Long Term Investing in Dividend Stocks

If you’re a beginning investor you probably have some money saved, and now you’re trying to figure out what to buy and why. Dividend stocks can be a good choice for the foundation of a long term investment portfolio.

Dividend payout vs. yield
One of the first things that you’ll need to know is that dividend payouts are in dollars per share, and dividend yield is the percentage of the current stock price that is being paid by the dividend. So, a stock that is trading at $100 per share and pays $5 per share dividend is said to yield 5%. The yield changes with the stock price. If the stock price were to drop, the yield would increase, and vice versa, assuming that the payout remains the same.

This is a one-year chart of Potash Corp (POT). The dividend of $1.40 was paid quarterly at 35 cents per share. You can see that the stock price and the yield always move in opposite directions. As one goes up, the other goes down while the payout per share remains the same.

Potash Corp one year  stock price vs. dividend yield chart

Chart by dividend.com

Dividend Aristocrats
One term to familiarize yourself with right away is "Dividend Aristocrats". This term applies to S&P 500® companies that have increased their dividend payout (in dollars per share) every year for at least twenty five years. This is important because it keeps the yield consistent as the stock price goes up, and it helps manage the downside risk if the stock price goes down. If you are going to own a stock long-term, you have to expect the share price to fluctuate over the years. Choosing the right dividend stock involves a combination of price action (fluctuation) and dividend growth.

Cost Averaging
In a nutshell, the reason why long-term investors buy more shares rather than selling when a stock price drops is because they are doing what is called cost averaging. Let’s assume you bought 100 shares of Potash Corp in June of 2013 at about $40, shortly before the huge price drop to a low of $28.85. That would be a tragedy, right? It would be if you had sold! You would have lost over $1,000! If instead you had bought 100 more shares at around $30, you would have cut your average cost per share by $5. Your average cost would be $35, and the stock would only have to rebound by $5 (instead of ten) for your investment to be out of the red. At the time of this writing, it’s trading at over $36. With 200 shares, you would be up by about $200 on the face value of the stock, collecting $245 in dividends in the meantime.

Potash Corp one year price chart

Chart by TD Ameritrade – click to enlarge

DRIP Programs
Direct ReInvestment Programs (DRIPs) are usually available through your broker and sometimes available directly through the company that issued the stock. With a DRIP program, you receive additional shares of stock instead of cash when a dividend is paid. This creates a compounding effect as the new shares generate dividends of their own. At 5% yield, you will get 100% of your cash back in 20 years, but by compounding it takes much less time. Also, getting more shares for "free" cuts your average cost per share. When the stock price is low, you get more shares for your dividend dollar (higher yield).

Tax implications
Dividend income in the U.S. is currently taxed at 15% and Capital Gains tax is also due when securities are sold at a profit, except with a Roth IRA which has no taxes on gains.

Disclaimer: I am not a registered investment adviser and I do not provide specific investment advice. I do not own any position in Potash Corp (POT) at this time, nor do I intend to initiate any such position within the next 30 days. The information contained herein is for educational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock you should do your own research and reach your own conclusion. It is up to investors to make the correct decision after necessary research. Investing involves risk, including loss of principal.

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