The Power of Dividends in a Portfolio
Why consider dividends?
Dividend income has represented roughly one-third of the total return on the Standard and Poor’s 500 since 1926. If dividends are reinvested, their impact over time becomes very dramatic. S&P calculates that $1 invested in the Standard and Poor’s 500 in December 1929 would have grown to $49 over the following 80 years. However, when coupled with reinvested dividends, that same $1 investment would have resulted in $1,259. (Bear in mind that past performance is no guarantee of future results, and taxes were not factored into the calculations.) If a stock’s price rises 8% a year, even a 2.5% dividend yield can push its total return into double digits. Dividends can be especially attractive during times of relatively low or mediocre returns; in some cases, dividends could help turn a negative return positive, and also can mitigate the impact of a volatile market by helping to even out a portfolio’s return.
The corporate incentive
Financial and utility companies have been traditional mainstays for investors interested in dividends, but other sectors of the market also have begun to offer them. For example, investors have been stepping up pressure on cash-rich technology companies to distribute at least some of their profits as dividends rather than reinvesting all of that money to fuel growth. Some investors believe that pressure to maintain or increase dividends imposes a certain fiscal discipline on companies that might otherwise be tempted to use the cash to make ill-considered acquisitions. Dividends paid on common stock are by no means guaranteed; a company’s board of directors can decide to reduce or eliminate them. However, a steadily growing dividend is generally regarded as a sign of a company’s health and stability. For that reason, most corporate boards are reluctant to send negative signals by cutting dividends.
Look before you leap
Investing in dividend-paying stocks isn’t as simple as just picking the highest yield. If you’re investing for income, consider whether the company’s cash flow can sustain its dividend. Also, some companies choose to use corporate profits to buy back company shares. That may increase the value of existing shares, but it sometimes takes the place of instituting or raising dividends.