Written by Nicholas Say. Updated by TraderHQ Staff.
Anyone who wants to create passive income with equities should know how to invest in dividend stocks. Many stocks pay a portion of their profits back to investors with regular payments, called dividends.
Much in the same way that a bond or bond fund creates passive income, dividend stocks make it simple to buy an asset and create a revenue stream. There are also ETFs that specialize in paying dividends, which are a great way to buy a range of individual stocks at once.
Like any kind of investment, buying dividend stocks requires some amount of education. There are many kinds of stocks and ETFs that pay dividends, and also some potential risks that need to be understood.
Dividend Paying ETFs
There are a few ways to create a portfolio of dividend-bearing stocks. Probably the easiest is to buy a few ETFs that pay dividends. You can also research individual stocks and create your own basket of dividend-paying companies, which is substantially more work. REITs are a specialized company structure designed to return capital to investors, and they also may be worth a look.
Buying ETFs that pay dividends is just like buying any other kind of ETF, but you will need to look at a few metrics before you make a purchase. One of the biggest advantages to buying dividend-bearing ETFs is that the company managing the ETF does all of the research for you. These ETFs will have built-in diversification, which is another great benefit.
Important Things to Consider When Buying a Dividend ETF
- Expense Ratio: The company that manages the ETF charges for its services. This is called the expense ratio. Clearly, lower is better. If the expense ratio is above 0.50% per year, it would be worth looking for a cheaper alternative.
- Dividend Yield: This is how much the ETF (or a company) will pay as a percentage of its market price. This rate changes as the component companies adjust their dividends and the price of the ETF’s shares fluctuate.
- Five Year Returns: The opposite of an expense ratio—higher returns are your goal.
- Market Cap of Component Companies: In general, an ETF will have guidelines about the size of the companies that make up the fund. Large-caps tend to be more liquid and less volatile.
Once you figure out which dividend ETFs are the best fit for your needs, you can buy them like any other ETF from your broker. In most cases, the dividends will be paid into your brokerage account directly, and you can either withdraw the payments or reinvest them.
Build Your Own Dividend Stock Portfolio
If you decide to build your own dividend stock portfolio, it will almost certainly be more focused than a dividend stock ETF. There are a few things to consider before you go this route and start sifting through the thousands of stocks in the U.S. markets that pay a dividend.
- Risk vs. Outperformance: It is almost always true that when a portfolio has less diversification, it will move more than the overall market in percentage terms (also called “beta”). If you are a skilled stock picker, this could be an advantage, although very few people can beat the markets consistently over time.
- Time Involved: Don’t underestimate the amount of time it will take to sort through all the stocks that pay a dividend. Creating a dividend stock portfolio requires time not only to build the portfolio but also to keep on top of all the changes companies make.
- Dividends Rise and Fall: In addition to probably having higher beta, a more concentrated dividend stock portfolio will be sensitive to changes in the dividends at the component companies. If one of the companies lowers the payment or cuts the dividend entirely, the impact on your overall portfolio will be much higher than it would be with an ETF.
What About REITs?
A REIT, or Real Estate Investment Trust, is a classification of company that allows investors to buy and sell shares in an entity that owns revenue-producing real estate. These shares are traded on major exchanges and are extremely liquid.
REITs are required by law to distribute at least 90% of their taxable income to shareholders, which often results in attractive dividend yields. However, any real estate investments that rely on tenants paying rent should be evaluated carefully based on current economic conditions.
Keep Your Income Streams Diversified
Dividends aren’t like interest payments from a bond. Companies can and do cut or eliminate dividends, which makes diversification even more important for dividend stock investors.
You should also be cautious of a company paying a very high dividend yield, as this may mean the stock has been sold down and the company will be slashing the dividend in the near future.
The Bottom Line
Dividend stocks are a good way to gain exposure to the capital appreciation that equities offer while also creating income. Reinvesting your dividends after they are paid can help you boost your income over time through compounding and grow your exposure to a company or fund.
Frequently Asked Questions
What is a good dividend yield to look for?
A dividend yield between 2% and 6% is generally considered a reasonable range for most investors. Yields below 2% may not provide meaningful income, while yields above 6% often signal that the stock price has fallen significantly, which could indicate the dividend is at risk of being cut. Focus on companies with sustainable payout ratios and a history of maintaining or growing dividends.
How often are dividends paid?
Most U.S. companies pay dividends quarterly, though some pay monthly, semi-annually, or annually. REITs and certain ETFs often pay monthly. You must own the stock before the “ex-dividend date” to receive the upcoming dividend payment. The actual payment typically arrives a few weeks after the ex-dividend date.
Should I reinvest dividends or take the cash?
This depends on your goals. If you’re building wealth for the long term, reinvesting dividends through a DRIP (Dividend Reinvestment Plan) allows you to compound your returns by automatically purchasing more shares. If you need current income or are in retirement, taking dividends as cash makes more sense. Many brokers offer automatic reinvestment at no additional cost.