Dividends: Why Are They Important to Your Investment Strategy?
When people think of dividends, they think of retirees looking for safety, security and predictable cash payments. Most of the big, exciting tech stocks that snatch all the headlines don’t pay dividends.
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But dividend stocks are hardly just for retirees, and the dividends they pay are far more important to the economy and to your investment strategy than just a modest quarterly payment. Dividends are the beating heart of the stock market and one of the best predictors of how a company will perform over time.
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What Are Dividends?
Some companies give a portion of their profits back to their shareholders as periodic cash — and more rarely, stock — payments. Those payments are called dividends. Companies pay dividends to entice new shareholders and to reward their existing ones.
Companies that pay dividends tend to be older, well-established and in command of a large market share. New companies that are just starting out have to reinvest every dollar back into the company in order to grow. That said, many of the biggest and most profitable companies in the world — Google, Facebook and Amazon, to name a few — don’t pay any dividends at all despite sitting on hundreds of billions of dollars in cash. Some investors prefer non-dividend stocks because dividends are taxed at the regular rate. They would rather the company reinvest its profits in the hopes that it will grow and the stock price will rise.
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Dividends are paid on a per-share basis. If a stock pays a 10-cent dividend, you would earn $10 on 100 shares.
Keep in mind these key facts about dividends:
- With the exception of options, dividends are the only way to profit from owning a stock without selling some of your stake in the company.
- When interest rates are low, dividends can provide better yields than bonds.
- Unlike bonds, dividend stocks can grow in value while still distributing cash payments, but also unlike bonds, the principal is not guaranteed — dividend stocks are subject to the whims of the market.
- Dividend stocks can give retirees and other income investors cash to meet expenses without forcing them to sell shares and deplete the pool of funds they depend on to live.
- Dividends are an indication of overall financial health — only companies that are mature and secure can afford to make regular cash payments to all their shareholders.
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Dividend Growers Tend To Be Elite Performers
Paying a dividend is one thing, but the companies that consistently increase their dividends over time — dividend growers — command an extra degree of respect from investors.
Consider the Dividend Aristocrats.
A small group of stocks on the S&P 500 — there are currently 65 — the Aristocrats represent a kind of all-star team of dividend growers. To make the list, a company has to increase its dividend every year for at least 25 years straight without missing a single year regardless of recession, bubble, downturn or crash.
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Only the most stable, best-managed, and most financially secure companies can pull off such an impressive financial feat, and it shows in the results.
A 2021 report from Hartford Funds shows an unmistakable connection between growing dividends and shareholder gains. If you had invested $100 in 1973, here’s what you would have had in 2020 depending on the dividend growth policy of the companies you invested it in:
- Dividend cutters and eliminators: $56
- Dividend non-payers: $844
- No change in dividend policy: $2,189
- Equal-weighted S&P 500 Index: $3,764
- Dividend payers: $6,946
- Dividend growers and initiators: $11,364
If you’re willing to pay a .35% expense ratio, the ProShares NOBL ETF tracks the S&P 500 Dividend Aristocrats Index.
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Dividends: The Slow, Steady DRIP of Supersized Gains
It’s not just market performance. Dividends can have a powerful compounding effect when you reinvest them instead of harvesting them as cash payouts. Dividend reinvestment plans (DRIPs) allow you to do exactly that. When you reinvest more dividends, you own more shares, which then pay more dividends that will then be reinvested to buy even more dividend-paying shares.
Over time, the snowball effect creates a self-sustaining wealth-generating machine that serves as the backbone of the stock market.
In the 50 years between 1970-2020, 84% of the total return of the S&P 500 came from reinvested dividends and the magic of compound growth, according to the Hartford Funds study. If you’re wondering whether you should enroll in a DRIP, consider the following. If you had invested $10,000 in the S&P 500 in 1960 without reinvesting your dividends, you would have had $627,121 by 2020. If you had reinvested your dividends, you’d have just shy of $3.85 million.
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Last updated: July 21, 2021
