Choosing the right investments is critical to building a healthy portfolio, but that can sometimes be challenging when there are seemingly endless stocks and funds to choose from.
The types of investments you choose will depend largely on your investing style and tolerance for risk. Some people may prefer buying individual stocks, for example, while others prefer mutual funds or exchange-traded funds (ETFs).
Regardless of your preferences, though, there's one type of investment that actually pays you to own it: dividend stocks.
What are dividend stocks?
When a company starts earning a profit, it has several options for how to allocate that money. Some businesses choose to return a portion of their profits to shareholders, and that payment is called a dividend.
To earn dividends, all you have to do is invest in a stock that pays them. Most dividend stocks make payments either quarterly or annually, and you'll earn a small amount for each share you own.
By investing consistently, you could potentially generate a source of passive income with dividend stocks. While each individual payment may be small (generally only a few dollars per share), when you own hundreds of shares after a few decades of consistent investing, those payments add up quickly.
One of the best perks of investing in these stocks is the ability to reinvest your dividends. With this strategy, rather than cashing out your payments, you can reinvest that money into more shares of that particular stock. This can help grow your portfolio exponentially. The more shares you own, the more you'll collect in dividends. And the more you receive in dividends, the more shares you'll own, and the cycle continues.
Choosing the right stocks
There are countless dividend stocks to choose from, but it's important to do your research before you buy.
One factor to consider is the dividend yield, which is the ratio between a company's dividend payment and its stock price. In general, a higher dividend yield is better because it means the dividend is larger in relation to the stock price.
However, if a company's dividend yield is too high, that could be a red flag. Sometimes a higher-than-average yield indicates a falling stock price, for example, or that the dividend payout is unsustainable.
When investing in dividend stocks, your best bet is to simply focus on buying strong companies with the potential for long-term growth. If these stocks also pay a dividend, that's a bonus.
How to get started
A great place to get started in dividend stocks is the Dividend Aristocrats, which is a group of companies that have increased their dividend payments every year for at least 25 consecutive years. Not only are these strong dividend stocks, but they're also overall healthy companies and solid investments.
You can also invest in many dividend stocks at once through a dividend ETF. Funds like the Vanguard High Dividend Yield ETF (VYM -0.54%) or the ProShares S&P 500 Aristocrats ETF (NOBL -0.42%), for instance, include dozens or hundreds of stocks that have a history of consistently paying dividends. By investing in an ETF, you can easily diversify your portfolio with a single investment.
Dividend stocks can be a smart option to create a source of passive income, but choosing the right investments is key. By doing your research and buying high-quality stocks, you can build a strong portfolio that will pay more than you may think over the long term.