First a little background on what exactly dividends are and how you can earn them. Dividends represent the portion of the earnings a corporation pays to its stockholders. Some corporations pay sizable dividends, and others may not pay any dividends. Mutual funds and Exchange Traded Funds (ETFs) also usually pay dividends.
These funds generally invest in publicly traded securities such as stocks and bonds. The stocks owned by a fund may pay dividends as indicated above, and bonds will pay interest. So the fund earns dividend and interest income from its underlying investment holdings. Finally, the fund passes this income through to the fund investors as dividends.
Mutual funds and ETFs can also earn income by selling the investments they own. This is more common with mutual funds, especially ones that portfolio managers manage actively. Mutual fund managers may sell underlying investments for various reasons. When they do, it often creates income in the form of capital gains.
The funds also pass these gains through to their shareholders. So you can earn dividends a couple of different ways. One is to directly own the common stock of a corporation. Another is to earn the dividends indirectly by owning a mutual fund or ETF. Such a fund in turn owns the income generating investments such as stocks and bonds.
All Passive Investors Should Demand Regular Cash Payouts From Their Investments
Regardless of your investment philosophy, it only seems logical that an otherwise passive investor would require a regular payout from his or her investment. When you buy a rental property, you expect to receive rents on a monthly basis. When you deposit money into a savings account you receive interest payments periodically from the bank. You don’t wait to receive a return on your money only when you sell the building. Or after you close your savings account, potentially many years later.
Well, the same should hold true for stock investments. Those active in the day to day management of the company in which you invest receive compensation such as wages and other benefits. You, as a passive fractional owner of the company also deserve to get paid. You have allocated your hard earned capital to this investment.
So if you invest in a profitable company you should expect management to pay you. They should pay at least some portion of those profits to shareholders on a regular basis. Yes, some time down the road you may sell your investment. You may even walk away with a nice capital gain. That is if you purchased at a good price and those running the company did a good job.
However, that could be years down the road. So the present value of that potential future gain will be worth less than if you received it today. Also, what if the company managers do not do a good job? Or what if you purchased at a poor price? Then you may not get anything from the investment the entire time you held it. Except for maybe a loss.
Dividends Provide Current Income For Living Expenses
Many investors seek dividend paying investments as a source of current income. They can use that income to help fund their lifestyle. So retirees, for example, often need income from their retirement fund investments. They no longer work, so they need to supplement other income such as social security to pay their living expenses.
Other investments such as bonds can also fulfill this need. However, in a very low interest rate environment, the income from bonds may be insufficient for many yield seekers. Not only can stocks supplement the income from bonds, but they also have the potential for long term appreciation.
Current income from dividends may especially appeal to more risk tolerant younger retirees. Or maybe to those who are very well off. Such wealthy individuals likely won’t use up their retirement savings during their lifetime. A such they expect to pass a good portion of their nest egg to their heirs. These younger or affluent individuals generally have longer term time horizons. So they may benefit from some exposure to stocks for growth. Stocks can also help offset the long term effects of inflation. But current income is not just for retirees.
Anyone with a need to supplement their income in order to pay the bills can do so with dividends. Some experts do not believe dividends or interest are necessary for this purpose. They instead recommend selling a portion of your holdings to generate any needed income. However, this can result in some negative consequences such as commission charges or possibly being forced to sell at an inopportune time. Not to mention having to decide what to sell.
Reinvesting Dividends Facilitates Automatic Saving and Investing
Dividends also may allow you to create an automatic saving and investing mechanism. You can accomplish this by reinvesting all or part of the dividends that your investments earn. Then you can sit back and let the power of compounding work. Its magic can help you build your wealth. Mutual funds generally offer the option to reinvest dividends at no additional cost. However, this can also be done with stocks and ETFs.
Dividend Reinvestment Plans
With stocks, you traditionally were able to reinvest dividends by registering with a corporation’s dividend reinvestment plan (DRIP). These plans are excellent tools for long term saving and investing. There are some key benefits with DRIPs.
One is that the cost to reinvest dividends with many plans can be zero or very minimal. Plus, you can purchase fractional shares. You generally cannot do this with brokerage accounts. With brokers, the commission may possibly be larger than the dividend. Also, you usually cannot buy fractional shares. It should be noted though that more and more brokerages and financial institutions now offer reinvestment of dividends.
In addition to mutual funds, some now also offer reinvestment for stocks and ETFs. And they do so without the usual commissions and fees. You should also note that some DRIP plans do charge somewhat higher fees than others. So look into the plan’s prospectus for information on fees.
DRIPs Minimize Emotional Buying And Selling
Another very important benefit of DRIPs is that you can’t buy and sell instantaneously as in a typical brokerage account. This way it is less likely that your emotions and short term trading will get in the way of your investing goals. Further, automatic reinvestment of dividends allows you to dollar cost average. You buy more of a stock or fund when it is cheap, and less when it is expensive.
At some point down the line, you may wish to sell a stock from a DRIP plan to maybe pay for college. Or to possibly use for a down payment on a home or a car. In such a situation, it is probably best to transfer the stock from the custodian of the plan into a brokerage account. You should do this some time before the planned sale. This way you can have a bit more security and control over the sale price with a limit order.
Stable and Mature Companies Typically Pay Dividends
Companies that pay dividends are also generally more mature, profitable, and stable. Payouts to shareholders may also force management to be more prudent in allocating capital. For example, a smaller amount of available funds may force the company to be more disciplined and not overpay for an acquisition.
A smaller budget may also prevent frivolous spending in other areas. Examples may include opulent headquarters or unnecessary equipment. Such expenditures are usually not required in order to maintain or increase profitability. So when you receive stock dividends, you are likely investing directly or indirectly in more stable, prudent, and arguably less risky companies.
Does That Dividend Yield Seem Too Good To Be True?
Any time you see an above average dividend yield on an investment you need to pause for a moment. You must be skeptical and consider some other factors as well. How long has the company been paying a dividend? Have there been any interruptions or decreases in the dividend history? Has the payout been increasing over the years?
This is generally an issue when dealing with individual common stock ownership as opposed to mutual funds or ETFs. With funds, their diversification makes this issue moot. The Nasdaq provides a very useful dividend history lookup page for stocks and ETFs.
Besides, too high a dividend yield may signal that a company is in trouble. A cut or suspension of the dividend may be imminent. The payout ratio (dividend payout / net income) is a very helpful tool in assessing a potential dividend cut. Generally, the lower the ratio, the safer the dividend. It is wiser to invest in a financially healthy business which pays a relatively smaller dividend. It is likely to be more sustainable and has the potential to increase over time.
Why Do Corporations Pay Dividends?
The decision for a corporation to pay dividends depends on many factors. The relative maturity or age of the company, growth opportunities, financial health, as well as line of business. All these factors have a bearing on the amount of money a corporation will pay to its shareholders in the form of dividends.
Slower growth companies in mature markets have fewer opportunities to reinvest their earnings. So they tend to pay relatively higher dividends. For example, consumer staples and utility companies generally pay consistent dividends. High growth technology companies often reinvest all their earnings into developing the next hot product.
Dividends Have Historically Boosted Total Investment Returns
The two components of investment returns are income in the form of interest and dividends, and capital appreciation. Capital appreciation is when the value of your investment increases above the price at which you purchased it. Unfortunately the prices of publicly traded securities can be volatile, especially in times of crisis. Prices can drop or fluctuate due to geopolitical events, economic turbulence, and other such factors.
For example, an interest rate hike can cause the price of a stock to drop even if earnings are up. Dividends, on the other hand, are relatively more stable. Granted they too are not guaranteed. However look to purchase financially sound companies with low debt levels. Then you can be fairly confident that you will receive your dividend in the face of geopolitical and economic headwinds. It should also be noted that dividends have historically provided almost half of the returns of the S&P 500.
Dividends May Be Taxed At Preferential Rates
It is true that dividends create taxable income. But as they say, the tax tail should not wag the investment dog. If something makes sense from an investment point of view, you should not forego the opportunity for tax reasons. You may own dividend paying investments inside a tax advantaged retirement account such as an IRA. In such a case, the taxation of dividends will not be an issue until you withdraw the funds.
But even in a regular taxable account, it is better to earn the money and pay the taxes than to not earn the income at all. Besides, the government has been taxing dividends at favorable rates in recent years.
Dividends which originate from business earnings of common stocks are referred to as “qualified.” It doesn’t matter if the company pays you directly or if the dividend flows through via a mutual fund or ETF. Such dividends will generally be taxed at the reduced capital gains rates as of the writing of this post.
Some Dividends Can Be Taxed At Ordinary Income Tax Rates
However, fund dividends which represent interest earned by underlying bond investments will be taxed at ordinary tax rates. The same holds true of short term capital gains passed through to investors by a fund. Further, the government taxes real estate investment trust (REIT) dividends which represent rental income at ordinary rates. Regardless of the source, if you do not hold the underlying investment at least 61 days, the dividends will not receive favorable tax treatment.
But there are tax efficient strategies you can implement as well. For example, you can hold dividend generating investments inside an IRA or other tax deferred account as mentioned above. This will defer any tax on the current income earned until you take it out of the account. Also, if your income for the year from all sources is below a certain threshold, you may not pay any tax on your dividend income.
Get Paid While You Wait For Capital Gains
Value investing generally involves buying companies which are currently trading cheaply. The general expectation is that their problems are temporary and will ultimately be resolved. If everything works out as expected, value investors often stand to make some very nice investment returns. However, one common mistake of many value investors is that they often get into these beaten down companies way too early.
As such, it can often take some time for the company to turn its fortunes around. So contrarian and value investors particularly like dividends. They can collect the dividends while they wait for their investment to turn around. Of course, this only works if the company is financially sound to the point where they do not need to cut the dividend.
But getting paid while you wait does not only apply to value investors. Any investor in equities ultimately expects the value of their investment to increase over time. Then they can ultimately sell it for a gain. So why not have your investment pay you while you wait for that capital gain to materialize?
So there you have it. Whether you invest in stocks directly, or indirectly via funds, you should always demand a healthy dose of dividends. They give you current income, boost your investment returns, and provide stability to your portfolio. Not to mention that they help you save and invest. Finally, the government may tax them at preferential rates. Click here for more articles on investing.