What's more exciting than tracking your investments and watching their value increase? Cold hard cash landing in your bank account, seemingly by magic, every three months.
At least that's how fans of dividend investing feel. They invest in companies that offer a percentage of profits to their stockholders each quarter because, presumably, the firm has made so much money, or is so well established, that there's no need to reinvest all of it back into operations. Why not spread the wealth?
Although dividend investing is rarely thrilling – it's a long-term game – these stocks rack up fans when interest rates are low and fixed-income vehicles offer underwhelming returns, says Adrian Mastracci, a fee-only portfolio manager and president of KCM Wealth Management in Vancouver.
"If you're looking for yield, some of these have a yield of somewhere between 2 and 4 per cent. That's higher than most GICs and higher than most bonds today," he says.
Considering that dividend-oriented stocks and exchange-traded funds may offer even higher yields, shouldn't all investors add dividends to their portfolios to create income? Here are four points you should consider before dipping your toe in the water.
Two kinds of investors tend to receive the most benefits from dividend investments: the young, who have a longer time horizon to work with, and retirees, who want to generate income during their golden years.
Younger, long-term investors harness the power of compounding interest. That's particularly true if they sign up for a dividend reinvestment plan, or DRIP, which automatically reinvests cash dividends in the company by purchasing additional shares often at no cost and sometimes at a discount. It's a good option, particularly for those who might be tempted to take their dividend income and blow it on a trip to Maui.
For someone who needs the money now, a DRIP doesn't make much sense. Older retirees use dividends to create a modest income stream that will pay the bills today rather than provide a nest egg for the future.
So if you want to make a fast buck within the next two or three years, dividend investing probably isn't for you.
"These are not things you want to trade very often," says Mr. Mastracci. "Once you pick your ETFs or five, 10 or 20 individual securities, keep it simple. Don't go mucking around."
Know where the money is coming from
Dividend stocks and funds have a reputation for being low-risk investments, but not all are created equal. If a particular yield is higher than average, look into it.
As a rule, experienced dividend investors tend to shy away from companies that pay out more than 60 per cent of their profits as dividends. That's because if sales dry up, or the industry faces some kind of implosion and profits tumble, the company has less of a cushion to protect itself. A business that earns $150-million and pays out $50-million in dividends might be a better choice than one that pays out $120-million.
There are always exceptions to this rule, says Paul McMillan, a senior investment adviser and portfolio manager with the Shewfelt McMillan Group in Vancouver. For example, True North Commercial Real Estate Investment Trust, a REIT based in Toronto, holds numerous government lease contracts, so Mr. McMillan senses stability there.
"But I still have to call the CFO and say, 'Hey, where is that dividend coming from? Is it sustainable and how can you be paying out 9 per cent?' There's got to be some risks there," he says.
Tax upsides and downsides
Some dividend investments in Canada offer a tax advantage, so long as you're investing in Canadian companies and you are a Canadian resident. In some cases, investors with lower incomes can even wind up paying next to nothing in income taxes because of these credits.
The not-so-good news? Dividend yields can increase the taxes you pay. In comparison, if you invest in something that increases in value and generates capital gains instead, you will defer paying tax until you sell that security.
"Every time they're paying you a 4- or 5-per-cent dividend yield, you're having to pay taxes on that right away," says Mr. McMillan.
Watch those emotions
Dividend investing is one of the most emotionally charged strategies around, says Ben Felix, an associate portfolio manager with PWL Capital in Ottawa.
On one hand, investors often think of their dividend income as "free money," so they're more likely to spend it rather than reinvest it. But on the other hand, because many dividend proponents become attached to their picks, they're less likely to panic and sell when the markets tank.
A good thing? It can be.
"They're telling themselves, well, I'm still getting my dividends so I'm going to keep holding," he says. "That's a lot better than the person who sells, doesn't get back in for six months and misses out on a bunch of returns."