You may be familiar with the concept of portfolio diversification, and you may also be familiar with the concept of dividend investing, but do you know how dividend investing can help you create a more diversified portfolio? When you invest in dividend stocks, you benefit twice from both the dividend payment as well as appreciation in the stock itself. How does this help you balance your portfolio as you head closer to retirement and after you have retired?
What’s a Dividend?
A dividend is a distribution of cash made directly to stockholders. Companies do this as a means of making their stock more attractive to investors as well as a means of getting rid of excess cash that the corporation may be holding. Dividends are often granted on a quarterly basis, but a dividend can be granted on a monthly, bi-annual or annual basis. While the dividend yield and the amount of each dividend are the two most important factors to look at when investing in a dividend stock, the frequency of the dividend can be important for compounding purposes.
What Are the Advantages of a Dividend Stock?
On average, a non-dividend stock will appreciate 7 percent each year. However, the annual average dividend is an additional 4 percent each year on top of that 7 percent capital growth, which means you can average 11 percent returns annually.
That extra 4 percent can then be reinvested back into buying more shares of the dividend stock, which enables you to take advantage of additional compounding. If you don’t want to reinvest your dividends back into the company, you can take a cash payment that can help pay bills or take care of other needs in retirement.
Companies that offer a dividend tend to be stable with a predictable cash flow. Otherwise, they wouldn’t be able to offer the dividend or wouldn’t offer the dividend on a regular basis. Companies such as Coke and Proctor and Gamble have offered dividends for the past 50 years.
How do You Choose a Dividend Stock?
Not all dividend stocks are created equal. The first thing that you want to look at is a company’s dividend yield, this is the percentage of the annual dividend compared to its current stock price. While you want the highest possible yield, higher yields can actually be a sign of an unstable company. In some cases, a business may offer a 15 or 20 percent yield to attract investors because its fundamentals don’t suggest it is doing well.
You should also look at how long a company has offered a dividend. There are instances when a company has offered a dividend and then revoked it later because it no longer had the cash to offer it. This can be problematic for investors who count on the regular income the dividends provide or are hoping to boost their savings through dividend reinvestment.
Those who are more conservative investors may want to look at Dividend Aristocrats, which are companies that have increased their dividend each year for the last 50 years or more. However, if an organization has offered a dividend for a year or more, there is a good chance that it will continue to do so. If it has offered a dividend for the last decade or longer, that is a good sign of stability.
Don’t Forget the Tax Advantages of Dividend Investing
If you receive a qualified dividend, it may be taxed at the same rate as other long-term capital gains. A dividend is qualified if it has been given to shareholders of an American corporation, a foreign company incorporated in a United States possession or any foreign company that otherwise enjoys United States tax treatment.
You must also hold that stock for at least 61 of 121 days starting from 60 days before the last dividend’s ex-dividend date. If you meet these requirements, you may not have to pay any capital gains tax on some or all of your dividends depending on your tax bracket.
You Don’t Necessarily Need to Invest In Stocks
There are many products available to those who want to diversify through dividend paying equities. If you don’t like individual stocks, you can buy mutual funds that allocate a portion of their holdings to divided stocks. You can also buy ETFs or index funds that come with high diversification, low fees and quality dividend payments.
Diversification is critical if you want to retire comfortably. It enables you to offset losses with gains elsewhere while also ensuring a return on your investment in the short-term, even if the underlying stock’s price stays flat or goes down during a temporary lull in the market.
Talk to your financial advisor to see if a dividend centered portfolio is right for you, and your retirement.
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