What is a Dividend Paying Stock?
You may have heard of dividends before, but do you know about dividend-paying stocks as an asset class? While they aren’t suitable for every investor, dividend-paying stocks can be a useful part of a diversified portfolio. Here’s what you need to know.
What are they?
You guessed it: dividend-paying stocks are simply stocks that pay dividends.1 Of course, that’s a pretty broad group: these companies can be anything from blue-chip consumer goods stalwarts to industrial giants. However, one fairly consistent feature is that dividend-paying companies tend to be large and relatively mature.
In other words, you’re unlikely to find a major growth stock in their midst.
The reason is that dividends are paid out to shareholders from earnings, and companies experiencing rapid growth often prefer to reinvest earnings instead of paying them out to shareholders. After all, expanding business lines or capturing market share costs money, and that money is most cheaply sourced from profits.
However, for a mature company that’s more established in its industry or niche, paying dividends could be key part of sharing the fruits of a successful strategy with shareholders. Such companies may not be expanding aggressively, so they can presumably afford to pay out part of their earnings.
Because of that, dividend-paying companies can have relatively slow growth and, perhaps, less exciting news to share in each year’s annual report
Dividends and long-term growth
But a more sedate growth rate doesn’t mean that dividend-payers are duds.
In fact, historically speaking, it’s just the opposite. In a speech for the Financial Industry Regulatory Authority,2 the legendary investor John Bogle noted that between 1926 and 2007, reinvested dividends accounted for 95% of the compound long-term returns of companies in the S&P 500. In other words, by his calculation, most of the total growth in the S&P 500 could be attributed to the compounding effects of reinvesting dividend income in company shares.
Bogle emphasized the point with an example: if you had $10,000 to put into the S&P 500 in 1926, you would have amassed over $33 million by September 2007 — if, and only if, you reinvested your dividends. What if you took the dividends as cash? Your holdings would have only grown to $1.2 million.
Using dividend income
Reinvesting dividends is powerful because it creates a kind of virtuous cycle: buying more shares with your dividends makes you eligible for even more dividends, which amass more dividend income and thus more share purchases. Over time, the compounded growth of all those dividends and new shares can drive significant growth.
However, not everyone uses their dividends to build larger investment positions: some people prefer to take dividends as cash to help finance retirement income or other needs. Depending on your personal financial situation, this could be an interesting choice. Dividend-paying stocks can sometimes have relatively high payouts, meaning more income for a given level of investment.
However, relying on dividend income from stocks isn’t without risk. To start, dividend income is not guaranteed. Rather, payouts for a given quarter are determined by the company at its discretion, meaning they can be stopped at any time. Because dividends are generally tied to company performance, you could see a simultaneous loss of dividend income and a decline in share value if a company’s financial position suddenly worsens.
On a related note, even if a company has been paying consistent dividends for some time, there is no guarantee that the company is stable, safe, or sound. While dividend-paying stocks may, on average, have less volatile stock prices, they can still fail to meet expectations, succumb to poor economic conditions, or even go out of business.
That’s why it’s important to keep in mind that dividend-paying stocks are still stocks, meaning that they bear some risk. It’s important to analyze whether investing in dividend-paying stocks is suitable for you as an individual and to put a risk management program in place to mitigate the risks involved.
Should I invest?
As with any investment decision, whether or not a particular asset class is suitable for you depends on your financial position, your goals, your risk tolerance, and your time horizon.
With dividend-paying stocks, you should be aware that despite their reputation for safety, they aren’t foolproof: you’re always taking a risk when investing in equities. While dividend-paying stocks can complement your portfolio in the right circumstances, it’s critical to ensure that you’ve addressed the risks involved before moving forward with a new investment strategy.
If you’re not sure about whether dividend-paying stocks fit into your portfolio, consider speaking with an advisor about your goals and needs. A long term investing plan will take into account both the realities of the asset classes involved and your dreams for the future — with the goal of balancing risk and reward in the way that’s right for you.