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When we think of stock trading, the phrase "buy low, sell high" is often echoed as a strategy for success. But there's another way investors can make money in the market: through dividends.
In short, dividends provide a way for companies to pay investors a share of their profits. Shareholders benefit because each share of stock they own entitles them to a set dividend payment. Companies pay out dividends in regular scheduled payments, either in cash or in the form of additional company stock, typically monthly, quarterly or annually. For this reason, you can almost think of dividend-paying stocks as a way to earn passive income.
"Growing dividends from high-quality companies can make a significant positive impact on a portfolio," Daniel Milan, managing partner of Cornerstone Financial Services, tells Select. "Albert Einstein summed it up well when he called compound interest 'the eighth wonder of the world.' Reinvested dividends are a driver of huge growth, much more than just market returns alone."
More than just providing a steady income stream, dividend-paying stocks have become a part of the conversation lately since they also protect your money against inflation, making them ideal for today's market conditions.
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Large companies that have a long history of paying consistent dividends each year have something to their advantage in an inflationary environment: they can weather — and actually benefit — from higher prices.
"The good thing for stock investors is [that] over the intermediate and long term, as products and service prices increase because of inflation, [a] company's revenue, earnings and dividends will increase," says Clark Kendall, certified financial planner, president and CEO at Kendall Capital.
Kendall calls out dividend-paying stocks like IBM, Johnson & Johnson, Procter & Gamble and Kellogg as examples of great ways to protect investors' long-term purchasing power when the prices of goods and services increase. "As interest rates go up, focus on the valuations of the companies you own…and own good companies," Kendall adds.
More specifically, Milan recommends seeking a portfolio of stocks with strong cash flows that yield an average of 3% to 4% or more and consistently grow dividends of 5% to 10% every year. "These are the types of companies you should target," says Milan.
Kendall and Milan are not alone in their thinking. Mike Schenk, deputy chief advocacy officer for policy analysis and chief economist at the Credit Union National Association, agrees that many companies with high-dividend stocks have long adopted business models that hold up well every time prices rise, eventually fueling their profits.
"Let's face it, consumers have to heat (or cool) their homes, drive to work and eat — even when prices are rising quickly," Schenk says. "Companies in the energy sector, those in the natural resources arena and those in the food and consumer staples sectors generally benefit from strong pricing power and cost management, allowing them to raise prices, maintain demand and boost profits."
Schenk's remarks are also backed up by past performance — he notes that historically, dividend payments have accounted for roughly 40% of total stock market returns. During inflationary times especially, investors can benefit from having portfolios that include stocks that increase their dividends the most.
Schenk is quick to suggest that average investors most certainly invest in stocks with dividend growth, but also reiterates that investment decisions be made carefully.
In times of rising inflation, he adds that portfolio rebalancing — responding in real time to events — can be expensive. "Inflation pressures have been building for a while and many high-dividend stocks are already valued to reflect those developments."
In general, his best advice is to take a long view, seek to build a diversified portfolio of holdings and resist the temptation to time the market and shop around. You can purchase stocks and build a portfolio through the best stock trading platforms that don't charge commission fees, including TD Ameritrade, Ally Invest, E*TRADE, Vanguard, Charles Schwab and Fidelity. Or if you want a simpler interface and trading platform, consider an investing app like Robinhood.
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When it comes to profiting from dividend-paying stocks, remember that slow and steady wins the race. "Discipline and patience are what's required for a successful dividend growth investment approach," Milan says. "These qualities are not exciting, nor are they in ample supply for most investors. But if we look at the history of dividend growth stocks, they've outperformed high-yield stocks, non-dividend payers and dividend payers significantly with less volatility."
Dividend-paying stocks can be a great addition to your portfolio, especially in the current environment since rising prices can boost company profits. If you're wondering how you can benefit more as an investor, consider speaking to someone professionally to help you decide your next step.
"Work with your financial advisor to be more conscious of where to put your investment dollars and look for opportunities you might otherwise miss," says Kendall.