Dividend is a profit distribution in the form of money (cash) or shares (stock) to the holder of a share. Think about dividends, as being paid as a thank you for believing, and investing, in the company.
It’s similar to receiving interest on lending out money. By providing companies with your trust & capital, they, in turn, reward you with a dividend. The amount paid is usually related to the amount of the profit achieved.
Below in this 4-minute video, AmerTrade discusses additional dividend facts.
It is therefore considered a safe(r) investment when you invest in so-called dividend aristocrats. When (starting) dividend investing, there are several important principles to consider:
- Dividend yield
- Dividend payout ratio
- Dividend frequency
- Ex-dividend date
- Dividend reinvestment program (DRIP)
The pitfalls
A large dividend yield brings an oftentimes fake promise. Companies can have a double-digit, or closer to 10% yield if one of the following situations occurs.
The company might have seen a large decline in share price, but has not updated its dividend payout amount. Given the yield is calculated as payout amount/share price, the number will suddenly look very attractive. A high payout does not last, as it trades off a companies growth potential.
Alternatively, the company might be in a rocky situation already. By increasing its payout amount, the potential return could bait investors into a dying company. Or, even worse, a scam!
In order to avoid scams and baiting, consider going for a ‘fair’ percentage between 1% and 5%, or re-evaluate your risk appetite.
The dividend payout ratio
Every stock that rewards its investors has a payout ratio. It’s always a good idea to review this statistic to understand the consistency and reliability of the company to make good on its promise.
In order words, it will give you the historical benchmark of how likely the company is to pay out the dividend promised.
Payout Frequency
Every company has the right to decide if they pay their shareholders. If they so choose to, the amount and frequency are also up to the company. Usually, companies pay per year or quarter. However, some pay every single month.
Whilst payout frequency can mimic the stability of a salary, the payout ratio is key to the reliability mentioned prior.
Timing when considering rewards
This comes down to the ex-dividend date. This is the day on which you would need to own the stock, in order to receive money at a future date. It’s for this important to keep an eye on your calendar, should you invest yourself.
Dividend products
Most often, it is stocks and ETFs that can provide you with a dividend return. As there is no guarantee a payout will occur, nor obligation for any company to offer one, it’s best to pick companies or themes you believe will grow over time.
We at Investing Guides do not invest in promises, but rock-hard facts & financial figures. It may not sound sexy, but it’s a lot safer! You could also look into bonds, for the bond yield when diversifying.
Dividend Snowball effect
Investing in dividend instruments gives you the ability to increase growth, assuming a positive market over a longer period of time. Not only will your instruments grow in value, but the dividend returned can be reinvested.
Let’s say we buy 20 USD worth of company X, we see a 3% return per year on company X and they pay a 2% dividend yearly. As we believe in this company, we reinvest the 2% annually and keep the 3% profit unrealized.
The calculation of total profit would be:
- 20 USD invested
- 5% return per year
- For 5 years
20*1.05^5 = 25.52 USD. In percentage that is (25.52-20)/20= 28% return!
Where, if you would not reinvest, the calculation and result would be:
- 20 USD invested
- 3% return per year
- For 5 years
20*1.03^5 = 23.18 USD. In percentage that is (23.18-20)/20= 16%
That is a 12% points difference, over only 5 years! The accumulating effect, or snowball effect, is real!
DRIP programs
Finally, there are brokers and institutions that offer a so-called DRIP program. You can consider these to effectively manage the above snowball effect, on your behalf. Automatically reinvest the cash you earn from your investments.
OK! That was a long read huh? Let us take a break and whenever you are ready, continue your investing journey here. Or join a dividend friendly broke like Etoro: