Why Investors Enjoy Dividends (And Why They Can Have Downsides)
John D. Rockefeller, the first billionaire in history, once remarked that his sole enjoyment in life came from the proceeds of dividends.
It's evident that individuals hold a fondness for dividends, and this sentiment is for good reason.
In fact, certain reports suggest that dividends have comprised 60% of the S&P 500's returns over a span of 20 years.
However, while these returns might appear significant, it's essential to understand potential pitfalls that can transform a promising dividend stock into a disappointment.
Prior to pursuing dividends, it's crucial to explore the positive, negative, and potentially harmful aspects of this investment approach.
Dividends
Capital appreciation tends to steal the spotlight in stories of investment success.
Think about the countless instances where someone purchased an investment for a modest sum and then later sold it for millions.
However, this isn't the only element contributing to your overall returns.
If you own dividend paying stocks, a portion of your earnings will come from the income you receive.
Within the investment community, there's a significant portion of people that values this additional cash flow immensely.
It's not uncommon to find investors who allocate their entire portfolio to stocks that provide dividends, and their reasoning is understandable.
Dividends can be likened to a grown-up allowance, carrying numerous advantages.
Moreover, unlike the fluctuating price of a stock, dividends tend to offer a more consistent return.
However, it's crucial to note that embracing a dividend-based investment approach isn't as straightforward as seeking the highest yields.
There's much to learn about selecting a dividend stock, and appearances can be deceiving – what appears to be a fantastic source of income might actually be a ticking time bomb.
So, today we'll explore dividends in depth.
We'll talk about who pays them, why people like them so much, and what you need to be careful about when pursuing them.
Who Pays Them?
In simple terms, companies pay dividends when they think investing the money back into their operations won't give them good returns.
This is why big and older companies often pay dividends, while younger ones prefer to use their earnings for growth.
But it's not just about age – the type of business matters too.
Some industries, like regulated utilities that provide electricity to cities, are better suited for paying dividends.
They have steady cash flow, while industries like the internet are fast-changing and don't always pay dividends because they're focused on growth.
So, companies like utilities are more likely to pay good dividends because of their stable operations.
Why Do People Love Dividends?
Understanding who benefits from dividends is quite straightforward, but comprehending why they are so appealing to people might not be immediately clear.
If companies can increase their value by reinvesting profits, does it truly matter whether we receive returns through dividends?
Well, the appeal of dividends becomes evident for certain individuals.
For instance, income investors or those who need to withdraw from their investments over time find dividends convenient.
With a steady cash stream, there's no need to sell their holdings for withdrawals.
This helps avoid transaction fees and the impact of market changes on their income.
Moreover, in Canada and the US, most dividends are qualified or eligible, meaning they receive preferential tax treatment compared to bond interest payments.
However, this tax benefit typically applies to stocks from your own country.
Another reason for the popularity of dividends relates to risk tolerance.
People often prefer predictable returns over uncertain ones. While a company might promise returns from retained profits, many investors favor receiving a dividend payout.
Additionally, investors tend to view dividend-paying companies as more prudent and conservative, making them attractive to those seeking security.
Perhaps the most significant reason investors cherish dividends is the snowball effect they bring.
A common strategy with dividend stocks is to use the received income to purchase more of the company's shares.
Although the initial impact is gradual, if you consistently follow this strategy over time, your money starts to compound on its own.
Don't just take my word for it – let's work through an example to illustrate.
Illustration Of Dividends
Imagine you have 20 stocks, each valued at $20, and they each pay an annual dividend of $1, giving you a 5% yield.
In the first year, you receive a total of $20 in dividends.
Interestingly, at the current stock price, you can purchase your 21st share.
As you move forward in year 2, this means you'll get $21 instead of $20 in dividends.
But, if you consistently use your money to buy more shares, your dividends will increase.
This creates a cycle where more shares lead to more dividends, which in turn allows you to buy even more shares.
After 10 years, you could have around 33 shares, resulting in a cumulative $33 per year.
This cycle is fantastic:
more shares mean more dividends, which leads to more shares, and so on.
However, the greatness doesn't stop here.
Dividends aren't always fixed. If the company you've invested in is growing, your dividends might increase too.
As the company earns more each year, shareholders often receive larger profit payments per share.
If we consider a 5% dividend growth rate, by year 10, you are getting just under $60 per year, and this growth rate is accelerating.
This is why dividends are so popular.
With any change in share price, your earnings start to multiply.
The dividends you get buy you more shares, and those extra shares earn you more dividends, which helps expand your holdings.
And as the per-share payment increases, your gains accumulate even more.
Letting this play out over time results in favorable outcomes, especially if the share price rises.
Dividend Reinvestment Plan (DRIP)
Additionally, some shares offer a feature called Dividend Reinvestment Plan (or DRIP), which lets you automatically use your dividends to buy new shares without any transaction fees.
Some DRIPs even allow you to buy shares at a discount to the market price.
So, if you were concerned about the fees or effort involved, you can now have this happen without any input from your side.
These mechanisms working in harmony are pretty impactful.
And if all of this is happening with just a 5% yield, just imagine the potential of a stock yielding 10%.
Drawbacks Of Dividends
Now, here's where we encounter a bit of a problem with dividends.
You're absolutely right in thinking that a company offering a higher yield can lead to better returns.
Yield is basically a stock's dividend divided by its price, so if we buy a stock yielding 10%, we'll earn 10% just from dividends.
However, the catch is that high-yield companies can be quite risky for investors.
While a high yield might promise a good return initially, it can also indicate that the stock's overall return might take a hit.
Why is that?
Well, remember that yield has two parts, and the quickest way for it to rise isn't necessarily for dividends to increase, but rather for the stock's price to drop.
A company's stock price can fall when investors become concerned about its operations.
So, a high-yield company could actually be a company facing difficulties, resulting in a decline in its share price.
You might be thinking:
Well, I'll still get my 10% yield, right?
The thing is, if a struggling company has financial trouble, it might need to reduce its dividend to save money.
So, just as you invested in the stock for that promising payout, you could end up with a less appealing income.
And here's the double trouble:
the market doesn't respond favorably when companies cut their dividends.
So, not only does this impact your dividend income, but the stock's price can take another hit as well.
Take the case of General Electric.
Their stock dropped by 12% when they announced a dividend cut in November 2017.
What Should You Do Instead?
While investing in dividend-paying stocks can indeed be a smart wealth-building move, chasing high yields can be risky.
A better approach is to invest in stable companies with a solid dividend policy.
You can find historical dividend information online to see how consistent a company has been with its dividends and whether they're increasing.
To gauge the sustainability of dividend payments, check out a company's payout ratio.
This ratio reveals the portion of a company's profits being paid out to investors, and if it's rising, it might indicate that the company is struggling to cover its dividend payments.
For investors who rely on income, strategies centered on dividends can be beneficial.
However, there's more to it than just focusing on high yield rates.
After all, if you're counting on your investments to provide you with an income, it's crucial to ensure that they're financially capable of doing so.
- Ivan