What is Dividend Investing?

What is dividend investing and how do you do it? We look at the strategy and the risks you should avoid when backing dividend-paying businesses

Francesco Lavecchia 23 November, 2021 | 9:01AM
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Dividend investing is simply a strategy of buying stocks that pay an income in the form of a dividend. This gives you a regular income stream from your investments, in addition to any growth in the market value of the stock.

There are a lots of good reasons for buying paying dividend stocks: in a low interest rate, fixed income investments like bonds may not provide enough income to overcome the depreciation of your capital; they provide a constant cash flow; dividend growth can be a powerful growth driver for the total return of your investment. According to a Morningstar study focusing on the S&P 500, dividend returns counted for the 16% of the total return in the decade 2010-2019.

There is some jargon you need to look out for when investing for income. A stock is referred to as trading "ex-dividend," which means it is trading on that particular day without dividend eligibility. If you buy and sell stock on its ex-dividend date you will not receive the most current dividend payout. Another term you may see is “preference shares”; these give your preference in receiving dividends over “ordinary” shareholders but you don’t have the right to vote on company resolutions or at AGMs.

The yield is also different from the amount received. For example, a share valued at 50p with a payout of 10p is yielding 20%. The share price could fall or rise and the yield will follow in tandem.

High Yield vs High Growth

There are two main strategies when it comes to investing in paying dividend stocks: having a high dividend yield approach, or having a high dividend growth strategy.

A high yield approach is based on picking the highest dividend yield stocks. This approach could give a high reward in the short term but could also be quite risky. The risk is to be tempted by the generous extra returns provided by the dividends, which may be unsustaintable and then find yourself in a dividend trap with a stock that no longer pays dividends, which can negatively affect the total return of your portfolio.

A high dividend growth strategy, meanwhile, is to focus on the quality of the business and financial health of the company. A high quality business should be able to grow profits regardless of the economic trend, while strong financial health often means a company can afford to continue paying dividends for the long-term. Worth noting also is that with such stable businesses, shareholders usually do not sell even in a market crash because they believe in the long-term viability of the company. These factors help explain why this type of stock shows a higher total return in the long-term.

You can receive dividends by investing directly in shares or via funds and trusts, and the managers collect them on your behalf. In the case of funds, you can choose whether to receive the dividends via the Income share class or have them reinvested via the Accumulation share class (seen as Inc and Acc in fund lists).

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Francesco Lavecchia

Francesco Lavecchia  è Research Editor di Morningstar in Italia