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Robert Abbott
Robert Abbott
Articles (609)  | Author's Website |

Dividend Investing: Earning Passive Income

The types of dividend stocks available, as well as their advantages and disadvantages

September 20, 2019

Are you an investor willing to take the slow and steady path to prosperity, while forsaking hot stocks and the possibility of a quick fortune?

Author Mark Lowe has a solution for you, laid out in his 2019 book, “Dividend Investing: Simplified - The Step-by-Step Guide to Make Money and Create Passive Income in the Stock Market with Dividend Stocks.” In it, you will find a comprehensive guide to a dividend strategy.

He explained, “Now, if your goal is to create a steady stream of regular passive income while gradually growing your investment portfolio, then dividend investing might be right for you.” He aimed to help individual investors understand the pros and cons of dividend investing, learn the language of it, explore dividend strategies, know how to undertake due diligence and more.

Not all publicly listed companies pay dividends, which is to regularly share their profits with shareholders. Some companies retain all their earnings so they can grow more quickly, others retain them because their shareholders would face tax bills if they paid a cash dividend, and for other reasons as well.

Many well-established companies pay dividends because it makes their stock more attractive to investors (which helps keep the share price up), while others want to signal their company is healthy and will continue to do well in the future.

Lowe reported that many types of dividend payouts exist:

  • Cash dividends: Actual cash is transferred from the company to individual investors. This transfer is considered income to the investor and is taxed.
  • Stock dividends: Rather than paying cash, some companies issue additional shares to investors. This avoids the tax exposure for investors. When it happens, the company will increase its number of shares by an amount equal to the value of the stock dividend, so its capitalization remains the same.
  • Which type is better, cash or stock? Both types have their fans and detractors, but overall, stock dividends generally have the edge because investors can choose between taking the cash now (and paying the tax) or deferring the tax to later (even many, many years later) when they sell some of their shares to raise cash or bring in income.
  • Other types of payouts include property dividends, scrip dividends and liquidating dividends.

Advantages of dividend stocks

There are several advantages or benefits to dividends and companies that pay dividends:

  • Mild risk: Dividend-paying companies are generally less volatile, meaning their share prices fluctuate less, reducing stress on shareholders.
  • Inflation protection: During bouts of inflation, companies can usually raise their prices and thus maintain or even increase their payouts, preserving the buying power of shareholders.
  • Solid returns during bear markets: Just because the market has slumped doesn’t mean the company will stop paying dividends and, in some cases, the dividends will offset declining share prices.
  • Buy more shares with your dividend payout: By reinvesting your dividends, you can buy more stock in the company without using additional cash. This is especially effective when companies offer formal reinvestment programs.
  • Earn passive income: Lowe wrote, “In fact, this is the primary advantage that entices many stock investors who are looking for investment plus supplemental regular income.”
  • Robust companies: Those with dividends are usually strong companies that are confident in their ability to share profits now and long into the future. The author added that the obligation to pay dividends forces management to be more responsible and cautious.
  • Demand from baby boomers: As the baby boomer generation moves into retirement, members of the cohort are buying dividend stocks for steady and consistent income. This suggests the demand for this type of stock should be solid for a couple of decades.
  • Two routes to profits: A dividend investor can realize ongoing profits in two ways, either by collecting dividends or by potential increases in the price of the stock.
  • Retain ownership of your stocks: If you hold only non-dividend stocks, you are forced to sell shares if you need cash. Timing matters because you may be forced to sell those shares when prices are low.

Disadvantages of dividend stocks

While there are lots of advantages, bear in mind there are also risks with this strategy. They start with the idea there are no guarantees:

  • High dividend payouts: Companies may like to share their profits, but they also need to keep enough cash to maintain growth and, at the same time, increase their dividends. A high payout ratio may become unsustainable and need to be cut.
  • Taxes: Cash dividends are subject to double taxation. First, the company pays corporate taxes on its profits, and then investors are taxed when they receive their dividends.
  • Policy changes: Boards of directors set dividend policies, and it is entirely up to directors to maintain, increase, decrease or even stop dividend payments altogether. Drastic changes may prompt some investors to trade or sell their shares.

Conclusion

Lowe began chapter one of “Dividend Investing: Simplified - The Step-by-Step Guide to Make Money and Create Passive Income in the Stock Market with Dividend Stocks” by outlining the types of dividend stocks available, and by listing the advantages and disadvantages of dividend investing.

Of the types of dividend stocks available, he explained there are two main types, those that pay cash dividends and those that pay stock dividends. The essential difference is taxation.

The number of advantages is greater than the number of disadvantages, but that should not lead investors to jump blindly into dividend stocks. Risk exposure remains and astute investors will carefully assess those risks before buying dividend stocks.

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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution."

Visit Robert Abbott's Website


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