Often, retail investors focus on the price of a stock, looking for companies with significant growth potential and rising stock prices. However, if you ask any seasoned investment professional, they will usually tell you that stock dividends are just as important – and arguably more important if you are a long-term investor looking for consistent returns.
Dividends are regular payouts that a company makes to stockholders, which are independent of the actual stock price. Not all stocks pay dividends – and those that do are referred to as dividend stocks. While dividend stocks may not be as exciting as some high-growth stocks, they have the potential to deliver significant long-term profits with lower risk levels than you would find with more speculative investments.
Here are the reasons why you should consider owning dividend stocks.
If you are like most people, then your time is a precious commodity. You spend long hours in your career, and the time that you have left over is usually quite limited. The time that is remaining is often taken up with other commitments, such as spending time with your family. There is very little time left over for you to generate additional income, particularly if you need to work more hours to make that extra money. For instance, starting up a business on the side in addition to a regular job consumes huge amounts of time and effort – time that you just don’t have available to you.
On the other hand, if you invest in dividend stocks, then you generate passive income. This is income you make without having to put in any additional effort. Once you have bought a dividend stock, then all you have to do is to wait for the check to arrive every time the company pays a dividend. This is the type of income that allows you to scale your finances – you don’t have to do anything to earn it.
In fact, dividend stocks can deliver a really significant amount of passive income. While the media often focuses on how major indices such as the S&P 500 rise and fall, the truth is that the majority of the returns from stock markets are due to dividends, not to stock price increases. For instance, over 90% of the long-term returns from the S&P 500 have historically come from dividends. You can tap into that 90% by making investments in dividend stocks – and you need to make little or no effort to do this.
Another good reason to consider investing in dividend stocks is that they are typically less volatile – the price tends to be much more stable compared to other types of stocks. In large part, this is because companies that offer dividends usually operate in more stable market sectors – for example, Johnson & Johnson, a well-known dividend stock, operates in the consumer healthcare products sector. Because things move much more slowly in these markets compared to areas such as high-tech, dividend stock prices tend to change more slowly in the short term. This doesn’t mean that the price of dividend stocks doesn’t go up – but you are shielded from major price fluctuations.
Another reason that the price of dividend stocks tends to be more stable is somewhat circular – it’s because the company actually issues a dividend. This means as the stock price goes down, value investors tend to step in and by the stock. This is because the dividend yield goes up – this is the ratio of the dividend amount to the stock price. Keep in mind that dividends are usually linked to the stock price, so if the price goes down, the dividend yield normally gets better. For example, if a stock is trading at $40 and offers a $1 dividend, then the return is 2.5% on your investment per year. However, if the stock price then goes down to
$20, the return suddenly goes up to 5%, even though the actual amount of the dividend remains the same.
Dividends also prevents downward price pressure from short sellers. Short selling is when a trader borrows a stock from someone who owns it, and then sells it. They hope that the price will then go down so that they can buy the stock back on the open market at a lower price, and then return it to the lender. However, when short sellers borrow a stock, they are responsible for paying the dividend to the stock owner. This makes dividend stocks a much less attractive proposition for short-sellers. They also know that if the price of the stock does go down, then value investors will often step in to buy it. This means that the amount the stock will go down is limited – and so are the potential profits of the short seller.
Better run companies
In general, companies that offer dividends are more mature companies that are backed by a solid management team. They have to be well-run in order to commit to providing a dividend in the first place – companies need to have clear control over their business to deliver the predictability needed for dividends. This makes them a much safer investment.
You only have to look at the types of companies that offer dividend stocks to see that this is the case. These are the blue-chip stocks that we all know about. Examples include household names such as Walmart and McDonalds, major oil companies like Chevron and Exxon Mobil, and pharmaceutical companies such as Pfizer. New players can also start to offer dividends at some point – for instance, Apple – but by the time that they do, they are usually already a well-run, mature company.
Compound your profits
One of the really attractive things about dividend stocks is that you can reinvest the dividends back into the stock – which means that your money compounds. For instance, suppose that you get a 4% dividend return from a stock every year on average – say $1 on a $25 stock. Now, let’s assume that you hold the stock for 25 years. You don’t get a total of a 100% return on your investment – 4% times 25 years. Instead, you will receive a 166% return thanks to the power of compounding.
Of course, if you just buy a stock and receive dividends, you’re going to have to pay tax on these dividends – more about that later. However, if you invest in dividend stocks through your IRA – or any other tax-sheltered retirement account – then it’s a different situation. All of the dividends that you receive will stay in your IRA – which means that they are not taxable until you start to take money back out of your IRA when you retire. In the meantime, you can reinvest those dividends within your IRA, and your returns will compound happily without the tax man taking a bite.
When you invest in high-growth stocks, you can’t just sit back and let your investment run. You need to be an active investor, constantly keeping an eye on the company’s performance and shifts in market sentiment. Otherwise, you run the risk of having your hard-won money evaporate when the stock takes a downturn. In general, high-growth stocks are much more susceptible to market conditions, so you have to constantly keep an eye on them, otherwise you won’t react fast enough when things change.
On the other hand, when you buy a dividend stock, you normally hold onto it for years. It is an automatic investment that doesn’t require you to be actively involved. Companies that offer dividends generally set a conservative dividend level that they know that they can deliver in the long run. This means that dividends don’t change very often – so you only need to look at what is going on occasionally. The stability of dividend stocks, combined with the fact that they are paying you regularly, means that you can afford to let them take care of themselves. Of course, this stability also means that the stock price won’t go up as quickly as some other stocks, but the dividends that you receive more than make up for slow stock price growth.
A shelter in bear markets
While individual stocks move up and down based on company performance, bear markets can move the entire stock market. Once investors lose confidence, they head for the exits, regardless of whether a particular stock is fundamentally a good investment. The whole market moves, and everyone loses – except for the short-sellers.
However, dividend stocks tend to perform much better in a bear market than other stocks. This means that if you invest in dividend stocks, you are more shielded from market conditions. Again, part of this is due to the dividend itself – even if the stock price goes down along with the rest of the market, the dividend will stay the same in most cases, unless the company stops dividends completely. Usually, you will see the same dividend returns that you saw before. While the stock price may decline in the bear market, you’re not looking to sell it – and the price will come back up once the market recovers.
Not only that, the amount that a dividend stock declines in a bear market is likely to be less. Again, this is due to same factors that make dividend stocks less volatile. First of all, as the price declines, the stock becomes more attractive to value investors because of the dividend it offers – the dividend yield goes up. Dividend stocks thus provide income to investors when good returns are hard to come by.
Second, short-sellers are reluctant to invest in dividend stocks – even in a bear market – because they have to pay the dividend and profit opportunities are more limited.
In fact, a bear market can be a good place to look for bargain dividend stocks. When the price drops, you can get some excellent dividend yields – 4% or more. Even when the price goes up later, the yield you get will then stayed the same because you bought the stock cheaply. Not only that, but a dividend stock is likely to recover more quickly from the bear market, so you win both on the dividend and on the stock price rise.
Reduce tax liability
Even if you don’t buy dividend stocks, using a tax-sheltered retirement savings plan, you still have the opportunity to reduce your tax liability. In most cases, dividends are taxed at a lower rate than ordinary income, making them a very attractive investment. This is because dividends are normally taxed at the long-term capital gains tax rate, rather than your regular income tax rate. For most investors – those that are taxed federally at 25%, 28%, 33% or 35% – the tax on qualified dividends is only 15%. If your tax rate is lower – 10% or 15% – then you don’t pay any tax on your dividends at all, and even if you are taxed at the top federal tax rate, you will only pay 20% tax on dividends.
The one caveat is that dividends must be qualified. There are a few criteria that a dividend needs to meet to be considered qualified. First of all, the dividend must come usually come from a US corporation or a company that is incorporated in a US possession – for example, Puerto Rico. However, dividends from some foreign corporations can also qualify, depending on what tax treaties exist between the United States and the country where the company is incorporated. Also, if the foreign corporation’s stock is traded on a US stock exchange – including as an American Depository Receipt (ADR) – then it also qualifies.
Finally, there are holding requirements for the stock – you need to have owned the stock for a minimum period of time, which can be 61 days or 91 days, depending on the type of stock. However, if you are a long-term investor, then this holding requirement is generally not an issue.