In stock investing, it really all comes down to dividends. Either dividends that the companies you own currently pay, or dividends they may pay in the future. Indeed, the price growth rate of a stock is normally tied to the growth rate of the dividend, both the one that it pays now and the one that it will probably pay in the future.
You see, a dividend is a portion of the profit that a company makes that it pays out to the owners – the stock holders. When a stock is young and growing rapidly, it may pay only a small dividend, or even no dividend at all, because it needs all of the money it can raise to grow the company. When it becomes a big company many years later, however, it might making enough money to pay out a few dollars per share each year.
The nice thing about dividends is that they allow you to make money from a stock even in years where the prices of stocks are gong nowhere. If you own shares in a stock that pays no dividend and the price just trades within a narrow range for several months, you will have received no return for your money during that period. If the stock pays a dividend, however, you can still be making a few percentage points of return each year even when the price of the stock is going nowhere. It is kind of like a bank account with the possibility of much bigger gains. (Realize, however, that movements down in price can quickly erase the amount of money you are getting from dividends, so there is no stability or guarantee like there is with a real bank account.)
Often a company will continue to pay dividends even when the price of the stock declines, helping to reduce the sting of the loss. In addition, because the percentage return (yield) of a stock will increase as the stock price goes down unless the company decides to cut the amount of its dividend, people are more likely to buy dividend paying stocks as they decline than those that don’t pay a dividend. This causes something like a safety net to be placed under the price of the stock. Of course this doesn’t work in cases where the business of the company declines since then they may need to cut or eliminate their dividend.
Despite the virtue of dividend paying stocks, they aren’t for everyone. If you are young and have s long time to invest, you’ll generally do better buying a portfolio of young companies that don’t pay dividends but have a lot of room to grow than you will with older companies that pay a good dividend but have already seen a lot of their growth. Dividends will also create income, which means you’ll need to pay taxes each year even if you reinvest the dividends unless the stocks are in a tax-deferred account like an IRA.
Dividend paying stocks can be great, however, if you need your portfolio to generate an income for you. If you receive enough money from dividends to pay for things when you’re retired, you will not need to sell shares of stock to raise cash. You can then let the value of the shares appreciate while you spend the dividends.
Another neat thing about dividend paying stocks is the compounding that comes. When you start out, you may only be making a 2-3% return each year in dividends. As the company grows, however, and makes more money, they may increase their dividend. Because the stock price increases they may still only be paying 2-3% based upon the price of the stock, so you’ll effectively be making a greater return on the amount of money you invested. Wait long enough and you may be making a 10, 20, or even 30% return based on your original investment each year! The power of compounding, even when it comes to dividends, is astounding.
When investing in dividend paying stocks, here are some things to consider:
1. To save taxes, keep your dividend paying stocks in tax sheltered accounts and non-dividend paying stocks in taxable accounts unless you need to spend the money now.
2. Companies that raise their dividends every year tend to be great companies as long-term investments. Find these and hold on.
3. Don’t buy a stock with a dividend that is much bigger than the rate of similar stocks in the market. It is probably about to cut the dividend.
4. If you don’t need the money for a while, consider using a dividend reinvestment plan, or a DRIP, where the dividends are reinvested to buy more shares. Again, this will need to be in a tax-sheltered account or you’ll still need to pay taxes on the dividends.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.