What Are Dividends and How Do They Work?

If you’re thinking about getting into investing but are afraid of losing money, then there’s a special type of security that you may want to consider: ones that pay dividends!

Dividends are some of the most highly sought-after types of assets among people who invest and save for retirement. They can add a sense of safety to a portfolio while still giving it room to grow. However, like any investment, they also carry inherent risks that you need to be aware of. 

In this post, we’ll talk about how dividend investing works and what makes them so universally desirable.

What are Dividends?

Dividends are the distributions that a company’s board of directors elects to pay its shareholders. In other words, if you own shares of a stock and the company they represent decides to distribute dividends, then you’ll receive a small payment simply for holding it in your portfolio.

These distributions will typically come from the profits that the company has generated. In a way, dividend payments are a way for a company to reward its shareholders for being investors, and let them share in its prosperity without having to sell the stock itself.

Which Investments Pay Dividends?

There are several types of investments that pay dividends:


Lots of publicly-traded companies pay dividends to their shareholders. Classically, these tend to be value companies – stable, conservative reputable names that may be trading below market value. Growth stocks, on the other hand, don’t usually pay dividends. As part of their goal to expand, they will opt instead to reinvest their earnings back into the company.

Mutual Funds and ETFs

Both mutual funds and ETFs (exchange-traded funds) will often choose to pay dividends to their shareholders. Lots of investors prefer these securities because it allows them to easily buy large collections of carefully selected stocks without having to research and invest in each one individually.


REITs or “real estate investment trusts” are stocks that are also known for paying dividends to their shareholders. Due to the nature of their business (i.e., collecting rent from business tenants and selling commercial real estate), they tend to pay higher dividends than the average stock. 

How Are Dividends Paid Out?

Most companies and funds will pay their dividends every quarter. However, some ETFs and REITs choose to pay monthly.

Dividend payments are generally expressed as a percentage of the current share price using what’s called the “dividend yield”. For example, a stock that’s currently trading for $100 and has a 4% dividend yield would pay:

$100 x 0.04 = $4 per year or $1 per quarter

The dividend yield of any publicly traded company or fund can be found on any major financial media website such as Yahoo Finance or Google Finance. 

Why Should I Consider Dividend Investing?

There are many good reasons to invest in assets that pay dividends.

Income Stream

Most people who invest in dividend stocks and funds do so because they want to create a steady flow of payments. This can be very important for someone who is retired and trying to replace their employment income. 

For example, consider someone who is retired with a $1 million nest egg. If their portfolio has a 4% dividend yield, then it could theoretically produce $40,000 worth of completely passive income every year for the rest of their lives.

Better Returns

Although it is not a guarantee, companies that pay dividends tend to outperform the non-dividend-paying ones. This means that in addition to receiving dividend payments, the stock price itself should also appreciate over time.

Lower Volatility

Classically, investors who wanted better returns than what bonds can offer had to take on extra risk by investing in stocks. However, what’s great about ones that pay dividends is that they tend to be larger, staple companies whose stock prices don’t fluctuate as much. This makes them a better choice for people who are risk-averse.

Better Quality Securities

Given the wide variety of financial products an investor can choose from, dividend stocks and funds are some of the highest quality ones. This is because by definition a company has to have earnings in order to pay dividends to its shareholders. This should give investors some confidence that the company is doing well financially, and not at risk of losing money.

Lower Taxes

When it comes to taxes, the IRS treats capital gains and dividends to its own special progressive tax bracket system. Instead of the normal seven brackets that ordinary income is taxed according to, dividends are only subject to three tax brackets: 0%, 15%, and 20%. Generally speaking, someone who earns their income from dividends, will pay much lower taxes than someone who receives income from a paycheck.

(Note that REIT dividends are excluded from this special tax treatment and considered ordinary income by the IRS.)

Opportunity for Reinvestment

One of the unique advantages of investing in stocks or funds that pay dividends is that you can use them to accelerate the growth of your portfolio. This is a strategy called DRIP or “drip reinvestment programs”. 

DRIPs work by taking the dividend payments and using them to incrementally buy more shares of the underlying asset. This leads to:

  • A larger volume of shares
  • Even more dividend payments

Over time, the investor will have a more robust portfolio and see it grow faster than someone who doesn’t utilize this strategy.

Risks of Dividend Investing

As with all investments, there is always the possibility of losing money when buying stocks and funds. Markets fluctuate all of the time, so you should expect that your portfolio may be down at times.

Also, dividend payments are never guaranteed. Companies and funds are free to change or even suspend their dividend payments altogether. This is why it’s important to screen investments for previous dividend payment growth rather than to pick one that currently has a higher-than-average payout.

How to Start Investing for Dividends

Investing for dividends is relatively easy to do. Go to any reputable trading app or financial platform, create an account, and start buying assets. Additionally, if you already have a retirement account such as an IRA, then you should be able to use it to buy dividend investments.

As with any investment strategy, it’s only effective if you continue to invest in it over time. To do this, you’ll need to allocate a portion of your budget toward your investment goals. A good way to do this is to use a helpful budgeting app like Buxfer. Determine how much you can afford to set aside, and then start making regular automatic contributions into your investment account. Before long, you’ll start to see the impact that disciplined investing has on your portfolio and your financial future.

Featured image source Pexels

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