Getting Started with Dividend Investing

When you purchase stock you are purchasing a small portion of a company.  The value of that stock is based on the profits or expected profits of a company.  Some companies take the profits they earn and reinvest that into the company to grow the business.  Other companies take a small portion of their profits back to the share holders as dividends and reinvest the rest.  That second category, ones that return a portion of the profits to stock holders, are dividend paying stocks.

1. Less Volatility - There are all sorts of stragegies that can be profitible. Focusing on momentum stocks, looking for small cap wonders, trading options - any of these and others can be quite lucrative. And as a matter of fact, I have done quite well on some of my small cap growth stocks recently. But with most trading strategies you have to protect your gains and avoid catastrophic losses by watching them like a hawk. But with large, established, income paying stocks a bad quarter or two does not send the stock plummeting down. Yes, income generating stocks can and do lose value, but they are not subject to the same wild rides. Simply put, stable income generating stocks allow you to sleep more soundly at night.

2. Capital Appreciation - I believe as baby boomers are entering retirement the demand for income paying securities will rise quite dramatically. Simply put, the returns of interest on CDs, government bonds, or simple money market accounts are so low that investors will flock to stocks that pay you to own them and have a track record of increasing those payments. Not only are the yields on large cap, income generating stocks higher then say U.S. Treasury Bonds (as of 2010) but those stocks frequently increase the amount they pay out ever year - giving your income a boost! Bonds and CD's have a fixed payouts - Dividend stocks do not. Yes, that dividend may go down in value but some large, established companies have a track record of increasing their payout over 25 years - even during the Great Recession!!! (and some much longer!) Since Baby Boomers will likely flock to dividend stocks, the law of supply and demand dictates higher prices for this category of stocks.

3. Dividend Stocks have a historical track record - Yes, just because something has gone up in the past does not mean it will do so in the future, but most of the gains that stock market as a whole have enjoyed are because of dividends. Professor Jeremy Siegel of Wharton calculated that over a 130-year period, 97% of the total return from stocks came from reinvested dividends. 97%!!! That means only 3% of returns since the 1870s came from capital gains! (AKA price appreciation) So do you want to fight history and take advantage of it?

4. Dividends receive favorable tax treatment - While the future may hold drastic changes to the tax treatment of dividends, as of publication they are taxed at a rate considerably lower then one's marginal tax rate. Dividends are taxed at just 15% - and in IRA accounts dividends are tax free or tax deferred. You pay taxes at your regular rate on savings or money market accounts but with many dividend stocks you get a higher yield at a lower tax rate!

To effectively and safely get started in dividend stocks I recommend having at least 8 different holdings across 4-6 different sectors.  This would mean great dividend paying stocks from say the financial, consumer goods, health care, and energy sectors. You can stocks you can be comfortable with from your financial adviser or the ratings section of your brokerage.

However, if you are starting your journey into dividend investing with anything less then $5000, sales commissions will eat into your profits and lower your return significantly.  That is why, for most beginning investors I recommend buying ETFs that focus on dividend paying stocks.

ETFs trade like stocks but invest like mutual funds.  That is to say they have lower fees and can be bought or sold with limit or stop loss orders.  And many ETFs on the market today have as their focus dividend paying stocks.

My favorite right now is SDY.  SDY focuses on what are called the Dividend Aristocrats - companies that have paid and increased their dividend for 25 or more years!  SDY has low fees and in owning this ETF you will have exposure to great dividend paying companies such as Eli LIlly, Johnson & Johnson, Abbott Labs, Clorox, Coca Cola, Exxon, McDonalds, 3M, and more.

Do yourself a favor and contact your financial adviser and run investment ideas past him or her. Stock and ETF investments can and do lose value. And for your information, I am long (meaning I own) shares of SDY and XOM.