With global financial markets still volatile, investors are searching for ways to enjoy growth in their portfolios while lowering the volatility usually associated with such growth. In addition, traditional income-producing investments such as investment-grade bonds and deposits are paying next to nothing. In an investment environment like this, you should take a long look at dividend-paying stocks to help lower market volatility and generate income.
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 total return achieved from investing in the company's stock, in addition to any increase in the share price. Companies are under no obligation to pay dividends, but they usually choose to do so because dividends provide an incentive to invest in their shares.
A company may choose not to pay a dividend because it wants to reinvest all its profits in the business, or it may need all its available cash to purchase another company.
How do dividends help?
There has been much research done on the impact of dividend investing versus non-dividend investing. According to a report by Lebel Harriman: "Dividend income has represented roughly one-third of the monthly total return on the Standard and Poor's 500 since 1926. According to S&P, the portion of total return attributable to dividends has ranged from a high of 53 percent during the 1940s - in other words, more than half that decade's return resulted from dividends - to a low of 14% during the 1990s, when investors tended to focus on growth.
"If dividends are reinvested, their impact over time becomes even more dramatic. S&P calculates that $1 invested in the Standard and Poor's 500 in December 1929 would have grown to $57 over the following 75 years. However, when coupled with reinvested dividends, that same $1 investment would have resulted in $1,353. (Bear in mind that past performance is no guarantee of future results, and taxes were not factored into the calculations.)"
Dividend-paying stocks tend to be less volatile than the non-payers because the dividend acts as an extra cushion in falling markets.
In 2003 the US Congress, following president George W. Bush's recommendation, passed legislation lowering tax rates. Until this reform, investors had to pay up to 35% tax on dividend income, which was treated as ordinary income. The tax reform lowered this level to a maximum rate of 15%, and many investors with lower incomes only pay 5% on this income. Obviously this has contributed to the popularity of investing in stocks that pay dividends.
In the go-go days of the late 1990s, when the stock-market bubble was still inflating, investors shunned dividends for hi-tech, high-growth companies, where hot stocks would double in a few weeks. All it took was the popping of the bubble and lowered tax rates, and investors jumped back in to "safer" profitable companies that actually share their profits with investors.
Many large, well-known corporations such as Coca Cola and Johnson & Johnson have been paying dividends for decades. In today's market climate, these companies pay dividends that yield 3% to 4.5%. Compare that to a one-year bond that - if you are lucky - you can squeeze out a 1.5% yield, and you can see why dividends have regained popularity. Not only do you get more income than from a bond/deposit, but you have the potential for capital appreciation as well.
There are many investment strategies that focus on dividends. For example, the "Dogs of the Dow" and Prof. Jeremy Siegel's method invest in large companies that pay high dividends. Other popular strategies concentrate on companies that increase their dividends every year.
Speak with your financial advisor to find out which strategies work best for you. To be a successful investor, you need to stick to whatever ever strategy you pick. If you start hopping from one strategy to the next, you will create a recipe for disaster.
Aaron Katsman, a licensed financial adviser in the United States and Israel, helps people who open investment accounts in the US.