Dividend Investing Basics: Pros and Cons of Dividend Investing!
One of the most popular ways to generate income from stocks is dividend investing. Here, the investors enjoy the benefits of dividend income along with capital appreciation. Anyways, if you are new to dividend investing, let me give you a brief introduction.
In this post, we are going to discuss the basics of Dividend investing. Here, we’ll cover the pros and cons of dividend investing that you should know before making your investment in dividend stocks.
What is Dividend Investing?
Dividends are basically a portion of income that a company distributes to its shareholders. Dividend investing means investing in those stocks which give high consistent dividends to their investors.
For example, in the last financial year (FY2020–21), ITC gave a final dividend of Rs.10.15 per share (1015%) on 06/07/2020 and an interim dividend of Rs. 5.00 per share (500%) dated 22/02/2021. The ITC share price at this time was trading between Rs 170–210. Therefore, if you were holding 100 shares of ITC company in your portfolio FY 2020–21, you would have received Rs 1,515, credited directly into your bank account without selling even a stock.
A lot of equity investors invest in stocks just for dividends. Dividend investing is a good way to earn secondary income along with enjoying the capital appreciation for your invested stocks. When invested correctly, investors can earn amazing income through dividends.
Pros of Investing in Dividend Stocks
Let’s start with the pros. Here are a few best advantages of investing in dividend stocks:
1. Passive Income
This is probably the biggest advantage of investing in dividend stocks. You can treat dividends as a passive income- which means getting paid without doing any work. For the people looking for a few alternate secondary sources of income, dividend investing is the answer.
Anyways, for making passive income through dividend investing, initially, you need to put big efforts to find good dividend stocks. However, once the work is done, you can enjoy passive income for multiple years.
2. Double Profits
If your invested stock goes up by 30% in the next 3 years, and you received a dividend yield of 3% per year from the same stock, the combined profits are way higher than just the capital appreciation. Here you can earn double profits compared to investing in companies that don’t give any dividends.
3. Defense against bad markets
Everyone makes money in a rising market. However, the scenario is different when the market turns sour.
In the bear market or corrections, the share price of a lot of your favorite stocks may fall. And hence you might not be able to make a good return from capital appreciation of stocks. However, if you have picked the right dividend stocks in your portfolio, you can enjoy a decent dividend income even when your portfolio is down.
Further, dividend stocks are generally big matured companies and hence are less influenced by a bear or speculative market. Investing in these companies can provide a good hedge to your investment from a bad market. In addition, dividend investing also helps in capital preservation. Even if the stock price of your invested company doesn’t go up, if you are getting regular high dividends, you will be able to preserve your capital.
4. Steady Income
Profits from stocks are only on ‘paper’ unless you sell them. This money is not in your bank account. The profits/loss are unrealized until the final settlement i.e. selling the stock. However, dividend stocks add steady income to your pockets without worrying about selling any stock.
5. Dividend Reinvestment
You can use the dividends that you receive from stocks to buy more stocks and reap the benefits of dividend reinvestment. Else, you can use that money to invest in any alternative investment options like bonds, gold, etc if you want to diversify your portfolio. Once you get the money back in your account, you have immense options to re-invest them back in whichever investment option suits you.
6. Long-term investment
One of the best strategies to make money from stocks is the same old philosophy of ‘buy and hold’. However, while investing for the long term, there may be a number of situations where the investors may be in the need of a few extra bucks. Here, selling stocks may be the only option available to them if they want to make money from their invested stocks.
Nevertheless, as dividend stocks offer a steady income stream, investors may prefer to hold the stocks longer and enjoy the benefits of long-term investing.
Cons of investing in dividend stocks:
No investment strategy is perfect and the same goes with dividend investing. Here are a few biggest disadvantages of investing in dividend stocks:
1. Low-growth companies
Most growth companies do not give dividends to their shareholders as they reinvest their profits in expanding their businesses like opening new plants, entering new cities, buying new machinery, acquiring small companies, etc.
On the other hand, big mature companies do not have so many opportunities and hence they offer a large profit to their shareholders. While investing in dividend stocks, the investors may be investing in low-growth companies that may not always offer high returns.
2. High dividend payout risks
A high dividend payout means that the company is distributing a major portion of its profits to its shareholders. For example, if a company made a profit of Rs 100 crores in a financial year and shares Rs 85 Crores as dividends, this means that the dividend payout ratio is 85%.
At first glance, it may sound favorable for the shareholders. After all, they are getting a major portion of the profit as dividends. However, in the long run, it may not be advantageous for investors.
Think of it from the other angle. When the company is not retaining enough profit for itself, it doesn’t have any big money left for reinvesting in its growth. And if the company is not reinvesting enough, it may face problems to grow, compete with rival companies, or even retain the same net profit in upcoming years. Moreover, if the company doesn’t grow or increase its profits, it can’t add more value or increase dividends for the shareholders in the future.
3. Dividend Taxation
The dividend received from an Indian company was exempt from taxes until 31 March 2020 (FY 2019–20). However, the Finance Act, 2020 changed the method of dividend taxation and the dividend shall now be taxable in the hands of shareholders. (The previous DDT liability on companies and mutual funds has been withdrawn.)
The tax burden was shifted from the recipients to the companies and Mutual Funds themselves. Hence, from FY 2020–21 onwards, dividends from domestic companies and mutual funds are taxable in the hands of the shareholders and unitholders at their applicable slab rates.
4. Dividend cut
This is the worst-case scenario. Dividends are not obligations and a company may decide to cut the dividends anytime in the future. Moreover, when the company cuts the dividends, even the share price falls significantly as the public sees it as a negative sign. And that’s why the dividend investors may face double side trouble.
Further, many times, the board of directors can also change the dividend policy of a company. This can again have an adverse effect on the dividend investors if the decision is made against the existing dividend policy.
When you should exit a dividend stock?
Now, that you have understood the pros and cons of dividend investing, the next big question is when should you exit a dividend stock. If you’ve invested in dividend stocks, look for the following signs periodically to avoid any dividend pitfall in your invested company. Here are the three signals that you should exit a dividend stock:
— Dividends start declining: A fall in dividend for a year compared to the previous one can be ignored by the investors as businesses can always have a few losses in some years. However, if the dividends start continuously declining year after year, it may be a sign for the investors to exit.
— High dividend payout: A payout ratio greater than 70% for the continuous years may be a warning sign that the company is not retaining enough profit for its growth.
— An adverse change in dividend payout policy: If the company changes its dividend policy against the favor of the investors, then again it may be a sign to exit that stock.
Closing Thoughts
Traditionally, the dividend investing approach was used by retirees or people entering their retirement age. As these people do not have any primary source of income (regular paycheck) after retirement, receiving small dividends per year in their account can be a good secondary source of income.
However, these days even young and middle-aged investors are looking forward to dividend investing. Why? Because it is always a joy to see dividends get credited to your account periodically. Moreover, they do act as a secondary income source.
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