One popular way of investing is putting funds into companies that pay dividends. Some of these companies pay a return that is as high as 7-8%. As global financial markets continue to be volatile, investors are searching for ways to enjoy growth in their portfolios while lowering the volatility usually associated with such growth. But what are dividends, and how can they help your investment portfolio?
What Are Dividends?
Dividends are the share of a company’s profits that it decides to pay to its shareholders. They are an important part of the return that an investor receives from investing in shares, in addition to any increase in the share price. Although companies are under no obligation to pay dividends, they usually choose to do so because dividends provide an incentive to invest in their shares.
When a stock pays an 8% dividend yield, what does this actually mean? If a certain company is trading at $25 a share, and it distributes $2 a share in dividends, if this dividend is divided into the price of the stock, the investor receives 8%. This yield changes according to the price of the stock and the amount of money that the company decides to allocate. In the example given above, if the share price were to drop to $20 the dividend yield would be 10%. Conversely, if the price of the stock would move up to $50, the yield would be 4%.
How Do They Help?
Much research has been done on the impact of dividend investing versus non-dividend investing over the past 30 years. According to Ned Davis research, from January 1972 through 2005, the companies in the S&P 500 index that paid a dividend returned over 10% annually, while the non-payers returned a lowly 4.1% annually. Over time, more than 65% of the return on stocks has come from the compounding of reinvested dividends. Dividend-paying stocks tend to be less volatile than the non-payers because the dividend acts as an extra cushion in falling markets. Keep in mind, past performance is no guarantee of future returns.
Too Good to be True?
With all this in mind, it is still important to be careful when deciding whether to invest in a dividend-paying stock. When a certain company has a dividend yield of 15%, this may sound very attractive. However, a key factor to note is whether the company will be able to continue to pay or even increase the amount of the distribution. Historically, companies that cut the amount of money they distribute have very poor performance going forward.
Dividend Downside
On the other hand, many investors don’t like it when companies pay out dividends because they prefer that the available cash is reinvested in the company, growing its profitability. Other investors say that if the company is in debt, some of the available cash should go into reducing or eliminating it. This school of thought is similar to what we learn in home economics. If a household is in debt, and suddenly the family comes into a large sum of money, all of its debts, loans and overdrafts should be paid off. It is better to use the opportunity to have a clean slate, rather than spending the newfound money on a vacation or other luxuries.
If you are considering investing in dividend-paying stocks, speak with your financial adviser to find out if it is appropriate for you.
The S&P 500 index measures Large-cap stocks in the US and stock market performance of leading companies in leading industries. An investor cannot invest directly in an index.
Aaron Katsman is Managing Editor of the Israel Opportunity Investor newsletter. He is lead portfolio manager for the Israel Growth Portfolio and Managing Director of America Israel Investment Associates, LLC. For more information, go to www.israelnewsletter.com or call 1-888-327-6179, or email aaron@profile-financial.com.
