In a way, the concept of investing in dividend stocks is ideal for people that think of earning money in the stock market as a slow, steady burn. After all, those that tend to invest in these types of stocks are typically doing so for relatively old-school purposes that seem to be eschewed by the typical day trader or another similar trader type. In short, those that invest in dividend stocks believe in the tried and true market motif of “slow and steady wins the race.”
Why Invest in Dividend Stocks?
The impetus behind investing in dividend stocks is twofold. Firstly, the investment typically stems from wanting to take advantage of the steady payments that come from the stocks of financially stable, mature companies over time. The second reason is that these stocks give investors a sterling opportunity to reinvest the dividends to purchase even more stock.
The results of this strategy won’t make the investor a killing overnight, but that’s not why they’re doing this investing in the first place. Rather, those that successfully invest in dividend stocks will see a gradually steady maturation of stock prices, which creates period dividend payments. In the case of well-established companies, these dividend payments will often trend upward over time, although it should be stated that there is no guarantee that this uptrend will occur.
Again, the stocks that are typically targeted in a dividend stock investment scheme are from companies that are known for their stability and their decided lack of cash flow problems. This balance makes the stocks less volatile about the rest of the market – something that could be quite alluring to those that wish to take a conservative approach to investing.
Needless to say, the goal of those investing in dividend stocks is not to make a ton of money in an expedient amount of time. Either they’re people that plan on being in the market for a long time, or they’re people in or near retirement that want to have a steady, somewhat reliable infusion to their nest egg.
Compounding – the Lifeblood of Dividend Stocks
The reason why investing in dividends stocks works so well as an investment strategy – and why so many people into long-term investing like the practice – has to do with compounding. This is the technical term for reinvesting earnings generated from market games to produce more earnings. In a way, you can think of compounding as the market equivalent of “playing with house money,” since you’re creating earnings from earnings as opposed to creating earnings from straight-up investment dollars.
This may not necessarily appeal to the investor reeled in by trade strategies dictated by speed and the constant monitoring of volatility and analytics. After all, it does take some time for the momentum needed to find success to occur. Given the course of time, it may be the most prescient demonstration of how the stock market works as a money generator. Its effectiveness is so great, no less than an authoritative mind than Albert Einstein called compounding “the eighth wonder of the world.”
The great thing about compounding is that you don’t need a whole lot of fancy analytics or advanced tools to make it work like you may with other investment strategies. You necessarily need four elements:
- An initial investment. This is most likely going to be a blue chip stock that has a proven track record for stability and market maturity.
- Earnings. This could stem from dividends, but it can also stem from interest or other market elements that turn one dollar into two.
- The reinvestment of earnings.
- Time to make it work.
Dropping Funds into a DRIP
One of the best ways that an investor can take advantage of the compounding power of dividend stocks is to get involved in a DRIP, or a dividend reinvestment plan. This is a company-offered plan that enables investors to automatically reinvest their dividends via the purchase of additional shares of fractional shares on the date of the dividend payment date. This can be an effective strategy because it eliminates the rigmarole of the investor receiving a dividend check just to send it back into stocks.
There are several advantages to the DRIP strategy. For one thing, the practice cuts down on commission fees, since the money isn’t directly shuttled to and from the investor and the stock. It also saves money on the investment itself, since investors may be able to pick up the stock at a discount based on the current share price. Plus, it eliminates the temptation of deviating from the investor’s long-term stock plans, since the thought of preceding the reinvestment and cashing in the dividends outright is removed.
The reason that companies offer DRIPs is that DRIP shares eliminate the middle man. The shares can be sold directly by the company as opposed to an exchange, which allows any proceeds derived from the stock sale to be reinvested into the company. It also enables companies to grow new equity capital over time while simultaneously lowering cash outflows that would normally be required for dividend payments. Because of the nature of the strategy, the practice also attracts the kind of long-term investor that’s willing to stick with a company stock through lean times.
Taxes and Dividend Stocks
The primary disadvantage behind investing in dividend stocks is that shareholders involved in the practice will have to pay taxes on the reinvested cash dividends despite the fact that they never receive the money. However, this is a minor quibble for the smart investor that makes sure to set aside the funds necessary to handle the taxation.
Even with the presence of taxes, investing in dividend stocks is an ideal method for those that adhere to the classic stock motif of gradually earning steady gains over an extended period. It may not be the flashiest way to make money in the stock market, but that’s fine. After all, those that deploy this investment strategy probably aren’t interested in flash.