What is a dividend?
It is one of the ways you can earn money when you invest. Not all companies pay dividends to shareholders. Instead, some companies choose to reinvest their profit into the company. Let’s take a look at the advantages of dividend stocks - maybe it is something to consider for your portfolio.
KEY TAKEAWAYS
- A dividend is a common way that companies distribute profits to shareholders
- They are paid out in regular intervals and the amount of dividends you receive relates directly to the number of stocks you own in that company
- Not all companies, however, pay out dividends
- It's worth investing in companies that pay out dividends to ensure you benefit from regular payments
When do companies pay out dividends?
If you decide to buy a stock where you will receive dividends, you should be aware of one important date: the ex-date.
This date decides whether or not you will receive dividends in that year, quarter or however the company arranges their payments. Why? Because you have to own the stock before the ex-date in order to receive the dividend payment.
So it’s not about owning a stock for a certain amount of days, it’s about owning the stock before the ex-date.
How to reinvest dividends?
- You buy ten stocks and receive a dividend payment accordingly.
- Instead of taking your dividends out as cash, you use this dividend to buy more stocks.
- Now, the total amount of stocks you own increases. As a result, the next time the company pays out dividends, you will receive an even bigger dividend payment.
- As the next dividend payment is bigger, you can now buy even more stocks, meaning the dividend payment the next time increases again, and so on and so on.
Do you see the snowball effect? Time plays a significant role here! So get those dividends working for you early on, if you want to make the most of compounding.
Pros of dividend stocks
Let's start with the pros: If you invest in a company that pays out dividends, the biggest advantage is that you receive dividend payments without having to sell the stock, or do anything in fact. The amount of dividends you receive relates directly to the number of stocks you own in that company.
When you receive a dividend, you can choose to either take out the money as cash or to reinvest the dividend and buy more stocks.
If you decide to reinvest the dividend and buy more stocks, you can really get that magic compound interest working for you (which Albert Einstein is said to have called the eighth wonder of the world!).
So receiving and reinvesting dividends means that you can benefit from this wonderous compounding and your investments will therefore grow exponentially over time (the longer the better).
Cons of dividend stocks
Then on to the cons: When talking about dividend stocks it is also a good idea to consider the cons there is about dividend stocks. One of the disadvantages is that dividend stocks are taxed twice, also called double taxation.
And how does that work? First, they are taxed when the company earns the money. Second, the dividends are taxed again when the investor receives their dividends. Also when you receive dividends but want to reinvest, you pay taxes when you receive the dividend the first time, but also when you receive the dividend the second and third time. So, on another note, an important thing to consider when looking at dividend stocks is tax. Most dividend payments are affected by their own set of tax regulations, and these can potentially take away a large cut of your final returns. So look into this!
A company may choose to reduce its dividend. Or, in the worst case, eliminate it if they have a difficult time economically. Therefore dividends are not guaranteed, if the company chooses to reduce its dividend drastically it can be harmful for a dividend investor.