Dividend stocks are stocks that pay out regular dividends to shareholders.

Dividend stocks are stocks that pay out regular dividends to shareholders.

The Power of Dividend Stocks: A Guide to Building a Strong Portfolio

Dividend Stocks

In the world of investing, there are many choices available to create income in portfolios. One popular way to do so is by buying dividend stocks. These stocks come from companies that not only provide regular dividends but also increase their payouts over time. While dividend income may be overlooked amidst the gyrations of the stock market, it is an important element of return that can help soften the blow during periods of market uncertainty.

What Are Dividend Stocks?

Dividend stocks are stocks that pay out a portion of either their income or their retained earnings to shareholders. These payments are known as dividends. Preferred stock sets the actual dollar amount to be paid out each period based on the par value of the security. On the other hand, for common stock, dividends are determined on a periodic basis, whether monthly, quarterly, semi-annually, or annually. These payments are set by the company’s board of directors.

In the United States, public companies generally pay out a consistent portion of earnings each quarter. Furthermore, the board of directors often increases the dividend payout each year, usually incrementally. One advantage of keeping dividends level and growing over time is that it helps stabilize the stock price.

It’s important to note that dividend stocks are different from bonds or interest paid in money market funds. With bonds and money market funds, investors know exactly how much each payment will be. However, with dividend stocks, investors know the yield of their stock based on the annualized rate that the company is forecast to keep paying. Over time, the dividend can grow, and this means the dividend yield could rise as well.

The Benefits and Risks of Dividend Stocks

For the most part, investing in dividend stocks is a good thing. These stocks have been shown to boost total returns over time. Since 1926, dividends have contributed approximately 32% of the total return for the S&P 500, while capital appreciation has contributed 68%. Therefore, sustainable dividend income and capital appreciation potential are considered important factors for total return expectations.

However, like any investment, dividend stocks come with risks. One of the main pitfalls is buying shares in a company that can’t afford to maintain its dividend. If a company’s earnings consistently decline, it will likely have to lower its dividend. One example of this is AT&T, which slashed its annual dividend by over 46% in early 2022 due to a spinoff with Warner Bros. Discovery. Existing AT&T shareholders received shares of Warner Bros. Discovery but also experienced a significant reduction in income due to the dividend cut.

Another potential pitfall is focusing solely on high dividend yields. A high dividend yield can be a warning sign because stock prices and dividend yields move in opposite directions. An unusually high dividend yield may be a side effect of a stock that has lost value. Additionally, certain sectors like real estate investment trusts (REITs) may have falsely high dividend payments due to combining dividend payments with return of capital payments.

Finding the Best Dividend Stocks

The main advantage of adding dividend stocks to a portfolio is the potential for steady growth of payouts, which can accelerate total returns over time. For example, if a company pays out $3.00 per share and the stock price is $100.00, the dividend yield is 3.0%. But if the company raises the dividend by 20% over the next three years, the investor’s yield increases to 3.6%, leading to a higher total return.

Unlike bond payments or CDs that remain fixed, dividends from stable dividend stocks can increase over time. This is why investors should seek out high-quality dividend growth stocks. A good place to start is with the Dividend Aristocrats, which are companies that have raised their dividend payouts for at least 25 consecutive years. There are also the Dividend Kings, which have increased dividends for a minimum of 50 consecutive years.

In conclusion, dividend stocks are a powerful tool for building a strong portfolio. They provide regular income, have the potential for capital appreciation, and contribute significantly to overall investment returns. However, it’s crucial to consider the risks associated with dividend stocks, such as the possibility of dividend cuts and falsely high dividend yields. By focusing on high-quality dividend growth stocks, investors can benefit from stable income and long-term growth. So, why not explore the world of dividend stocks and unlock their potential for your portfolio?