Investing in dividend stocks can be a great investment strategy. Dividend stocks provide two sources of return: regular income from dividend payments and capital appreciation of the stock price. This is why so many Wanderers love the dividend strategy—it provides a source of income to fuel their current adventures, while leaving capital alone to grow for their future adventures. Here we'll try to answer a few questions about dividend stocks so you can decide if they are right for you and your investment goals.
Income Generation
Dividends are a means to produce income for the investor of a company's stock. Those dividends can be automatically reinvested in the stock through your brokerage, or it can be paid out to you in cash.
Dividend Yields
A dividend's yield is the percentage of its stock price that it pays out as a dividend. This is generally calculated by adding the previous four quarter's dividend's together, and dividing by the current stock price.
Why are downturns both painful for div stocks and also a buying opportunity?
When you buy dividend stocks your primary focus in on the yield of the dividend. You are looking to generate income, after all. Meanwhile, though, the stock market will continue to do what it does—go up and down. While it is nice to earn 5% on a stock each year from its dividend payments, it's not fun to watch the stock price drop 10%. When that happens, you suddenly look at that same holding and realize that it will take two years of dividends just to make up for the loss in the stock's price.
That's the painful part. But there are two redeeming qualities that dividend stocks have in this situation. One, stocks tend to go up over time. While the stock may be down 10% today, it's quite likely, barring some major problem with the company, that it will be higher a year, two years, or five years from now. Two, if we assume that the dividend paid won't be affected by a 10% stock price drop, then basic math shows us that any additional investment we make in the stock today will pay a higher overall dividend yield.
You can see how this works in the example below. AY (Atlantica Sustainable Infrastructure) is a renewable energy company with a stated goal of increasing their dividend paid to shareholders. Over the years they have been able to do so despite the ups and downs of the market. It's easy to see then how buying a stock like this when it is priced lower, produces a higher overall dividend yield. If we are able to continue investing over time, history would tell us that the stock will increase, and any purchases we made during periods of stock price weakness will pay us back more than the shares bought at higher prices. In other words, steady dividend stock investing should provide a good income, and a solid return in the long run.
The Risks
With dividend stocks there are essentially two major risks. One is that the stock price declines, and continues to decline. This is obviously bad, but is tempered at least somewhat by the fact that you are being paid a dividend.
Which leads us to the second major risk, which is a dividend cut. Companies sometimes are forced to cut the amount of their dividend. This is especially true when the stock price is declining because they likely have less revenue to pay the dividend with. As you can imagine, this exacerbates the pain of holding the stock. You've got both a declining stock price, and a declining dividend yield.
Mitigating Those Risks
History doesn't tell the whole story, but with stocks it can at least give you some peace of mind. Before you buy any dividend stock take a scroll back through its history. Has it maintained its dividend over the long-term? Even during big market downturns? Has its dividend yield increased or decreased over time? If there is a large dividend paid one quarter, why was that, and will it be a regular occurrence or was it a one-off? These are all questions that can be easily answered with a few minutes on the stock's chart, and a few minutes on Google.
Conclusion
Dividend stocks can play a key role in any portfolio. They work especially well for those who want to invest for the long-term, but also would like a steady stream of income from their investments. That income can be used in a myriad of different ways. One of our Wanderers came up with an ingenious plan to pay his home's energy expenses by investing in energy dividend stocks. The income he generates from these dividends he uses to pay for his monthly energy bill. When he added a swimming pool to the backyard, he also increased his dividend investments to meet the costs associated with heating it. By doing this he alleviates the burden of a large monthly expense, while at the same time investing for his future. A similar plan can be made to offset world travel expenses, or the slip fee on a boat. Think it over, and formulate a plan for yourself.