Dividend Investing for the Long Term

When it comes to investing, many people feel overwhelmed...and rightfully so. There are so many options that you can put your money toward. There are bonds and bond funds. There are individual stocks, stock mutual funds, and stock ETFs. There are Index Funds. There are money market funds. Within these categories, there are even more options.

Do you want US government Treasure bonds? Do you want tax-free municipal bonds? What about corporate bonds. Do you want to follow the Russell 2000? How about the S&P 500 or the Dow Jones Industrial Average?

When all of these choices are available, it's no wonder that people feel as though there is a bit of information overload.

While investing can seem complicated, it doesn't have to be. Many companies or funds will return a portion of your invested capital on a monthly, quarterly, or annual basis. Dividends are the secret sauce that can help you achieve your investing goals. These payments are real cash that can come in the form of a check or a direct deposit to your investment account. That cash can then be used for a number of things. You can pay bills with it. You can let it accumulate and buy a portion of another company with it. You can also reinvest the cash into the same company that paid it out and get additional shares of the stock that will also pay dividends and increase your overall payout over time. Dividends can be a relatively stable source of passive income, and these payouts can be more steady than capital gains. However, there can be problems when investing for dividends.

While dividends can pay out a growing source of income over the long term, there are still some risks that can cause problems. The first major risk is chasing a high yield. Some stocks will yield more than 10 percent on an annual basis. This is usually a big red flag in the world of investing. The S&P 500 as a whole has a dividend yield of right around 1.8 percent. This includes some companies like Google and Amazon that do not pay a dividend. It also includes companies like AT&T, which was yielding nearly 6 percent in late 2015. Few companies on the S&P will actually pay a huge dividend. Generally, the reason why there is a very large yield is related to a massive drop in price. Sometimes, the market will make mistakes in this regard. However, more often than not, there is usually an important reason why a company drops in price. This is usually related to major market headwinds as technology changes, commodity prices drop (or rise, depending upon the company), or revenue falls because of a recession.

When it comes to investing for dividends, one of the more common strategies is the purchase of companies that are considered dividend aristocrats. This designation is made up of companies that have paid out a steadily increasing dividend for 25 years or more. Some of the companies have paid an increasing dividend for more than 50 years. Coca-Cola and Johnson and Johnson have increased their dividend payout for 53 years each. That streak goes back to the Kennedy administration. Each and every year since, an investor in these companies have seen a raise, many times it's been more than a raise from working. These are the bluest of the blue chip stocks, and it actually pays to own them. Of course, it's a good idea to avoid buying these stocks when they are overvalued. Note that buying an overvalued stock can cut down on total returns basically forever.

When thinking about dividend income and whether an aristocrat will be able to continue paying and growing a dividend over time, be sure to look at the payout ratio. This is related to the current payout and the net income that a company has coming in. A lower payout ratio will allow a company to continue to pay a dividend. If a company is only paying out 40 percent of its net income in dividends, and it grows that income by 10 percent, an investor could expect a dividend increase of around 10 percent. On the other hand, if a different company has a payout percentage of 90 percent and revenue is stable, it is not likely that there will be a major increase in the dividend. If there is, it won't be long until the dividend exceeds the net income. This will not be a good situation for investors, as the company's share price will likely drop, and there will be an increasing likelihood of a cut in the dividend. When investing in dividend stocks, be wary of a very high payout percentage that remains so for more than a year or so.

One of the best ways to increase dividend income is through the reinvestment of dividend income. This allows for Einstein's eighth wonder of the world, compound interest, to work for you. If a company pays out a dividend that has a yield of 3 percent, by reinvesting, you should increase your dividend income by 3 percent. If the same company increases its dividend by 7 percent in a given year, and you reinvest, you can expect your dividend income to go up approximately 10 percent on a year-over-year basis. In just 7 years, your dividend income from this hypothetical company will double. That's probably better than most pay increases from a job will do for the majority of people. While dividends are not the only way to make money in the stock market, they can definitely provide a nice source of income for years into the future if an investor chooses the right company.