5 Reasons Why Dividends Matter
A couple I met with recently observed that their investments in a stock fund showed a gain at a time when the market overall was trading sideways. Asked for an explanation, I talked with them about dividends.
I reminded them that we included dividend-paying stocks in their portfolio for diversification, stability and long-term growth. The results they noticed were a sign of how dividends add to total return.
A dividend is an elective distribution of a portion of a company’s earnings to its shareholders. Dividends are generally issued as cash payments but can also be in the form of shares of stock or other property. The dividend rate may be quoted in terms of the dollar amount each share receives (dividend per share) or as a percent of the current market price (dividend yield).
Historically, dividend-paying stocks have delivered a good portion of the market’s gains during up markets while providing some degree of protection when the market is down. Over time, that leads to a smoother ride for investors and a steady source of income for retirees.
Here are five reasons why investors need to incorporate dividends into their portfolio.
No matter what the market is doing, dividends make sense. In up, down or sideways markets, dividends add to your total return. This is most evident when the market is flat, as my clients learned. With dividends, your stock portfolio can make money even while stock prices are not rising. And if you are automatically reinvesting the dividends, you can benefit from adding shares at a discount when stock prices are low, which accelerates the upside once the market recovers.
It is important for investors to understand what they are investing in. Companies that pay dividends send a clear, tangible message to shareholders about their business fundamentals and future prospects. Businesses can use all sorts of accounting gimmicks to manipulate their balance sheets or income statements, but they cannot fudge a dividend. They must pay out dividends in real money.
Consistency matters, and dividends remain the most reliable part of investors’ stock portfolios. Businesses go to great lengths to maintain their dividends. They will endure hardships before they consider cutting or eliminating a dividend because investors view steady dividends as a sign of continuing success.
Since 1960, the combined annual dividend on the S&P 500 Index has declined from the previous year only seven times. Using 10-year rolling periods – a more meaningful measure for long-term investors – the S&P 500 dividend never declined in the last 50 years.
Maintaining that consistency requires dividend-paying companies to be more disciplined. They need to make more reliable business decisions and seek better investment returns.
When executives know they have to pay out earnings as a dividend, they’re forced to concentrate on the most productive projects and to reduce sloppy capital management. Essentially, management can’t screw up the cash it doesn’t control – cash that the board of directors has pledged to pay out as dividends. This directly translates to the performance of those companies.
Since 1979, the Russell 1000 Value Index (dividend payers) has averaged 11.9% annual total return, whereas the Russell 1000 Growth Index (non-dividend payers) has averaged 10.6% annual total return.
In today’s low-yield environment, it’s easy to be enticed by high-dividend payers. However, don’t equate a high-dividend yield to a high-quality business.
A company’s dividend yield is determined by dividing the annual dividends per share by the share price. So generally, there two ways a dividend yield can go up:
- The dividend goes up as the result of the company increasing payouts to shareholders. Check the company’s recent news releases or regulatory filings for dividend announcements.
- The yield is rising because the share price is declining. That may be a sign that the business is doing poorly or is sensitive to rising interest rates.
Dividend-paying stocks aren’t just for older people or conservative investors. In modern history, dividends have been responsible for approximately 20% of the total return of the S&P 500 Index.
When you are young, reinvesting your stock dividends allows you to purchase more shares and compound your returns. In retirement, you can receive the dividends as cash and use them to supplement your retirement income.
No matter where you are in your investing life, dividends make sense.
Historically, dividend-paying stocks have given investors much of the growth potential of the market but with slightly smaller losses during market declines – an attractive blend that balances income, stability, and growth.
No matter what the market is doing or where you are in your investment life, every investor needs to incorporate dividends as part of a balanced portfolio.
Adam Baley is a registered representative and investment advisor at Landaas & Company.
(initially posted Sept. 24, 2015)