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What Is Dividend Investing? Understanding How It Works

What is dividend investing? A dividend investment strategy focuses on stocks that distribute dividends. Learn more about dividend investing, its benefits and risks, and how to avoid making common mistakes.

April 15, 2024 6 min read

Dividend investing is an investment strategy that focuses on stocks that distribute dividends. Dividends are payments made by companies — in the form of stock or cash dividend — typically on a quarterly basis.

When investing in dividend-payers, investors can potentially profit in two ways:

from dividend payments
from any price appreciation of the underlying stock

Dividend Stocks: What They Are and How They Work

Every company makes a capital allocation decision on how much of their net income to reinvest towards growth versus returning to shareholders. A dividend is the portion of income that the company decides to return to shareholders. Companies can issue dividends in the form of additional stock or cash.

Companies that issue consistent dividends provide returns to investors in the form of steady income. By contrast, many growth companies believe in their ability to generate higher value for shareholders by using proceeds for expansion or capital investments. The board of directors decide whether to pay out the company’s profit in dividends.

Mutual funds and exchange traded funds (ETFs) also issue dividends. This usually is the result of underlying stocks held by the fund issuing a dividend, which are then passed to shareholders of the fund.

Quick Quiz

Are higher dividends always better than lower dividends? If ETF A issues a dividend of $4 per unit and ETF B issues a dividend of $3, is ETF A better?

Yes

No

Not necessarily

You are right! Higher dividends are not necessarily better than lower dividends. Read the section "What is Dividend Yield?" to learn more.

Higher dividends are not necessarily better than lower dividends. Read the section "What is Dividend Yield?" to find out why.

What is Dividend Investing?

Dividend investing is an investment strategy focused on instruments that issue regular dividends. You can invest directly in stocks that have a history of issuing regular dividends or in ETFs or mutual funds that invest in a portfolio of dividend-yielding stocks.

What is Dividend Yield?

Not all dividends are created equal. To judge the comparative attractiveness of a dividend, you need a measure that normalizes for underlying stock price to provide an equal footing for evaluation.

One such measure is the dividend yield. To calculate dividend yield, divide a company’s annual dividend per share by the current share price. Dividend yield is the measure of dividend you have earned for every dollar invested.

Dividend Yield = (annual dividend received per unit or share)/(price per unit or share)

For example, imagine ETF A issues a dividend of $4 per unit and ETF B issues a dividend of $3 and that each unit of ETF A costs $40 and each unit of ETF B costs $20. The dividend yield of ETF A works out to be ($4/$40) 10%, whereas the dividend yield of ETF B works out to be ($3/$20) 15%. If all else is equal, ETF B with its higher dividend yield would provide a higher return than ETF A.

Types of Dividend Investing Strategies

Broadly, dividend investing strategies fall into one of two categories based on the criteria being followed and the investment goals targeted.

High Dividend-yield Strategies target companies with high levels of dividend yield. These strategies have the potential to offer a high level of dividend income and the opportunity for capital appreciation.

Dividend Growth Strategies focus on investing in companies with a history of consistently growing their dividends. The ability to grow dividends consistently over long periods of time demonstrates qualitative attributes, such as fiscal discipline and operational efficiencies, and can potentially lead to growth from dividend income as well as capital appreciation. ETFs built with this strategy usually track indices of stocks that have grown their dividends over consistently long periods of time.

Benefits of Dividend Investing

Investing in stocks that provide high dividend yields helps investors to:

1

Generate Passive Income

Dividend-paying stocks can be a source of passive and regular income. Companies use stable and increasing dividends as a signal of confidence in their firm’s prospects, while market participants consider such track records a sign of corporate maturity and balance sheet strength.

2

Reduce Risk/Volatility

Dividend payments potentially can provide a cushion to losses that occur from a decline in stock price. The embedded quality bias of companies that consistently increase dividends may also weather market drawdowns better than broad market indices.¹

3

Limit Tax Impacts

Qualified dividends are taxed at lower rates than ordinary income for certain investors, making those dividends potentially a tax-efficient means of obtaining income.

Risks of Dividend Investing

When considering where and how to invest, consider:

Tax Implications
Some dividends may be taxed as income, unless they are in tax-advantaged accounts like 401(k)s or an IRA. Thus, dividend investing may increase your tax liability. This is true of reinvested dividends as well.

Low Growth Potential
Companies that pay regular dividends are naturally reinvesting less into growing the company, which could impact the total return.

Possible Policy Changes
Even companies that have a history of offering regular dividends may decide not to issue dividends in a particular year in reaction to changing economic conditions or company-specific factors. As companies are not obligated to distribute dividends, dividend income is not guaranteed.

Dividend Investing Mistakes to Avoid

When implementing any investing strategy, investors run the risk of overlooking factors that can end up having a large impact on returns.

The Dividend Value Trap
Relying solely on dividend yield as a metric for investing often leads investors to chase high yields at the cost of high risk to their capital. A high dividend yield may not always signify high total return. The average dividend yield from S&P 500 companies fluctuates between 3% and 5%.² It’s prudent to be wary of very high payout ratios that are funded by debt and declining cash flows.

Choosing Dividend over Company Fundamentals
Chasing dividend payouts without considering the quality and durability of a company can lead to issues like shrinking dividend yields, loss of capital, and volatility in total returns. Therefore, look for companies with competitive strength, long-term expected earnings growth, strong cash flow, and a low debt-to-equity ratio.

How Do Dividend ETFs Benefit Investors (and Limit Risks)?

The ETF structure itself provides some potentially useful benefits. The following benefits can enable dividend investors to:

1

Reduce Tax Liability

Because ETFs rarely distribute capital gains, ETFs can potentially reduce the tax liability of investors. By reinvesting profits rather than declaring dividends, ETFs can offset the tax implications that come with dividend investing. Make sure your ETF due diligence includes checking the fund’s history of dividend distributions.

2

Rely on Index Tracking to Pick High Dividend Companies

Since many high dividend yield ETFs track indexes, the process of vetting companies is done for you.

3

Reduce Costs

ETFs typically have lower management fees and operating expenses compared to mutual funds. The average expense ratio for index ETFs is 0.57% versus 0.84% for mutual funds.³ When expenses and fees are low, investors keep more of their returns.

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Glossary

Dividend Equities
Equity securities that pay dividends. A dividend is a distribution of a portion of a company’s earnings, decided by the board of directors, to a class of its shareholders. Dividends can be issued as cash payments, as shares of stock, or other property. Equity, also known as stock, is a type of security that signifies ownership in a corporation and represents a claim on part of the corporation’s assets and earnings.

Dividend Equity Investing
A style of investing focused on owning companies or a portfolio of companies that make distributions and, in turn, reinvesting those dividends regularly with a view to slowly accumulating wealth over the long term.

Dividend Paying Stock
An equity security that pays a portion of company earnings in a payout to certain shareholders, usually on a quarterly basis. In recent years, increasing numbers of mutual funds and ETFs have begun combining such dividend-paying stocks into larger equity portfolios designed to augment income-generation at a time of low bond yields.

Exchange Traded Fund (ETF)
An ETF is an open-ended fund that provides exposure to underlying investment, usually an index. Like an individual stock, an ETF trades on an exchange throughout the day. Unlike mutual funds, ETFs can be sold short, purchased on margin and often have options chains attached to them.

Tax Efficiency
A term that describes various approaches to investing that minimize tax liability. Certain types of investments, including funds like ETFs or securities like municipal bonds are valued for their tax efficiency, as are tax-protected accounts such as Individual Retirement Accounts (IRAs) or Roth IRAs. Also, certain practices, such as tax-loss harvesting, which is designed to lighten tax obligations, are considered ways to pursue greater tax efficiency.

Value Trap
A stock or stock fund that appears to be trading below its intrinsic value, but that fails to increase in price. The stagnant share prices of value trap investments might indicate that a particular company or entire sector may be challenged, and that valuations may not be moving higher.

Volatility
The tendency of a market index or security to jump around in price. Volatility is typically expressed as the annualized standard deviation of returns. In modern portfolio theory, securities with higher volatility are generally seen as riskier due to higher potential losses.

Footnotes

Disclosure

ETFs trade like stocks, are subject to investment risk, fluctuate in market value and may trade at prices above or below the ETFs net asset value. Brokerage commissions and ETF expenses will reduce returns.

The S&P 500® Index is a product of S&P Dow Jones Indices LLC or its affiliates (“S&P DJI”) and have been licensed for use by State Street Global Advisors. S&P®, SPDR®, S&P 500®,US 500 and the 500 are trademarks of Standard & Poor’s Financial Services LLC (“S&P”); Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”) and has been licensed for use by S&P Dow Jones Indices; and these trademarks have been licensed for use by S&P DJI and sublicensed for certain purposes by State Street Global Advisors. The fund is not sponsored, endorsed, sold or promoted by S&P DJI, Dow Jones, S&P, their respective affiliates, and none of such parties make any representation regarding the advisability of investing in such product(s) nor do they have any liability for any errors, omissions, or interruptions of these indices.

The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor.

Frequent trading of ETFs could significantly increase commissions and other costs, such that they may offset any savings from low fees or costs.

Investing involves risk including the risk of loss of principal.

The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA’s express written consent.

All information is from SSGA unless otherwise noted and has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.

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