Investing for dividends is like planting an apple tree. In the beginning, the tree is small and might only give one or two apples. But if you take the seeds from these apples and plant them again (reinvesting the dividend), you will over time get a whole apple orchard that gives you fruit every single season, regardless of whether the garden of your neighbor withers.
"Whatever you send out in word or deed, will return to you."
— Florence Scovel Shinn
In dividend investing, the money you send out into the market returns to you as a steady stream of passive income. To master this strategy in depth, there are two key metrics you must understand crystal clear: Dividend Yield and Payout Ratio.
Two important key metrics
- Dividend Yield: This shows how large the dividend is as a percentage of the stock price. If a stock costs 100 kroner and they pay 5 kroner in dividends, the dividend yield is 5 percent. But beware: An extremely high dividend yield (for example 15 percent) is often a warning that the stock price has just plunged, and that the market expects the dividend to be cut soon!
- Payout Ratio: This shows how much of the profit the company distributes. If they earn 10 kroner per share and distribute 6 kroner, the payout ratio is 60 percent. A healthy payout ratio is often between 40 and 70 percent. If it is over 100 percent, they are paying out more than they earn, which is unsustainable in the long run.
Dividend Aristocrats: This is an exclusive club of companies (especially in the US) that have not only paid dividends, but have increased their dividend every single year for at least 25 consecutive years. They are the holy grail for dividend investors.
Pros and cons in depth
Advantages
- Provides predictable and passive income. You make money while you sleep!
- Companies that pay steady dividends are often large, stable, and profitable giant corporations.
- You avoid the psychological strain of having to sell your shares to get cash during a financial crisis.
Disadvantages
- Dividends are taxed. This can slow down the compound interest effect compared to companies that keep the money and reinvest it tax-free internally.
- Companies that pay large dividends often grow much slower than technology companies (you miss out on the most explosive stocks).
- If inflation is very high, a fixed dividend can lose its purchasing power over time.