With interest rates still hovering around their historic lows, yield-seeking investors often turn to dividend-paying stocks. Aside from the income they can generate for investors, dividends can significantly enhance total investment returns.
One way companies reward their shareholders is by sharing their profits. Companies that consistently generate profits can choose to reinvest them in the business or pay a portion of them to shareholders in the form of a cash dividend payment, often paid quarterly or sometimes monthly.
How Dividends Work
Shareholders can choose to keep their dividend as income or reinvest it to purchase additional shares. Either way, a dividend payment is taxable to shareholders, unless it’s received in a qualified retirement plan. Qualified dividends are taxed at a special tax rate not exceeding 20%. Depending on the amount of a shareholder’s adjusted gross income, the tax rate can be 0%.
Companies can increase, decrease, or stop dividend payments at any time. That determination is made by the company’s board of directors based on how well the company is performing. When a company experiences financial difficulties, the board may decide to reduce or suspend its dividend. When companies exceed expectations, the board may decide to increase the dividend or declare a special one-time dividend.
Look for Companies With a Long Track Record of Paying Dividends
Companies that pay a dividend are thought to be financially stable with predictable earnings. It’s that predictability that allows companies to continue to pay dividends through up- and down-market cycles. Some companies have been paying dividends for many decades and a select group of companies, known as Dividend Aristocrats, have managed to increase their dividends in each of the last 25 years. Some companies have been increasing their dividends for 50 or more consecutive years.
Don’t Get Drawn in by High-Yielding Dividend Stocks
During periods of low interest rates, dividend yields can appear very attractive. For several years, the average yield of S&P 500 stocks has been around 2%, with some blue chip stocks yielding 4% to 6%. These are among the largest and most financially stable companies in the market. While some have had to reduce or temporarily suspend dividends during times of economic distress, none have eliminated them altogether.
It’s not uncommon to find dividend stocks yielding upwards of 8% to 10%. But it’s important to consider why their dividend yields are so high. Dividend yields fluctuate with the share price. When share prices decline, the dividend yield increases, and vice versa. Depressed share prices can be a sign a company is in financial trouble, which brings into question the safety of its dividend. Even with a high dividend yield, a poor performing stock can drag down investment returns.
The Difference Dividends Can Make
Over the long term, dividends have played a significant role in the total returns of the market. Going back to 1970, nearly 85% of the total return of the S&P 500 can be attributed to reinvested dividends and the power of compounding.
The Power of Dividend Compounding
Growth of $10,000 1960 to 2020
Here are some other reasons why it would be important to add dividend stocks to your investment portfolio:
- Historically, large-cap, dividend-paying stocks have performed better than the broad market often leading stock market turnarounds.
- A large number ofdividend-paying companies are multinationals with global diversification that reduces their exposure to domestic instability and currency volatility. Companies with broad exposure in developed and emerging markets tend to generate more stable revenues.
- Larger, blue chip companies have a solid history of paying dividends and even increasing them during periods of slower economic growth. While many did decrease their dividends during the economic slowdown, they have since raised them back to their pre-recession levels and are on pace to increasing them further in the near term.
- Large-cap stocks tend to perform better than small-cap stocks and bond investments during periods of higher inflation. Inflationary pressures can result in higher interest rates which will depress bond prices and hurt the bottom lines of smaller, leveraged companies. Large companies that can raise their prices in inflationary cycles can actually increase their earnings. Dividend-paying stocks also provide steady returns during times of stagflation and deflation.
- Over the prior two decades, dividends have provided nearly 50% of the total stock market return. Dividends are always positive, so they can act as a counterweight in down markets.
Do you want to learn more about how dividends can provide the retirement income you need? Not all dividends are created equal…You must make sure the companies that are paying you dividends now will keep doing so in the future. Let us do a dividend stress test on your account so you can know.
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