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What's the best way to earn passive income in 2021?
Many online gurus promote the latest crypto, starting a YouTube channel, and good old-fashioned real estate, which all can potentially make you some money. But, have you heard about dividend stock investing?
We believe dividend stocks are a great vehicle to creating some real passive income.
With dividend stocks, companies pay you percentages of their profits just for owning their stock, usually once every quarter.
Today, we're going to demystify dividend stock investing, and help show you a path to creating a solid foundation for your passive income journey.
Let's get down to business!
What Exactly Is A Dividend?
When a successful company becomes really big, they usually face a problem:
They can't sustain their prior growth.
They've either cornered their market, or become well established, and ‘hit the wall', so to speak.
Whereas before it would have been wise for them to reinvest their profits back into the business, now that they're successful and established, it's not so easy to keep investing for growth.
For example, AT&T has become so large that it can't grow very fast, like a younger tech startup.
So, instead of investing all the profits into growth, they give it to their shareholders through dividends.
Dividends are regular cash payments to shareholders, or people who own a stock.
“That doesn't make sense! Why would a successful company want to give their profits away like that?”
Well first, on the stock market, every company is publicly owned by its shareholders.
They're not truly “giving it away”.
There isn't any requirement for big companies to pay dividends to their shareholders, but offering Dividends is a great way to incentivize shareholders to keep their money in a company's stock.
Dividends are also usually not offered by younger companies' growth stocks, whose rates of return may be higher than the big-name companies who offer dividends.
It's a win-win, all around.
Also, if you prefer watching instead, check out my video on this topic below!
Some Dividend Lingo
Before we go any further, here are some dividend investing terms you should be familiar with!
Direct Deposit: Dividends are cash payments paid directly into the brokerage account you use to buy and sell stocks (if you have an older account, sometimes you'll get a check in the mail).
Quarterly Payout: Most companies pay dividends on a quarterly basis, but you can find companies that pay out on an annual, bi-annual, and even monthly basis.
Reinvesting: Once paid out, people usually face a decision between keeping their dividend income as cash, or reinvesting their payment back into their dividend stock to maximize their return.
Generally speaking, if you're just starting off, you'll want to defer payments and reinvest until you're able to use it to become financially independent.
Dividend Yields: Technically, each dividend is a set dollar amount per share, but this isn't the real “stat” to keep track of. It's more accurate to compare different stocks by their dividend yield – the percentage your dividends earn relative to what equity you own per share.
For example, if you bought 1 share of a stock for $100 and you earn $5 a year in dividends, this would be a 5% dividend yield. Most dividend stocks offer a 2-5% dividend yield.
Declaration Date: When a company decides to pay a dividend, they announce it on this date.
Ex-Dividend Date: This is the cutoff date to receive a dividend. If buy the stock prior to the ex-dividend date, you will receive the next upcoming dividend payment.
To make sure you receive your first dividend, make sure you buy your stocks the day before the ex-dividend date at the latest!
Date of Record: This is the day all shareholders are counted and ‘locked in' for the upcoming dividend payment. You must be counted on the record in order to receive your dividend.
Payment Date: This is the actual day the dividend payments go out to shareholders. everyone on record receives their dividends.
These dates may be confusing, but as long as you buy and hold your stocks long-term, you won’t have to keep track of any of these dates.
Dividend Stocks and Growth Stocks
There are two main ways to make money in the stock market: dividends, and asset appreciation.
If you're familiar at all with the stock market, you probably already know what asset appreciation is:
- You buy the stock, it's value appreciates (grows) over time, and then you sell the stock for a higher amount. Buy low, sell high.
- Let's say you bought a stock for $60, and after a year it grows and is worth $70. After that year, you've made $10 through asset appreciation.
Stocks that primarily offer value through asset appreciation are called growth stocks.
What determines if a certain stock is either a dividend or growth stock is if a company is in growth mode (reinvesting profits) or income mode (sustaining profits).
Dividend stocks are great for passive income because they pay you as you own them – pure growth stocks need to be sold in order to give you any monetary value.
However, stocks aren't always just either dividend or growth stocks…
Here's where things start to get spicy.
- While some companies are purely in Growth mode (like Amazon), and others are purely in Income mode (like AT&T), there are still other companies that are kind of in the middle (like AAPL).
- You can find these companies offering what's called a dividend growth stock, which doesn't have the same dividend yield percentage a pure dividend stock would, but also appreciates in value over time!
Especially for younger investors, these lower dividend yield ‘combo' stocks are really attractive, because they can pay you passive income now while still growing in the long game.
While you're usually trading off the higher dividend yields of pure dividend stocks, your total investment still grows with the power of Compound Interest. A killer combo!
Dividend Stocks vs High Yield Index Funds
When it comes to dividend investing, there's a couple different strategies you could take.
One involves simply choosing and buying the individual stocks that are appealing to you, and diversifying your investment as you see fit.
This gives you full control over your assets, though it requires thorough market analysis on your part, and is a more active approach for those who aren't new to the game.
A more passive, ‘set-it-and-forget-it' strategy would be by leveraging high yield dividend ETF's (Exchange Trade Fund).
These index funds are a professionally managed fund that owns a plethora of various dividend stocks, and cost a regular percentage-based fee called an expense ratio.
ETF's use the sum buying power of their total investors, and diversify that into the market.
What this provides is an easy way to diversify your total investment – making it more resilient versus risk – as well as the ease of knowing your investments are going to solid businesses.
With high yield index funds, you make your one-sum investment, collect every quarter, and don't worry about managing the back end of things. The ‘most passive' passive income could be.
Here’s a few popular High Dividend Index Funds:
- Vanguard High Dividend Yield ETF (BYM): Vanguard has some of the best quality funds out there, with minimal fees! This fund utilizing 414 different dividend stocks, featuring Johnson & Johnson, JPMorgan, and Procter & Gamble.
- Schwab U.S. Dividend Equity ETF (SCHD): This fund features a regular dividend yield of around 3.6%, and focuses on tracking “an index focused on the quality and sustainability of dividends”.
- Vanguard Real Estate ETF: This REIT (Real Estate Investment Trust) owns real estate instead of stocks. This functions as a dividend stock ETF, but uses a different means of generating the income. REITs usually have slightly higher fees, and slightly higher yields than other Dividend Yield ETFs.
Best Dividend Stocks To Buy in 2022
We said we were going to help you build a solid foundation for your passive income, and here we are.
If you're looking for a place to start investing dividends, I own the following stocks.
This list only includes true “Dividend Aristocrats” – companies listed have been paying and growing dividends for 25+ consecutive years.
Feel free to look any of these up using M1 Finance, or your favorite watchlist! (Personally, I use M1 for dividend investing.)
3M (MMM): A leading power among dividend stocks, 3M has been growing and paying dividends for over 57 consecutive years! This company is a leader in industrial technology, and bears a solid dividend yield of over 4%.
Coca Cola (KO): A tried and true investment, critically acclaimed among big names such as Warren Buffet. Coca-Cola currently pays a solid yield of 2.7%, and has paid dividends for over 100 years. Can't go wrong with Coke!
Genuine Parts Co (GPC): Genuine Parts is the parent company of NAPA Auto Parts. They feature a great dividend stock with a yield of 2.8%. Because of the reliance on older cars by the general populous, GPC is a great recession-resistant dividend pick.
Procter & Gamble (PG): Another solid recession-proof business, Procter & Gamble manufactures crucial everyday items like soap and cutlery. Their current dividend yield is sitting at 2.23%. A big, beautiful, boring company!
Target Corp (TGT): A great example of dividend growth stock. Everyone knows Target, but not many know that their stock value appreciated over 60% between 2020 and 2021! Their dividend yield is only about 1.8%, but stock growth will make that number look smaller than it really is.
Caterpillar Inc (CAT): Another solid dividend growth stock. Caterpillar currently offers a dividend yield of 2.37%, and has grown by nearly 40% during the pandemic.
Looking for more? Here's our 2022 Mega List of Dividend Aristocrats!
Dividend Investing Mistakes
As with any new venture in the stock market, there are always a bunch of pitfalls waiting for you to make the wrong move.
Some of these we have learned personally from experience, and we'd love to help you avoid the pain of stepping into these newbie traps.
Here's the most common mistakes…
1. Chasing High Dividend Yields
Chasing high dividend yields is actually the #1 biggest mistake you can make as a new dividend investor.
Dividends are not guaranteed. Companies' Board of Directors can change their minds at any time.
(Most companies who thrive off of dividends are incentivized to not do this, as many of their investors would then sell and cash out of their stock.)
When Dividend Stock companies hit rough patches, their stock value will fall, but their dividend yield per stock (The actual paid amount per stock, not the percentage) will remain the same.
Because of this fluctuation, you will see some unhealthy dividend yields pop up that provide anywhere from 6%-12% return.
If you're seeing a company with these kinds of percentages, go the extra mile when researching them.
- How is this company's revenue doing?
- Has this company's stock value taken a recent plunge? If so, why?
- Are there any current problems in this company's industry?
More often than not, purchasing these high dividend yield stocks is a major mistake.
These high yield percentages are often a sign that the company has hit rough waters.
Most of the time, the company has suffered recent losses, and the dividends they have are likely unsustainable.
And as we've mentioned, for dividend companies in “profit mode”, keeping those dividends active is a major incentive for most of that stocks' investors.
“The Dividend Trap”
You can easily run into a situation many call the dividend trap: where you've recently bought into a company with unhealthy high dividend yields, just to have them quickly cut their dividends.
Usually, when a dividend-paying company's dividend yield spikes, their older investors will soon after pull out and sell.
When that happens, you're stuck holding onto a dwindling, dead stock – no more passive income, and unlikely to grow. Don't make this mistake.
2. Putting all your Eggs in One Basket
‘Putting all your eggs in one basket' may as well be in the ABC's of investing, but in the context of dividend stocks, it's even more true.
Companies can lower or eliminate dividends at any time.
For example, imagine you are heavily invested in Coca-Cola, and they just took a big loss.
If they lost enough profits, they could very likely make the decision to turn off or lower their dividends for a season.
In this scenario, if you've been paying your mortgage and groceries off of only Coca-Cola Dividends, you won't be having a good time!
With dividend investing, make sure you're extra diversified, to avoid outcomes like this.
3. Not Doing Enough (or any) Research
Whenever you approach a new dividend stock, you need to make sure you're stepping into something that's solid and sustainable.
This is why the ‘Dividend Aristocrats' are so well acclaimed.
Though we've given you a great start regarding various individual stocks we like, if you only “take our word for it”, and don't do your own research, what may seem sustainable at first may turn out to be a dead end.
In addition to the research questions we provided before, consider these points before ‘pulling the trigger' on your new asset:
- How exactly does this company create revenue?
- What is this company's 5 year track record concerning dividends?
- Is this company financially stable?
- What is this company's BBB Rating?
- How much debt does this company have?
- What is it's debt-to-income ratio?
- Is this company still competitive in its field?
- Is this company facing any legal problems or fiascos? Have they in the past?
- How has this company reacted to loss or bear markets in the past?
- How active are they in pursuing new strategies for their successful business?
- Is this stock likely to grow or decline over time?
While you should deliberate where you're putting your money, even a cursory search could save you from simply throwing away your investing cash.
By doing the proper research, you can even find dividend stocks with higher dividend yields that are aggressive in a healthy way.
4. Losing Your Patience
Dividend investing is a long game. Especially if you're starting out with limited funds, it may seem like you're not making any worthwhile return.
Dividend investing is not a get rich quick scheme.
It takes time for compound interest to work its magic, and creating a robust dividend stock portfolio takes time as well! It can take 20+ years to build out a truly powerful portfolio.
Take time doing your research, learning more about the ins and outs of how it all works, and build a solid foundation for yourself for the years to come.
You will see steady return and real wealth-building as you invest wisely, and let it grow.
5. Not Reinvesting Dividends
Listen Millennials. Gen-Z'ers. Reinvest your Dividends. Just do it.
By reinvesting, your returns directly purchase you more compound interest, and grows your investment without you even thinking about it.
Unless you're already at a stage where you have a very diversified portfolio, and your full dividend yield income can replace your current income, reinvesting is the superior option.
By reinvesting, you are actively boosting your asset's growth, making you reach financial independence quicker. This could save you years of work, and will maximize your returns.
Dividend investing has been used for hundreds of years as a reliable way to build wealth over a long period of time.
And now, with applications like M1 Finance, it really has never been easier to start building your own financial legacy.
Seize the day my friends, and invest wisely.
Thanks for reading.
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