Why and How to Invest in Dividend-Paying Stocks

No matter what your stage of life, dividend-paying stocks can be a valuable way to supplement your income and improve portfolio growth potential. 

For example, investors who are many years from retirement often reinvest their dividends to boost returns. In fact, a hypothetical $10,000 investment in an S&P 500^® Index fund in 1993 would have swelled to more than $158,000 by the end of 2022 had dividends been reinvested but only to $88,000 had dividends not been reinvested (see "The dividend dividend," below).

For retirees, regular payouts from dividend-producing stocks have the potential to provide a steady stream of income. And while dividend yields from S&P 500 companies may have declined over time, it's important to consider that in the context of inflation.

High inflation, as we've experienced for the past few years, erodes purchasing power, meaning your dividends must be greater to keep pace with rising prices. The opposite is also true: A low-inflation environment puts less pressure on your income. Consequently, over the long term, you want your dividends to exceed, or at least keep pace with, the rate of inflation.

Not all companies pay dividends, of course. Smaller, less-established companies, which may often provide above-average returns on the value of their stock, can justify reinvesting in themselves rather than paying out dividends to shareholders. 

Larger and more-established companies, by contrast, tend to see slower growth and lower returns, and as such typically pay dividends to help retain existing shareholders and attract new ones. Indeed, of the approximately 500 large-cap stocks tracked by the S&P 500, nearly four-fifths pay dividends.¹

Dividends are determined on a quarterly or annual basis and a company typically pays a cash dividend directly into a shareholder's brokerage account (other forms of dividends are paid in stock). Dividend yield, calculated by dividing the annual dividend by the current stock price, is one key metric that helps investors understand the return they might generate on a stock and get a sense of how various dividend-paying stocks stack up against each other.

Consider a simplified example: for a company that pays a 2% annual dividend and whose shares are trading at $100, an investor with 100 shares would receive an annual dividend payment of $200 (2% of one $100 share = $2; $2 x 100 shares = $200).

Dividend yields for many of the largest U.S. companies tend to be lower than that example. As of February 2023, the average dividend yield of S&P 500 index companies was 1.68%, up from around 1.3% at the beginning of 2022 but still well-under recent inflation levels and Treasury yields.
 

When it comes to investing in dividend stocks, many investors turn to mutual funds or exchange-traded funds that offer access to dividend-paying companies across industries.

Those who prefer to hold individual stocks might instead want to follow in the footsteps of famed investor Benjamin Graham, who favored companies with three attributes:

1. A history of steady dividend growth: Consistently increasing dividends are generally an indicator of healthy corporate fiscal policy.
2. A low payout ratio: When companies exhibit a low ratio of dividends to earnings, it suggests they're retaining some earnings, making it less likely they'll reduce dividends in the future.
3. A respectable current dividend rate: According to research by Robert D. Arnott and Clifford S. Asness, low dividends beget lower stock prices, while high dividends beget higher stock prices.² However, unusually high dividends can be a sign of corporate distress. So a good rule of thumb is to look for dividend stocks yielding at least as much as the current 10-year Treasury but no more than twice that amount.

Not only may these key characteristics help you identify worthy dividend payers, but companies exhibiting such attributes also tend to be higher quality with lower leverage and debt—which could potentially help your portfolio better weather a downturn.

That said, no investment vehicle is perfect. Dividend stocks are subject to the same vicissitudes as all other equities. And unlike bonds—whose coupon payments are nearly guaranteed, barring default—dividend payouts could be trimmed or eliminated altogether without warning.

All of which is to say that dividend stocks should not be viewed as a replacement for traditional fixed income investments but rather as a complement to a diversified portfolio.