The best any expert can say about the stock market right now is that future returns will be uncertain, and volatility may be the new normal. Although there are slivers of light shining on some parts of the economy, many storm clouds darken the near to intermediate-term outlook on the stock market.
Make no mistake; this is not a gloom and doom stock forecast. Quite the contrary, investors should maintain a cautious optimism and remain invested in the stock market, albeit fully hedged against uncertainty and volatility.
One of the best strategies for accomplishing this is investing in dividend stocks as a portfolio stabilizer and a source of returns in an uncertain economy. In order to help you decide if dividend investing is right for you, we’ve put together this comprehensive guide. Of course, always consult with your financial advisor to understand what you’re buying and why you’re holding it in your portfolio.
What is Dividend Investing?
Dividend investing is a strategy focusing on investing in companies that regularly distribute a portion of their profit as dividends to shareholders. The most direct way a business can affect shareholder performance is through a cash dividend. A cash dividend is simply a return of investment to the shareholders. Each year, or each quarter, the board of directors announces a dividend that is paid in cash—sometimes in stock—directly to shareholders.
The better-performing companies will periodically increase their dividends. Some companies have been paying dividends for decades, so it becomes an expectation and a way to attract new investors. Once a company starts paying a dividend, it will go to any length to continue to pay it because not doing so indicates the company may be in trouble.
Creating Your Dividend Investing Strategy
Not all dividend stocks are created equal. As with any investment class, it’s important to establish strict criteria for selecting the stocks that best match your profile and meet some standard of quality. Chasing the highest yields can be as risky as investing in junk bonds. Over the long term, companies with an established record of uninterrupted dividends, a clean balance sheet, and a positive earnings outlook will outperform the higher-yielding investments in terms of both dividend income and capital appreciation.
When investing for the long term, diversification is always the key. With dividend stocks, you can invest across many sectors and among various dividend-paying investments, such as common stock, preferred stock, real estate investment trusts (REIT), ETFs, and mutual funds.
What to Look for in a Dividend-Paying Company
With dividend stocks, investors need to apply the same due diligence they would use to purchase any stock, careful not to focus strictly on the dividend yield, which can be especially alluring after the stock price has fallen. It would be essential to know why the stock price fell and whether there may be the possibility of a dividend adjustment.
One of the most important factors to consider is the company’s debt-to-equity ratio, which could put pressure on the dividend during a down economy if it is too high. Dividend payers that have no trouble generating excess cash flow can be relied upon to pay their debt and dividend in any economic environment.
You also want to look at a company’s dividend payout ratio, calculated by dividing the annual dividends per share by earnings per share. The dividend payout ratio represents the portion of net income the company is paying out as cash dividends. Companies with a payout ratio of less than 50% are considered financially stable, with the potential to increase earnings over time.
What to do with Cash Dividends
Investors need to decide what to do with their cash dividends. If the company is performing well and driving solid investment performance, you probably want to reinvest them back into the company. That drives investment performance further. However, if the multiples become unattractive over time, reinvesting in the company may not make sense. That should prompt a decision as to whether the stock is still attractive.
Whether you hold or reinvest your cash dividends in the company, they are subject to income taxes. The advantage of dividend income over other forms of income is it is taxed at a maximum rate of 20% (plus a 3.8% surtax for the highest-earning taxpayers). The tax rate for taxpayers in the lower tax brackets is 15%.
Why Now Is the Time to Invest in Dividend Stocks
While high-quality dividend stocks are not likely to generate market-leading returns in any given year, they will lose less money on the downside, which is the key to growing portfolio value over the long term. Investing in high-quality dividend stocks is not about generating outsized returns; instead, it is about generating a rate of return meaningfully greater than the inflation rate while preserving capital during protracted market declines. Dividends are always positive, so they are a counterweight in down markets.
Many investors are unaware that dividend yield and growth have accounted for approximately 40% of long-term stock returns since 1930. During decades when inflation averaged more than 5%, they accounted for 54%.
Eventually, the U.S. economy will right itself, and sanity and stability will return to the markets with large-cap, dividend-paying companies leading the way. Until then, and even then, dividend stocks will provide an effective counterweight to most risks investors will encounter, including inflationary pressures (or stagflation), increased market volatility, interest rate fluctuations, or market declines. There has never been a better time to make dividend stocks an integral part of your investment portfolio.
Adding a dividend stock component to your portfolio will not only increase your tolerance for volatile markets, but it can also become an enduring source of income regardless of the movement of stock prices, inflation, and interest rates.
Ready to find out if dividend investing could be the ballast you need in uncertain times? Or perhaps a source of income you could use to fund your future retirement?
No matter where you are in your investing or retirement journey, our team at Platt Wealth Management can help. Simply schedule an appointment with one of our trusted advisors to discuss your opportunities today.
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