Dividend stocks offer four huge advantages over other investments and should be a part of everyone’s investing plan
Is it any surprise that dividend stocks have been one of the most popular investing strategies since the first payment was made to owners of the Dutch East India Company over 400 years ago?
While investing in other stocks may offer the dream of getting rich when the investment is sold, dividends stocks provide a constant cash payout that you can spend or reinvest.
Two major stock market crashes in less than a decade have made dividend investing even more popular and more necessary. Investors have seen their price appreciation wiped out multiple times with dividends being the only remaining value.
With interest rates at historic lows and bonds paying almost nothing after inflation, investors have also found new hope for income in shares of companies with healthy dividend yields.
Dividend stocks may just be one of the only true paths to financial freedom. The safety and reliability of dividends turn you into an owner, collecting income off the assets, rather than simply a renter of other people’s assets.
The four principal advantages of dividend stocks:
- Powerful returns on compound interest
- Ability to reduce inflation risk
- Safety when the stock market crashes
- An income stream and financial freedom!
The Advantages of Dividend Stocks and Income Investing
Maybe the strongest evidence in favor of dividend stocks is the actual return in the market. The graph below shows the annual compound return to four groups of stocks in the 37 years to 2010.
Shares of companies that paid dividends but did not regularly raise their payments provided investors with a 7.1% annual return over the period, well above the 1.8% annual return from companies that paid no dividends.
But companies that regularly increased their dividend payments did even better, returning an average 9.3% over nearly four decades!
In dollar terms, if you had invested $10,000 to a portfolio of dividend stocks in 1973, by 2010 you would have more than $268,500 in your account. Compare that to $126,500 in the portfolio of companies that paid dividends without regular payment increases and just $19,350 in the portfolio of non-dividend stocks.
I’m counting on the strong returns from dividend investing in my Dividend Stocks for Growth and Cash Flow fund created on Motif Investing. The investing fund is a group of 12 stocks and three of my favorite dividend funds. The fund pays a dividend yield of 4.4% and has jumped 12.9% just in the last two months.
I like using Motif Investing because I can create funds like this and then buy all the stocks for one commission. Buying the 15 separate investments in my dividend fund on another investing site would mean a commission of $105 even on the cheapest trading site but I pay just $9.95 on Motif.
The outperformance of dividend stocks makes sense on a financial level. For a company to pay dividends, it must make a detailed projection of its cash flow and plan sometimes years in advance for sales and growth projects.
Once a dividend is set, a company dare not cut the payment for the signal of weakness it sends to investors. For this reason, a dividend payment is a limitation on the use of cash and helps discipline management.
Free cash flow is like a narcotic to management, clouding their judgment and often leading to overconfidence. Management sees all the money rolling in and starts to think about building their legacy through pet projects, executive perks, and billion-dollar acquisitions. A high and increasing dividend payment keeps management grounded and limits the amount of trouble they can get into.
With management constrained by the dividend, they’re only able to go with the most profitable projects and have to think twice before giving themselves massive bonuses and perks.
Dividend Stocks as an Alternative to Low Rates and an Inflation Hedge
The Ten-year Treasury bond, the instrument against which all other bonds are priced, hit a record low of 1.39% in 2012. Inflation that year increased by 1.7% so the U.S. government was actually charging investors a third of a percent to hold their money each year over the next decade.
To me, that doesn’t sound like any way to meet your financial goals!
Since the market uses the rate paid on risk-free treasuries to price other bonds, the yields on all fixed-income investments have come down to the point that you might have trouble meeting investment goals with a portfolio of bonds.
Even corporate bonds only pay a 2.6% yield after accounting for inflation and with no prospect for price appreciation if held to maturity.
Dividend investing has come to the rescue for many people living off the income from their investments.
A lot of dividend-paying companies have been in business so long, they are nearly as safe an investment as the U.S. government. Some even have a better credit rating!
Since companies are generally able to increase prices along with inflation, dividend stocks offer a protection against inflation that you won’t find in bonds. Bonds lose their value with inflation and higher interest rates, dividend stocks hold up and even increase in value.
Besides the tendency for dividend payments to increase with inflation, there are several groups of dividend stocks that offer additional protection against rising prices. Utility companies, the classic defensive dividend stocks, are sometimes contractually allowed to raise the rate on their services by an inflation adjustment above and beyond an allowable rate of return. The adjustment may lag a year or two but will even out over many years and compensate for higher prices.
Other popular categories of dividend-paying companies exclusively invest in real assets. Companies that hold real assets like energy infrastructure and real estate carry a natural inflation hedge because the assets maintain their value against rising prices.
But isn’t inflation dead? Prices rose just 0.8% last year and have averaged just 1.7% over the last five. Before you shrug off the need to protect your assets against the loss of purchasing power, take a look at the graphic below.
Even at a low rate of 2.0% inflation, the value of your money halves in 34 years. Imagine getting to retirement and your money buys half as much as you were expecting.
Low inflation over the last decade may be the exception rather than the rule. In the 30 years to 2000, the average annual rate of inflation was 5.2%, more than double its current rate. Tack on historic programs of monetary stimulus by central banks all over the world and you’ve got a recipe for higher prices in the future.
While we may not see the 7.1% rate of inflation experienced in the 70s, we are likely to see rates closer to 3% over the next several decades.
At a moderate 3% annual rise in prices, your dollar is worth just two-thirds of its value in 10 years and it takes just 23 years to halve its value.
Dividend Stocks Yield Provides a Safety Net
For me, all the data on dividend stocks and market-beating returns is just icing on the cake. Like many investors, dividend stocks are my ‘sleep-at-night investments.’ Studies show that dividend-paying stocks are less sensitive to market changes and outperform the general market even more when stock prices come down.
Over the two decades to 2012, dividend stocks within the S&P 500 posted an annualized return of 11.3% against 10.4% for stocks that paid no dividends. Again, icing on the cake but the dividend-payers also did it with lower risk and volatility in prices.
Shares of stocks that paid no dividends were 20% riskier than dividend-paying stocks over the period. Not only did the dividend-payers beat the non-paying stocks by nearly a percentage point on an annual basis, but they did it with much less risk.
While stock prices may rise or fall in any given year, dividend returns will always be positive. That dividend check is money in your pocket and can’t be taken away even if stock prices collapse. Over the 85 years to 2012, stocks in the S&P 500 increased an average of 24% on up years with 5% of that from dividends. During years where stock prices fell, the average loss was 15% but dividend payments still offered a positive 3% return.
When the market is rising, returns to dividend stocks are good and adds to total returns. When the market is falling, returns to dividend investing are great and cushions you from bigger losses and panic-selling.
Dividend Stocks for Income and Financial Freedom
Finally, dividend investing provides a stable source of income for millions of Americans.
Americans are increasingly relying on dividend income for their everyday needs. Data from the Bureau of Economic Analysis shows wages and dividends as percentages of total personal income over the three decades to 2013. Wages and salaries have sunk to just half of total personal income while dividend payments have grown to more than 5% of the total.
In fact, more than $757 billion was collected from dividend payments in 2012.
If you look at the graph not as the personal income of the country but as a representation of your own income, one other thing becomes really clear about dividends…
Dividends are your path to financial freedom.
As a young investor, you are relying heavily on your salary to pay the bills and dividend income is probably relatively small. Over the years, as your portfolio grows, dividend income grows and becomes a larger part of your total income. Dividend investing can help you reach the financial freedom to depend less on wages and more on the fruits of your labor.
What are dividends?
Running a company is a constant choice between growing the business and taking hard-earned profits. If profits are used to invest in more equipment and other business necessities, they could lead to more profits in the future. Profits paid out to the owners may not add to business growth but they are the ultimate reason for creating and running that business, to make money.
A dividend is those profits paid out to the owners of the business. While small companies may just have one or a few owners, very large companies raise money through selling shares and distributing the ownership over thousands of owners.
The decision to return profits or invest in the business isn’t necessarily an either/or decision. Most successful businesses make enough each year to return a little bit of profit as well as invest in future growth.
For most companies, dividends are paid every three months according to a fixed amount for every share you own. There are companies that pay dividends twice or once a year, or even twelve times a year but these are the exception rather than the rule.
Most companies pay a fairly constant dividend because many investors depend on that cash flow for living needs. For this reason, management often plans several quarters in advance to make sure they will have the money to pay for growth projects and a consistent or rising dividend.
Besides regular cash dividends, a company may find itself with excess cash that it no longer needs. In this case, the Board might approve a ‘special’ or one-time dividend payment. The process of paying out this dividend is the same but it is usually much larger than the regular dividend payments.
How the dividend stocks process of paying a dividend works
The Board of Directors is a group of people elected to represent you as an owner of the company. When management decides it will have sufficient cash for growth projects, the Board of Directors votes to declare and pay a dividend. The entire dividend process includes four important dates.
The declaration date is the day the dividend is announced by the company to the public. On this date, the company will also announce a date of record and payment date for the dividend.
The date of record is the date that determines which shareholders will actually receive the dividend.
The ex-dividend date is the first day that the stock trades without the dividend. This means, anyone that did not own the shares prior to this day will not receive the dividend payment. In a confusing twist, the ex-dividend date is usually before the date of record. This is because of the time it takes for share ownership to actually be recorded with the company, usually two business days.
For example, if the date of record for a dividend payment in shares of McDonald’s (MCD) is on Friday, the ex-dividend date will likely be on Wednesday of that week. If you sold your shares on Wednesday, you would still receive the dividend payment because your sale would not be recorded with the company until after the date of record when it has determined who gets the payment.
The payment date is the day you will see the dividend appear in your account according to the amount and how many shares you own. For example, if you own 100 shares of the Coca-Cola Company (KO) and the company pays a $0.30 quarterly dividend then you will receive $30 on the payment date.
Types of dividend stocks
There are more than 800 publicly listed companies that trade on the New York Stock Exchange, the Nasdaq and the American Stock Exchange that pay dividends. In fact, the list of dividend-paying stocks is so large and diverse that your biggest challenge is going to be choosing the best for your portfolio.
Fortunately, dividend stocks can be categorized to narrow the field of options for your own investment needs. The groups are not exclusive, so some companies may be in multiple categories but the list will be a good start to thinking about different types of stocks.
The table below shows the dividend yield, average annual return over the last decade and the risk on some popular income investments.
The return and risk on these income investments will differ from year-to-year and the chart shouldn’t be used as a plan to load up on those with the biggest returns.
While dividend stocks offer a lower income yield than corporate bonds, they offer the opportunity for price gains as well. Bond prices may even decline sharply on higher interest rates, eating into the dividend yield. Bond prices fell in 2014 and investors lost money while dividend stocks saw their prices surge by more than 20% over the year.
In fact, as rates increase closer to long-term averages over the next few years then bonds and bond funds could get hit even further. For an increase of just 2% in the rate on the Treasury bond, the price drops approximately 17% and losses would be felt across all bond investments.
Not only do dividend stocks pay a higher yield than stocks across the general market (S&P 500) but they have a higher total return and do it with less risk!
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While I have made the distinction between investments in MLPs, REITs and dividend stocks in the table, all three are an important part of an overall dividend strategy. Combining the high yields and relatively low risk from all three asset classes can help smooth out market fluctuations and provide strong and stable income. This combination of different types of investments is a critical part of our eight stock market basics and how to start investing.