When investing in stocks, there are two potential ways to make money – appreciation and income.
Appreciation happens when the stock you buy goes up in value, but it is possible to make money on a stock even if the price remains the same. Many stocks pay regular dividends to their shareholders, and those periodic payments can add up. Over the last couple of decades, a large part of the total return from stocks has been due not to appreciation, but to dividends.
That track record has led many investors to take a second look at dividend-paying stocks. With interest rates near historic lows and savings accounts paying next to nothing, many investors are looking to dividend stocks as a way to build a steady income. But while dividend stocks can play a role in a balanced portfolio, it is important to understand not only the benefits but the potential pitfalls as well.
When evaluating dividend stocks, it is tempting to look at yield alone. After all, buying a stock that boasts a dividend of 6, 7 or even 8 percent or more gives you more bang for your buck. But it is important to look beyond the yield, to the underlying value of the stock. Some high dividends are the result of steady increases in payout, but others are the result of a falling stock price. When the price of the shares falls, the dividend rate rises, but that falling stock price could also mean the dividend payout – or even the company itself – is in danger.
One way to screen out the likely winners in the high dividend arena is to look at the track record of the company. Firms that have consistently raised their dividend payout year after year may be a safer bet than those with a spottier dividend record. This is not a guarantee, of course, but it is one way for investors to protect themselves.
Another way for investors to protect themselves is to do plenty of research on the companies they invest in. Looking at things like earnings growth, revenues and products in the pipeline are always important, but it can be even more critical for investors who will be relying on dividends to make ends meet.
Mutual funds and exchange traded funds provide yet another way for investors to reduce their level of risk while still reaping the rewards of investing in dividend stocks. There are hundreds of these funds on the market today, some actively managed and others that simply buy and hold a basket of stocks with a long history of paying steady dividends. As with individual stocks, it is important to look at the track record of these funds, including their performance in both up and down markets.
Investors who need to build a steady stream of income off of their portfolios can use dividend-paying stocks to provide some of those needs, but it is important to balance those stock market positions with bonds, certificates of deposit and other less risky investments. Perhaps the largest downside of investing in dividend-paying stocks is the potential for loss.
Unlike CDs, stocks do not come with a guarantee, and there is always a chance that the share price will drop. That could reduce, or even negate, the value of those dividend payments. Understanding these risks, along with the potential benefits, is the key to successful dividend stock investing.