I Think Dividend Investing Is the Single Best Strategy for New Investors

If someone came to you and said they had $1,000 to invest and wanted your help in deciding where to put it, what would you tell them?

Based on recent market returns, your inclination might be to say a tech exchange-traded fund (ETF), such as the Vanguard Information Technology ETF (NYSEMKT: VGT). Since they're just starting out, you might suggest more of a foundational piece, such as the Vanguard S&P 500 ETF (NYSEMKT: VOO).

I think the latter choice is certainly defensible. You want to start your portfolio with something that's broadly diversified, ultra-low cost, and can be held for decades or more. The tech ETF probably isn't a good choice for a starter portfolio (at least as the first fund to own). It's far too focused on a riskier single sector to be the point you want to build from.

But for someone investing for the first time, I think dividend stocks are the best place to start. This might seem like an overly conservative choice in a market that has been rewarding just the opposite. But for someone who might just be learning about how long-term wealth is created, dividend stocks and ETFs will do a better job of teaching them how to invest the right way.

Image source: Getty Images.

What is a dividend?

A dividend is simply a portion of a company's earnings that is paid out to shareholders. Most companies pay them out on a quarterly basis, but a small percentage pay them monthly or even annually.

Companies that issue dividends are generally considered to be higher quality, more mature, and more durable. This is because they often don't start paying dividends until they're well established and generate sufficient cash flows and profits to support them.

Some of the best dividend stocks are those from companies that continue to raise their payouts annually, often called dividend growth stocks. This commitment to rewarding shareholders regularly makes the stock attractive to income seekers and helps reinforce the idea that their business is on firm financial footing.

But none of this is guaranteed. Companies can raise or cut their dividends based on their financial condition and economic environment. But most companies that begin issuing dividends prefer to keep those payments steady or growing if at all possible.

One of the advantages of dividend stocks is that they give you two potential sources of return: share price growth and dividend income. Many of the big tech and artificial intelligence (AI) companies don't pay dividends because they're using all of their cash to grow their businesses. Their total return will be based solely on share price changes. Dividend income can help support total returns during times when the share price is falling.

History makes a strong case for dividend investing

You may not guess it based on recent returns, but dividend stocks have an established history of outperforming other types of stocks over the long term. And this is where I think the risk/reward trade-off becomes such an important part of building your portfolio. A Ned Davis Research study looking at stock performance since 1973 shows that stronger dividend payment and growth policies have historically resulted in better total returns with lower risk.

Data source: Ned Davis Research.

The logic is pretty straightforward. Dividend growers should, in theory, be generating more cash flow and more profits in order to support higher dividend payments. Companies with steady dividends may demonstrate consistent corporate health, but perhaps without the stronger growth. Dividend cutters are likely in some financial distress and need to hang on to whatever cash they can to support the business.

Another Hartford Funds study showed that over the past 85 years, dividend income contributes roughly 1/3 of a stock's total return. Combine these factors together -- better historical returns, lower risk, high-quality balance sheets -- and I think you've got one of the best long-term investing strategies for those folks starting out for the first time. Or anybody, really.

Growth and tech stocks can provide spectacular short-term returns, as we've seen in recent years. But they can also experience greater downside risk and spectacular busts. Just look at what happened when the tech bubble burst in the early 2000s, and the Nasdaq-100 lost over 80% of its value. Dividend stock investing offers more stability and helps limit some of the more excessive risks.

Here's how I'd start dividend investing today

Researching individual dividend stocks can be time-consuming and complex. So I'd start with a broadly diversified dividend ETF that offers a basket of high-quality dividend stocks in one place.

The WisdomTree U.S. Total Dividend ETF (NYSEMKT: DTD) gives you access to essentially the entire dividend stock universe. The Vanguard Dividend Appreciation ETF (NYSEMKT: VIG) and the ProShares S&P 500 Dividend Aristocrats ETF (NYSEMKT: NOBL) invest in long-term dividend growth stocks. The Schwab U.S. Dividend Equity ETF (NYSEMKT: SCHD) considers dividend growth history, balance sheet quality, and yield in its selection process.

Dividend investing doesn't necessarily need to account for your entire portfolio. Eventually, diversifying into tech or international stocks can provide balance. But as a foundation for a beginner investment portfolio, I think dividend stocks are a great start.

David Dierking has positions in Schwab U.S. Dividend Equity ETF, Vanguard Dividend Appreciation ETF, and Vanguard Information Technology ETF. The Motley Fool has positions in and recommends ProShares S&P 500 Dividend Aristocrats ETF, Vanguard Dividend Appreciation ETF, and Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.