If you have been following along this blog, you know by now that Money Is Time and you should start investing immediately! You’ve been reading up more on the subject, but now you’ve heard more about dividends and are a little confused. Don’t worry. I frequently get the question, “What is a Dividend?” Here we will demystify these mystical little passive income streams.

What Are Stocks?

Before we can talk about what dividends are, first we need to make sure that you know what a stock is. Stocks are a type of financial security which signify company ownership. In other words, the stock holders of a company are the collective owners of the company.

For example, let’s assume that Getting Rich Young Industries has 100 units of stock outstanding. These 100 units are called shares. If I own all 100 shares of Getting Rich Young Industries, then I own 100% of the company and all of its assets. Now let’s pretend that I sell 30 shares of Getting Rich Young Industries to Brittney and 20 shares of Getting Rich Young Industries to Michael. I now own 50% of the company, Brittney owns 30%, and Michael owns 20%. There is a lot more to learn about stocks, but these are the very basics.

What Is A Dividend?

Let’s now assume that Getting Rich Young Industries makes $100 every year from selling financial software (This is just for example. We do not sell financial software at this point in time, and these earnings are totally made up for the purposes of this exercise). The $100 that the company makes each year is owned by the shareholders. In this case, I would have a claim on $50, Brittney would have claim on $30, and Michael would have claim on the remaining $20.

So where do dividends come into the equation. Getting Rich Young Industries is a growing company. We, the owners, will probably not want to take that $100 out of the company. Instead we are likely going to reinvest most of it. Let’s assume that we are going to reinvest $90 in the company to try and grow more next year, but the owners would like to take out the other $10 for personal use. The $10 that is distributed to the owners/shareholders, is called a dividend.

Passive Income With Dividends

In our example earlier, the three owners would likely have a lot to do with the day-to-day workings of the business. Large shareholders tend to be actively involved for quite a few reasons. In the real world there are typically much larger numbers of shares for public companies. For example, Apple has about 5.54 Billion shares outstanding as of the time of this writing. Due to these large number of shares, it is unlikely that you will ever become a large enough shareholder to be actively involved in the company management. Thankfully for us, there are large investors that should be keeping on eye on how things are working for us. This is the thought behind the passive investor.

Even though you are not working on the day-to-day of the business, you still own a piece of the company. Therefore, you are still entitled to a share of the earnings (even if it is less than a billionth of the company). The great part about this, is that even if you don’t do any work, you still make money from your stocks as long as they continue to earn money! Apple currently pays about $2.08 per share in dividends.

Dividend Growth

You may be thinking $2.08 per share, when AAPL is selling for over $100 currently doesn’t sound like very much. I would probably agree with you, although this is fairly close to the S&P 500 average dividend rate currently of about 2.13%. Where dividends get really exciting though, is when we talk about dividend growth. Without having to buy any additional shares, or do anything special, the dividends tend to grow over time for each share with the growth of the stock price. Let’s go into a mutual fund example below.

Vanguard Dividend Growth

Mutual fund companies work in the same way. A mutual fund is just a collection of stocks. By owning a share of a mutual fund, you quickly and easily become a part owner of many different companies. Let’s use the Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX) as an example.

If you bought a single share of VTSAX on January 2, 2001 for $30.39, you would have received your first dividend of $0.073 on March 16, 2001. Over the next twelve months, you would have received a total of about $0.309 in dividends. If you would have held your one share of VTSAX until today, even if you never bought another share, that single share would have gotten you about $1.005 in dividends in 2015. That’s a growth rate of 8.18% for the dividends alone! Not to mention that your single share would have grown in value to $50.01 by January 4, 2016.

What Dividends Are Not

Dividends are a fantastic passive source of income. However, before we go further, I want to warn you a few things about dividends.

1. Dividends are not the only important thing about stocks. Remember, every dollar that gets paid out in dividends is a dollar that the company is not reinvesting in the company. Companies with a lot of growth potential still, may be better of reinvesting all of the earnings rather than paying out dividends. Many people look at high dividend rates as a sign of a company on the decline. This is not always true, but it is something to be aware of. There may be a good reason that a company has a very high dividend rate. Additionally, dividends may be taxed at a higher rate than long term capital gains. So if you are in a taxable account, it may make sense to shift your high dividend payers into a non-taxable account and your growers into the taxable.
2. Dividends are not guaranteed. At any time the company could stop a dividend, fail to increase the dividend, or even give out a much larger dividend. Dividends tend to be stable over time because the owners are supposed to keep stockholders’ best interests in mind. However, you should be aware of the risks involved.
3. Dividend payments will cause the stock price to fall in the short-term. When a company pays the dividend, the stock price immediately drops by the amount of the dividend. This makes sense because if a company is worth $100, but then pays out $2 in dividends today, it should now only be worth $98 because it has $2 less in cash on hand. Another thing that you should be aware of so that you don’t panic if you see the price suddenly drop on dividend day.

Why I Love Dividends

1. Dividends are passive. Dividends are one of the truest forms of passive income if you are a minority shareholder. Somebody else does the work of running the day-to-day and you collect a check. There is only minor work that you have to do. Once a year, you should review your portfolio in case you need to make changes.
2. Dividends grow over time. The fact that dividends grow over time is one of my favorite things about dividends. Knowing that I am not only buying a passive income stream, but I’m buying a passive income stream that will grow over time without me having to do anything? That’s such an awesome feeling to know that your income will actually be growing over time.
3. Mutual Fund Dividends are relatively stable. Although no companies are required to pay dividends, when you average across a large number of businesses, you get a relatively stable dividend rate. This is how I maintain confidence that I will receive another dividend check and over time it will likely be larger than the last one I received. Especially when you use a company like Vanguard, where the shareholders of the funds also own the company.
4. Dividends can be automatically reinvested. One really cool feature about dividends, is that with most brokerages have an option to automatically reinvest your dividends back into the fund. That means that every time they pay you, you can automatically buy more little passive income streams. This all adds up over time, so make sure to take advantage of this feature!

How Do I Start Getting Dividends?

All you have to do to get started, is to open up an investment account. If you’re not sure what type of account to look at, check out our article on How To Start Investing or The Beginner’s Guide to 401Ks.

You should know by now that I am a big fan of Vanguard for your mutual fund investments. They have the lowest fees in the industry. This is an important feature because high fees can literally mean thousands less in your account down the road. Vanguard and Fidelity are where my retirement investments currently are

However, if you are hard set on buying individual stocks make sure you don’t put all your money into only a handful of stocks! You have to diversify to reduce your risk! For a small investor, this is difficult to accomplish without spending a lot of money on transaction costs. So do yourself a favor, and go with a mutual fund if you’re a small investor and ESPECIALLY if you are new to investing.

If I still haven’t convinced you to go the mutual fund route, at least save yourself some money by using some of the discount brokers out there. The two that I recommend most are Scottrade and TradeKing (Note: These are affiliate links and I will earn a small commission at no extra cost to you if you decide to open an account. This had no impact on my decision to promote these products. Both are listed in StockBrokers.com’s list of best online discount brokers as of 2/15/2016).

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“An investment in knowledge pays the best interest.” -Benjamin Franklin