Dividends explained: guide on how to earn passive income

July 18, 2023

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Investing in dividend stocks could be the first step towards building wealth and a reliable portfolio. Dividends are often a core element of any long-term strategy, as they represent a source of passive income. Read on to find out a thorough guide on dividends and why you may want to invest in dividend-paying stocks.

What are dividends?

Dividends represent the distribution of a portion of a company’s profits among its shareholders, allowing them to benefit from the company’s success. When a company generates profit, it can either reinvest the capital into its operations or distribute it to shareholders.

The distribution of profits is accomplished through dividend payments, which provide shareholders with a monetary amount for each share they own. In some cases, shareholders may receive additional shares through stock dividends instead.

Dividend investments are appealing due to their ability to generate passive income. The idea is that by investing in companies that consistently distribute dividends, investors can either build wealth, pocket the money and use it to cover any expenses or reinvest the amount received.

In practice, successful dividend investing requires more than passive participation. Reinvesting dividends becomes crucial to leverage the power of compound interest and create a snowball effect over time.

Furthermore, selecting the right companies to invest in is essential. Factors such as the dividend payout ratio, industry leadership, and a track record of increasing dividend payouts should be considered.

To simplify the process for investors, there are lists available that feature quality companies with a long history of dividend distribution. Additionally, there exists a large community of dividend investors who share their analyses and investment portfolios.

Despite these resources, novice investors often wonder if there is an easier way to pursue dividend investing. It’s important to note that investing directly in individual stocks is just one option for implementing this strategy – also, copytrading can save time and helps you leverage the knowledge of experienced investors, so you may want to check the best copytrading brokers.

Starting a dividend-earning portfolio with ETFs (Exchange-Traded Funds) might also be a suitable option for passive or inexperienced investors, for which you may want to check the best ETF brokers. However, it’s essential to evaluate the potential gains and losses associated with each approach—be it individual stocks, ready-made portfolios, or funds—when investing in dividends.

In summary, the choice of investment method depends on various factors, and careful consideration should be given to the specific goals and preferences of each investor.

Advantages and disadvantages of buying stocks to invest in dividends

Investing in individual stocks is the traditional and often cost-effective approach for dividend investing. Here are the advantages of selecting stocks:

Personalised portfolio: Investing in stocks allows you to handpick the specific companies you want in your portfolio, providing a highly personalised approach.
Easy to monitor: when you handpick your own companies, you understand them and it is easier to monitor each of them.
Easy taxation: depending on the chosen companies, it may be easier to calculate your taxes at the end of the year compared to investing in complex products like funds. However, double taxation may apply in the case of some foreign stocks.

It’s important to note that these advantages come with certain considerations:

Financial knowledge: Investing in dividend-paying stocks requires a certain level of financial knowledge to identify suitable stocks for your portfolio.
Time commitment: Building and managing a stock portfolio demands a significant amount of time, particularly for monitoring stocks and including them in tax returns. Therefore, it’s crucial to have a genuine interest in this endeavour.
Cost limits: buying individual stocks can be extremely costly (unless you opt for fractional shares). Also, it is hard to achieve diversification benefits with a limited budget. At the same time, the more assets you have, the more difficult it will be for you to manage and keep track of all of them.

Advantages and disadvantages of investing in dividend stocks through ETFs

ETFs, or Exchange-Traded Funds, are investment funds that are traded on stock exchanges, similar to individual stocks. They are designed to track the performance of a specific index, sector, commodity, or asset class (such as stocks). ETFs offer investors the opportunity to gain exposure to a diversified portfolio of securities in a single investment.

ETFs have different objectives, and some are focused on dividend-paying stocks. For example, the S&P 500 Dividend Aristocrats index consists of US companies that have been consistently increasing their dividends for more than 25 years.

Some ETFs may distribute the dividends, others may reinvest them, so you can choose the right one for your needs and strategy.

Advantages:

Diversification: ETFs provide better diversification as you can gain exposure to a basket of dividend-paying companies at a reasonable price.
Simplicity: Investing and managing your portfolio becomes simpler since you don’t have to individually choose and analyse stocks.
Lower Costs: ETFs generally have lower costs compared to investing in individual stocks (i.e., you invest in a basket of assets in only one trade).
Flexibility and liquidity: ETFs trade like stocks, providing flexibility and liquidity. You can buy and sell them at any time during market hours.

Taxation is perhaps one of the main drawbacks of ETFs (and other funds, such as mutual funds). If you invest in an ETF issued abroad, such as US or France, you may have to pay additional tax – for instance, dividends from an ETF issued in France or US are taxed by 30% in the domestic country, which greatly reduces your gains.

In addition, you need to check the status of the ETF if issued in the UK. You may want to invest in one classified as reporting or distributor, as these are usually associated with less tax: the ETF gains are subject to capital gains tax (usually lower than income tax). Gains from ETFs with a different status may be taxed as income, which can be as high as 50% (depending on your income tax bracket).

Have a look at our guide on how to choose an ETF, the best ETFs right now, and the best ETF brokers to get started.

Advantages and disadvantages of investing in dividend stocks through mutual funds

Mutual funds are similar to ETFs, in that they are funds that pool investor’s money and invest them into a diversified range of assets according to well-established objectives. Both types are managed by professionals, but mutual funds are not exchange-traded – they can only be bought at the end of the trading day.

Intuitively, there are multiple mutual funds that invest in dividend-paying stocks.

Unlike ETFs, mutual funds are usually actively managed (which means that managers buy and sell assets to ensure compliance with the fund’s strategy or objectives, or to outperform the market rather than just track its performance, resulting in higher returns).

On the other hand, the main disadvantage is that active management also results in higher costs. As previously mentioned, you can’t trade mutual funds on the exchange, so they are less liquid than ETFs.

Learn more about index funds index fund guide and find out the differences between funds in our index funds vs ETFs article.

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Dividends: summary

In conclusion, investing in dividends can be a rewarding strategy for generating passive income and building long-term wealth. Dividends represent a company’s distribution of profits to its shareholders, allowing investors to participate in the company’s success.

When considering dividend investing, there are multiple options available, including investing in individual stocks, exchange-traded funds, or mutual funds. Regardless of the approach chosen, reinvesting dividends and leveraging compound interest is key to maximising the potential returns from dividend investing. Careful research, analysis, and an understanding of the individual investor’s goals and preferences are crucial for success.

Dividends FAQs

How are dividends paid to shareholders?

Answer: Dividends are typically paid out to shareholders in the form of cash, although they can also be paid in additional shares of stock. Cash dividends are usually deposited directly into shareholders’ brokerage accounts.

How often are dividends paid out?

The frequency of dividend payments varies depending on the company’s dividend policy. Some companies distribute dividends on a quarterly basis, while others may pay dividends semi-annually or annually.

What is the significance of dividend yield?

Dividend yield is a commonly used financial metric to assess the income potential of a dividend-paying stock. It represents the annual dividend payout relative to the stock’s current market price. A higher dividend yield indicates a higher potential income return from the investment, but it’s important to consider other factors such as the company’s stability and dividend sustainability.