In the last year or so, I have seen a renewed interest in “dividend investing”. Dividend investing means that people select what stocks to buy based primarily on the amount of dividends that the company pays as a percentage of the price of the stock. This is called the Dividend Yield. Before getting into more details, let me define some terms and concepts:
What are dividends and why do companies give them? A dividend occurs when a company distributes a share of its profits to its owners. Dividend payments are not required, but many companies choose to pay their stockholders a dividend every quarter. A dividend payment can show that the Board of Directors and company management are confident in the future of the company. Another reason to pay dividends is that once the company starts paying the dividends and establishes and a history of making the dividend payments, the dividend acts as a floor for the stock price, protecting their owners in bad times.
How important are dividends to the ordinary investor? According to Standard & Poor’s, dividends comprise about 44% of stock’s total return over the long term. Since most companies are reluctant to reduce dividends paid from the prior year, investors can get a steady stream of cash. Most dividend payments also qualify for lower tax rates than interest payments from bank accounts or bonds.
This all sounds great—steady cash flow, a floor for the stock price, better tax rates and a higher price for the stock when you want to sell. What can go wrong? Plenty:
- The biggest risk is that when the company needs to stop paying the dividend or pay less than the prior year, the price of the stock also collapses. If an investor was relying on the dividend, in one motion that investor not only looses their cash flow, they also see a dramatic loss in principal.
- The company stops investing in itself to pay the dividend, hurting its future growth prospects.
- The investor overpays for the expected dividend and the stock price doesn’t grow over time.
- Loss of diversification—some industries are more likely to pay dividends than others and when an industry is beaten down, dividend yields can rise. This can lead to the investor losing their diversification and be too heavily weighted to one or two industries. Then, when a sector gets into trouble (i.e. banks in 2008), the investor’s entire portfolio loses value all at once.
Dividend producing stocks can be used in 2 primary ways in a portfolio. First, they can be used to replace some yield lost with today’s low interest rates. Second, they can be used to reduce the overall risk of your other stock holdings. Like all investing products or ideas, dividend investing involves risks and may not be right for you and your specific circumstances. Speak with JK Financial Planning, Inc. to review your goals and current situation before making any changes to your investment plan.