’s available for every stock quote.
Your brokerage should have plenty of research tools too. My primary brokerage, Fidelity, has an excellent array of analysis tools and data access. TD Ameritrade is also excellent for research.
I’ve created a free research tool, the Dividend Aristocrat Best Value Ranking tool. Use it as a starting point for your research and selection refinement. The Dividend Aristocrats is only composed of 50+ stocks. The CCC list is more comprehensive.
Use other peoples opinions to challenge your own. But do not buy or sell a stock based on an article on the internet or a TV pundit alone.
Paid Dividend Stock Newsletters
So-called experts are quick to mention a stock for further research, but it’s not as often that they recommend buying a stock.
That’s where paid newsletters come it. For a reasonable annual fee, you can receive actual recommendations on what stocks to buy and hold. You still need to perform research on your own, but they are good starting points.
Stock newsletters are transparent about their methodologies. If you understand and agree with the investment criteria, you can put more faith in the recommendations.
I subscribe to and recommend Sure Dividend for dividend investors. The newsletter recommends ten top dividend stocks every month. But it also ranks several hundred other dividend growth stocks, breaking them out by sector and safety rating.
Sure Dividend is very clear about its investment criteria for buying and selling stocks. I use this newsletter as a starting point for ideas. Then I perform further due diligence on whatever stock interests me the most, base on the sectors that need more exposure in my portfolio.
Use the Sure Dividend coupon code “rbd31off” to save 20% on your annual subscription. It’s well worth the money.
Dividend Growth Investor, a long-time anonymous blogger, also has a paid dividend newsletter that shares his monthly dividend stock picks.
Step 4: Buy Stock
Once you’ve determined your strategy, opened a low-cost online broker account, and done adequate research on several stocks, you should be ready to make your first purchase.
For your first stock, I recommend selecting not only a stock that you find attractively valued but also a company that you know and like.
This is because investing in companies is ownership, and you should be proud of the stock you own. Plus, you should already understand the business model, making it easier to follow its quarterly performance.
If you’re buying through a traditional brokerage, select one stock to buy first. If you’re following the pie investing strategy, select a group of at least five stocks to get started.
Invest only a fraction of what you can afford your first time to get used to the process. You’ll be more comfortable once you own your first position and can always increase your investment amounts as your portfolio grows.
Step 5: Track Dividend Income
The account data in online brokerage accounts is usually sufficient for tracking dividend portfolios. However, dividends investors are often meticulous about tracking every dividend earned, down to the penny.
To estimate your forward annual dividend income, multiply the number of shares owned by the annual dividend amount for each stock.
Once you have more than five or ten stocks, this process becomes tedious.
I’ve developed a preferred method for tracking dividends. I explain the process in detail in the post, How I Track Dividend Income in Excel.
There’s a free spreadsheet linked in the article, where I explain how to use it.
Another blog called Two Investing has a free Google Sheet that automatically integrates external data sources into the spreadsheet, calculating everything for you. Slick and free.
The ability to measure progress is one of the great joys of dividend investing.
Step 6: Monitor Portfolio
The final step is to monitor your dividend stock portfolio. Unfortunately, not all companies last forever. Some go out of business, some merge with others, and sometimes companies stop growing.
Since consistent dividend growth is the goal, a dividend cut is one reason to sell a stock. Ideally, you want to sell before it cuts the dividend. Other reasons to sell include accounting irregularities, negative growth, significant overvaluation, and negative long-term industry trends.
If you have a portfolio of more than ten stocks, you need to have a system in place to monitor your portfolio. Yahoo Finance has always been a source for portfolio news, but unfortunately, the website has become overwhelmed with ads.
A free service I recommend and use to track my portfolio is Seeking Alpha. Input your portfolio holdings, then request to have emails sent to your inbox for any new or earnings.
At a minimum, investors need to read the earnings headlines about your portfolio every day.
I also recommend tracking the total return on your dividend portfolio. I use Personal Capital to monitor all of my investments. Motley Fool also has an excellent free tool to monitor your investments against the S&P 500 index, but it requires manual input.
Common Traits of Quality Dividend Stocks
Read the Dividend CCC list at DRIPInvesting.org, and you won’t recognize many of the names. Quality dividend stocks tend to be boring, unknown companies in businesses you don’t think about very much. Industries include utilities, defense, consumer goods, energy, industrial goods, retail, telecommunications, and financial.
Many companies operate wide-moat business units where disruption is unlikely because of the nature of the business.
An example of a typical company I like to give is Dover Corporation. The company that has paid and increased its dividend for more than 60 years.
One of its business divisions manufactures grocery store refrigeration products. It’s a wide moat business with very high barriers to entry because you can’t just start manufacturing new grocery refrigerators.
And nobody wants to because it’s not a high-growth business.
But the business is profitable, and revenue is predictable and mostly recession-proof.
Quality dividend growth companies tend to have conservative management teams that put their customers and shareholders above everything else. The dividend growth should match the earnings growth over long periods. Management must also be willing to cut the dividend to avoid financial distress. A dividend cut is usually a sign that the dividend growth investor should sell and move on.
Lastly, dependable dividend growth companies need to invest for the future. Even though high growth isn’t expected, some growth is. If organic growth is slowing, expect to see growth through acquisitions at reasonable valuations.
Basic Dividend Stock Evaluation Criteria
Several metrics should be considered to evaluate dividend stocks. Investors tend to favor stocks with a strong history of dividend growth. But what’s more critical is future growth and dividend sustainability.
The metrics used to evaluate dividend stocks are the same as any stock, with a few additions.
The list below is a starting point for new investors. I purposefully kept the descriptions elementary not to overwhelm you. Google any of these to read more and apply the knowledge to your research.
- PE Ratio
- PEG Ratio
- Dividend Yield
- Yield on Cost
- Dividend Growth Rate
- Payout Ratio
Price-to-Earnings (PE) Ratio
The PE ratio is a standard valuation metric used to compare stocks. It equals the price of the stock divided by the earnings per share. For example, if a company trades at $20 per share and earns $0.80 per share annually, the PE ratio is 25.
= 20/0.80 = 25
The lower the PE ratio, the more undervalued the stock. However, expect higher PEs for faster-growing companies and lower PEs for slower-growing companies. The historical average PE ratio of the S&P 500 index is 15.76. Today it stands around 21.20 (as of 08/14/19).
I source this metric from the Yahoo Finance Key Statistics page.
Price-to-Earnings Growth Ratio (PEG ratio)
The PEG ratio factors earnings growth into the PE ratio. Take the PE ratio, and divide by the earnings growth rate. For example, a company with a PE ratio of 25 growing earnings at 12.5% would have a PEG ratio of 2.0.
= 25/12.5 = 2.0
Generally speaking, a stock with a PEG ratio near or under 1 is considered undervalued.
I source this metric from the Yahoo Finance Key Statistics page.
The dividend yield is kind of like an interest rate. A stock yielding 2.5% percent will pay $25 per year in dividends on a $1,000 investment (before taxes).
Calculate the yield by dividing the annual dividend by the stock price. For example, if an $80 stock pays $2.00 annual dividend, the dividend yield is 2.5%
= 2.00/80 = .025 = 2.5%
The dividend yield constantly changes as the stock price changes.
I source this metric from Yahoo Finance.
Yield on Cost
Since the dividend yield is always changing, dividend investors like to calculate the yield on cost (YOC). The yield on cost is the dividend yield of the cost basis, which factors in dividend growth over the years.
For example, if an investor purchases 10 shares of XYZ stock for $80 per share, that’s an $800 investment (cost basis is $800 or $80 per share). If that stock pays a 2.00 dividend today, the yield on cost is 2.5% (same as the yield). However, if over time, the company raises its dividend to $3.00 per share, the yield on cost is now 3.75%. The YOC metric shows the power of dividend growth.
= 3.00/80 = 3.75%
I calculate this metric in my dividend tracking spreadsheet.
Dividend Growth Rate
The dividend growth rate is the annual percentage rate of increase in the dividend payment. It can be measured year-over-year, or as a 3-year, 5-year, or 10-year rate.
For example, if a company paid a $1.00 dividend per share in 2018 and $1.10 in 2019, the dividend growth rate is 10%.
= 1.10-1.00/1.00 = 10%
The dividend growth rates are easily accessible in the Dividend CCC list from DRIPInvesting.org. Seeking Alpha also conveniently maintains this metric for individual stocks.
Dividend Payout Ratio
Last but not least, the dividend payout ratio is a helpful metric to help determine if the dividend is sustainable and poised for growth. Calculate the ratio by dividing the annual dividend amount by the annual earnings per share. For example, if a company earns $2.25 per share in a given year, and the annual dividend is $1.00, the dividend payout ratio is 44.4%.
= 1.00/2.25 = .444 = 44.4%.
I source this metric from the Yahoo Finance Key Statistics page.
Tax Consequences of Dividend Investing
If you own dividend stocks in a taxable (non-IRA) account, the dividends you received will be taxed.
They are not taxed when you receive them. The dividend is taxed when you file your tax return in the first quarter of the year.
Brokers are required to provide a Form 1099-DIV to the IRS and to investors to report any dividends received over $10. Each DRIP you own will do the same, which can add up to a lot of forms at tax time if you own several.
The total amount of the dividends you receive is then reported on line 3 (2018) of your 1040 tax form and is considered income.
Most dividends are tax at the same rate as capital gains at the federal level. Dividends are also taxed at the state level.
There are two types of dividends, qualified and ordinary. Qualified dividends are taxed at the capital gains rates; ordinary dividends are taxed as ordinary income (same as your salary).
Before getting into the tax rates, let’s quickly go over what qualified vs. ordinary means.
Qualified vs. Ordinary (non-qualified)
According to the IRS:
Dividends can be classified either as ordinary or qualified. Whereas ordinary dividends are taxable as ordinary income, qualified dividends that meet certain requirements are taxed at lower capital gain rates. The payer of the dividend is required to correctly identify each type and amount of dividend for you when reporting them on your Form 1099-DIV for tax purposes.
The nuance between the two can be intimidating at first. But the company paying the dividend is responsible for identifying what type it is and reporting it to the IRS and you. Take it from your 1099-DIV and use it to input your electronic tax return.
Most dividends paid by corporations are qualified. If you own the stock for 60 days or more, the dividend is taxed at the rates indicated in the table below.
Ordinary (aka non-qualified) dividends are taxed at the ordinary tax rate. These include dividends paid by real estate investment trusts (REITs), master limited partnerships (MLPs), from tax-exempt companies, on employee stock options, and dividends delivered as a result of investing in derivatives (stock options).
Qualified Dividend Tax Rate Table
An additional 3.8% tax on the dividends is applicable for those with a modified adjusted gross income (MAGI) over the following thresholds:
Benefits of Dividend Investing
Predictable Passive Income
Dividend income is predictable. As the market fluctuates wildly over time, high-quality companies tend to pay consistent and gradually growing dividend payments to investors. From this predictable income, you can project what you’ll earn in the coming 12-months, and estimate the income further out.
Less Reliance on Retirement Withdrawals
My favorite reason to invest in dividend-paying stocks is to reduce reliance on withdrawals from retirement accounts. A diversified and monitored portfolio producing dividends is a sustainable income source that can be relied upon to pay for living expenses. The more expenses covered by dividends, the less needed from retirement drawdowns.
Fewer withdrawals will enable tax-advantaged accounts to grow for longer, leaving more money for later on.
Generally, stocks that pay a dividend are less volatile than stocks that do not. By definition, the beta (or volatility measure) of the S&P 500 index is 1.00 (SPY). The beta of the Dividend Aristocrats stocks, as measured using the NOBL ETF, is 0.89. A beta below 1.00 means the stock less volatile than the S&P 500; above 1.00, it is more volatile.
Potential to Outperform the Market
By putting all of your money into index funds, you will never outperform the market. Your returns will match the market (minus the fund fees), and most people are comfortable with that (including me).
Dividend investing, however, gives you the potential to outperform the market, even though it takes a serious commitment to achieve this over time.
Criticisms of Dividend Investing
Dividend growth investors sometimes feel like the rented mule of the investment world. Growth investors criticize the limited upside potential while staunch index investors say picking stocks is a loser’s game.
Both argue that the dividend strategy is likely to underperform the market indexes over the long-term.
Beating a broad index fund over long-periods of time with dividend growth investing is a challenge, that may not be worth pursuing considering the effort. Though it can be done.
If retirement income is your investment objective, beating the market is a secondary concern. Sure, it’s nice to have both.
A growth stock investment strategy is difficult to beat the market as well without investment newsletter guidance. The strategy takes even more research effort than dividend investing. The stocks are more volatile and in industries that tend to be less mature.
Unnecessary Taxable Events
As was discussed in my appearance on ChooseFI, a podcast about pursuing financial independence, dividend investing in a taxable account creates a taxable event for every dividend. Upon receiving a dividend, the price of the stock decreases by the dividend distribution per share, leaving you no wealthier than the day before (and less wealthy, factoring in the tax).
Though VTI, the total stock market ETF by Vanguard, does pay a dividend, it’s lower than a typical diversified dividend growth portfolio.
This makes indexing more tax-efficient than dividend growth. To avoid the tax altogether, invest either index funds or dividends in a tax-advantaged account such as an IRA or Roth.
From a tax perspective, growth stock investing in companies that do not pay a dividend is the most efficient.
Dividend investors can avoid taxation by using IRAs, but the income cannot be used to spend if you’re under the of 59 1/2. This is why I started my portfolio in a taxable account, to begin with, to fund spending before age 59 1/2. While the FI community doesn’t endorse, dividend growth investing remains a valid and popular strategy though it’s sub-optimal from a tax perspective.
Stock Picking is Hard
There’s an overarching view that individual investors cannot outperform the market over the long term, so why bother? Individual stocks carry greater risk than a large pool of stocks. The fewer stocks you own, the greater the risk you’re taking.
When you’re starting with just a few stocks and a few hundred or thousand dollars, the risk isn’t that important (you’re still learning the ropes). But the larger your portfolio grows, the more important is it to diversify.
I’ve determined for my objectives, I’m willing to build a portfolio of individual stocks to diversify my income leading into retirement. Yes, that involves making individual stock selections, which takes work. But after maxing out tax-advantaged accounts into index funds.
But it’s work that I enjoy. And I get to own the companies I like, and not the ones I don’t. If my overall portfolio doesn’t beat the market some years, I’m OK with that. I have a reliable income stream to show for it.
Dividend Investing vs. Other Stock Investing Strategies
I’ve already made several comparisons of dividend investing vs. index stocks and growth stocks. Here’s a bit more in this section, and I’ve added active trading and options trading.
Index Investing vs. Investing in Dividend Stocks
I wrote an extensive piece on this topic called Individual Stocks vs. Index Funds – Why I Choose Both. Most investors are better off index investing. I’ve always invested passively in retirement accounts because I wanted to set it and forget it from the moment I started my first job.
At the same time, I had a surplus to invest and chose to invest in individual stocks. That portion of my overall portfolio started very small but has grown considerably over the years.
Indexing is a beautiful strategy because you can know nothing about investing and still match market returns with just one or two investments. Dividend investing takes more work and isn’t right for anyone that doesn’t want to do the work.
Growth Stock Investing vs. Investing in Dividend Stocks
I’ve dabbled in growth stock investing over the years. In my early years of investing, I failed to hold onto winners and held the losers instead. I’ve now realized that growth stock investing requires a very long-term outlook, just like dividend investing does.
However, finding the right growth stocks takes a lot more research, including learning about broader global industrial trends. Then you must link leading stocks to the growth trends to find the long-term winners, after parsing through dozens of stocks to find the right ones.
I used to read The Economist every week to try to identify trends and find the right stocks. But my outlook was too short-term. Now, I don’t have the time to read that much. I found more success in dividend investing and stuck with that strategy instead.
But nowadays, I’m dabbling in growth stocks again, using the Motley Fool Stock Advisor for some help in identifying the long-term trends and stocks. I use the newsletter for ideas, then follow through with research. The research is more about trends rather than stock valuation (Motley Fool is not a value investing strategy). I categorize these as speculative growth stocks on my Portfolio page.
Motley Fool has been the leader in paid newsletters for the past two decades. They tell you exactly what growth stocks you should invest in and the top stocks to buy today. Being a subscriber for about six months, I’ve been exposed to some companies I would never have known before. I own a few and have already earned good returns.
Most novice investors experiment with active trading at the early stages of their journey. The appeal is there, to try to time the market or an individual stock for a quick gain. Momentum works in your favor, and volatility is your friend.
The problem with active trading is that it needs to be a full-time job to succeed. Traders need to follow market queues, perform technical analysis, subscribe to newsletters, and place stop-loss orders on every trade to avoid significant losses.
Since it takes so much time to be successful (and success is elusive), I don’t recommend beginners become active traders. You may get lucky and make some money, but luck runs out. And every trade is accompanied by a fee and short-term capital gains tax.
Options trading is an advanced investing strategy that involves stock options (sometimes called derivatives). I have also dabbled in various options strategies. Namely, call LEAPs and covered calls. I once made $3,000 from a trade back in 2008 from a LEAP purchase on a semiconductor stock.
But that was lucky. I didn’t know what I was doing, and it took way too much time and brainpower. I also lost plenty of money.
Professional day traders often specialize in option tradings. Certain strategies can lower your risk and help you earn ‘singles and doubles’ fairly reliably. Home run option trading is a bit riskier.
Unfortunately, this too is a full-time job that comes with a lot of heartburn and requires a particular personality.
For me, it’s too much work. I prefer sitting back and watching my dividends arrive every month.
Conclusion – How to Invest in Dividend Stocks
Some key takeaways:
- Dividend investing is not for everyone. Only invest if you’re willing and able to do the research. Use a stock index fund strategy as an alternative.
- Be sure to max out retirement accounts before investing in taxable accounts. Dividend investing is more tax-efficient in retirement accounts.
- Follow the six steps of dividend investing in getting started; slowly build a diversified portfolio, or use the pie strategy to diversify more quickly.
- Choose your stocks carefully, based on the ability of the company to pay a sustaining and growing dividend over several decades. Learn basic valuation metrics before getting started.
- Pay close attention to the tax consequences of dividend investing. If you’re using a taxable account, you’ll pay taxes on the income in April.
I hope this article helps you understand how to invest in dividend stocks, and get started if you’re a novice and the strategy is right for you. If there is anything I missed, please feel free to leave a comment below, and I’ll update the post to answer your question (if I can).
Disclosure: Long CVX, DOV, T, V
Photo via DepositPhotos used under license.