ASX dividend shares not only offer investors some handy passive income, they also have the potential to deliver capital gains.
Over time, even modest annual share price gains can help build significant wealth thanks to the magic of compounding. Dividends can also be reinvested with the same compounding growth impact over a period of years.
And with many ASX dividend shares offering franking credits, you might also be able to hold onto more of that passive income when it's time to square the books with the ATO.
But not all income stocks are created equal.
Some companies share their profits with investors, some don't
Many ASX shares don't pay any dividends.
Some may still be in the early growth stages where they're not making any profits to share out with investors. Other companies may be making sizeable profits but choose to reinvest that cash to pave the way for future growth.
If you get into the right stocks, these can still present great opportunities to build your wealth over time.
Quality ASX dividend shares offer another route to potentially building a comfortable retirement nest egg. These companies are sharing out some of their profits but ploughing enough back into operations and growth plans to hold onto their market-leading positions.
Which brings us to…
Avoid this ASX dividend share trap!
New investors researching ASX dividend shares may find themselves lured in by the highest-yielding stocks.
While some high-yielding stocks may continue to pay outsized dividends, be aware that the figures you see quoted are trailing yields. This is a backwards looking metric by definition. It's based on the dividend payments over the past 12 months divided by the company's share price.
This figure can easily be distorted to the upside if an ASX dividend share has seen a sizeable fall in its share price in recent months. That will inflate the trailing yield, but it doesn't mean you can expect that kind of yield moving forward.
Alternatively, you can look at forecast yields. While these can prove useful, at the end of the day a forecast yield is just that. A forecast. Even the best analysts can't accurately predict (with any consistency) what the next year will bring. Let alone the next five years.
Whether you're investing in ASX dividend shares or ASX growth shares, it's important to research the company's financial health.
If it's paying high dividends, it may not be investing enough in expanding its market size or dominance. That could see its share price fall over time, potentially also leading to lower future payouts. This is the dreaded dividend trap.
Also note that some ASX shares operate in cyclical industries, like commodity stocks.
Take ASX energy shares, for example. These paid out some juicy dividends when energy costs were soaring in 2022. But the payouts, while still solid, have reduced as energy prices have come down.
Of course, when energy prices eventually run higher again, these same shares are likely to again offer some outsized dividends.
I'll leave off with this pearl from Warren Buffett: "You don't have to be smart, as long as you stick to what you know."
So, make sure you know what kind of ASX dividend shares you're investing in. And if you're not sure, look into getting some quality advice.
