Investing is often more than "stonks go up." Many investments also pay dividends—cash distributions to shareholders. And while they might just be a dollar per share here, and a few cents per there, cobbled together and left to simmer over time, they can become the difference between retiring on a budget and retiring on a beach.

So today, we're going to teach you some dividend basics so you can put these wealth-building payments to work for you.

The Tea

When you buy a stock or fund, you expect it to grow in price over time so that down the road, you can sell it for a tidy profit.

But that's not the only way to earn a return on a stock or a stock fund.

You can also collect dividends. These are cash payments a company makes to its shareholders—occasionally on a one-time basis, but more often regularly, say, once a quarter or once a year. And in many cases, if nothing goes drastically wrong, the amount of the dividend will remain level or even grow over time.

Dividends are extremely powerful wealth builders, if you're patient. 

Here's an example using the S&P 500, an index that most people use to measure stock market performance over time.

• Historically, the S&P 500 has delivered an average "total return" (price plus dividends) of 10% each year.
• The S&P 500's current dividend "yield" (how much in returns you can expect to receive from dividends in a year) is 1.5%.
• Thus, if the S&P 500 returns 10% this year, only 15% of that will come from dividends.

The magic of dividends comes alive over time. Those dividends are cash—extra money that's put back into your account, which you can turn around and re-invest. When you do that, those dividends compound your returns over time, earning you much, much more than you would've earned without them.

Check this out: If you received only the price returns from an S&P 500 over the past 25 years, you'd earn roughly 282% on your investment. Not bad!

But look at how much better the return is when you factor in reinvested dividends. (Returns illustrated by an S&P 500-tracking ETF; note that expenses are included in performance.)

Remember: The price return was about 282%. But the total return (price plus dividends reinvested) is 500%.

So while dividends might only be responsible for 15% of a single year's returns, over the past 25 years, they've been responsible for nearly 43% of returns! And even longer-term, most studies pin that number at nearly half of the stock market's returns!

The Take

So, now that you know what dividends can do, what do you need to know about them?

Definitions

Let's start out with some of the most important terms you'll come across when you deal with dividends.

• Dividend: A cash payment from a company. These are often paid on a regular basis. In the U.S., that basis is usually quarterly, though dividends can be paid less frequently (annually or semiannually) or, on rare occasion, more frequently (monthly).
• Special dividend: A one-time cash payment from a company. Usually a way of paying shareholders from an exceptional influx of cash, like selling off a large asset.
• Dividend yield: The percentage of an investment's price you can expect to receive back in dividends. To calculate yield for most U.S. stocks, you typically just annualize the most recent payment, then divide by the share price. So, let's say a $100 stock pays 25 cents per share each quarter. Its yield is 1%. ($0.25 x 4 / $100 = 0.01, or 1%).
• Yield on cost: The yield based on what you originally paid for the stock. Let's say you bought a stock at $100. It's now $200. It pays 50 cents quarterly, so the current yield is 1% ($0.50 x 4 / $200 = 0.01, or 1%). But your yield on that $100 cost is 2% ($0.50 x 4 / $100 = 0.02, or 2%).
• Payout ratio: The percentage of profits or earnings that go toward funding the dividend. Let's say a company pays $1 per share in dividends this year, and it earns $2 per share. Its payout ratio is 50% ($1 dividends / $2 earnings = 0.50, or 50%). Payout ratio is used to get a general idea of how safe a dividend is. There are no hard benchmarks, but a company that only pays out 25% of its profits as dividends has much more room to grow its dividend than a company that pays out 50%. If a company pays out 90% of its profits to fund its dividend, you might want to monitor it closely—a bad financial year could threaten the dividend.

What You Can Do With Your Dividends

Again, a dividend is a cash payment, which gives you several options. Two of them are more fitting for people investing toward retirement, and one of them is more fitting for people in retirement.

#1: DRIP (Dividend reinvestment plan)

Some companies and funds allow shareholders to automatically reinvest their dividends through what's known as a DRIP (dividend reinvestment plan). DRIP plans are helpful because even if the dividends paid to you don't add up to enough money to buy a new share, the DRIP program can still buy fractional shares for you—even if your brokerage account doesn't allow for them.

In some cases, fractional share brokerages (and even some brokerages that don't normally allow for fractional shares) will provide DRIP services for you.

#2: Reinvest your dividends in other ways

If a DRIP is not available to you, your dividends will still accumulate in your account. From there, you can wait until they add up enough to:

• Reinvest in more shares of the stock or fund that's paying you the dividends
• Invest in new stocks or funds

#3: Use the cash

If you're not yet retired, your dividends are generally best put to work back in your portfolio. But many retirees use dividend cash as part of their regular income.

Remember: Once you retire, there's no regular paycheck coming in from work. You get Social Security payouts, and you fund the rest of your retirement from your investments. In many cases, that means "drawing down" (withdrawing) from your nest egg. 

But if we can be blunt for a minute: If you retire at 65, you don't know if you'll need that money to last you until you're 70, 80, or 90. So if you bleed your nest egg dry at age 80, but you live until 90, those 10 years could be financially difficult. That's why many retirees have many holdings that generate regular income, allowing them to draw down less of their nest egg.

A Few Ideas

Over the past month or so, we've written about several groups of dividend-paying investments that are worth exploring. Among them?

• Dividend stocks for beginners: If you're new to dividend investing, or investing in general, these dividend stocks represent some of the most straightforward, dependable, and easy-to-understand companies to start with.
• Dividend Kings: Dividend Kings are companies that have improved their dividend each and every year for at least 50 consecutive years. These stocks have unparalleled dividend track records, backed by companies with sterling fiscal management and an ability to adapt throughout the years. 
• Monthly dividend stocks: It's rare for stocks to pay monthly, but some do it. They tend to be higher-yielding than most stocks, and their dividends compound a little quicker than quarterly payers. But they're especially helpful to retirees who want to align their dividend income with their monthly bills.
• Real estate investment trusts (REITs): These are a special type of company that deals in real estate. Many of these companies own (and sometimes even operate) real estate, from apartments and strip malls to hotels and driving ranges. Others deal in  mortgages, mortgage-backed securities, and other real estate "paper."
• Dividend ETFs: Rather than buy one or two individual dividend stocks, some investors would prefer to diversify across dozens or even hundreds. Dividend-themed exchange-traded funds (ETFs) are an inexpensive way to do exactly that. 

If you've made it this far, congratulations! You've not only learned a lot, but you've also probably damaged your eyeballs from too much screen time!

Hopefully, you still have some snow outside. If so, go out and play in it while you still can!

Riley & Kyle

WealthUp (Young and the Invested is now WealthUp)

This article does not constitute individualized investment advice. These stocks appear for your consideration and not as personalized investment recommendations. Act at your own discretion.

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