As you start to get your feet wet in the figurative pool that is the stock market, you’ll hear the word “dividends” over and over again.
You often hear that dividends are important, dividends are income, and dividends should be a part of every investor’s portfolio. But what exactly are dividends? How is income generated through them? And are they truly important for every investor?
Dividends are an important concept in stock market investing. They’re so important that some investors center their entire portfolios around them, only purchasing stocks that not only pay higher-than-average dividends. But they have their limitations too.
What Are Dividends?
Dividends are a form of income generated from investing in publicly traded companies. This income is actually a portion of the profits generated by the company that you invest in.
At the end of each quarter, when a publicly traded company that pays dividends calculates the amount of profits they made in the quarter, some of those profits are set aside as a way to return value to its shareholders.
Publicly traded companies must declare dividends before they are paid. This means that the company must publicly say that it will pay dividends to its investors. These declarations create a legal obligation for the companies to pay the predetermined amounts to their investors. If there is no declaration of dividends, there simply won’t be any paid.
When dividends are declared, the amount to be paid will be explained in numeric dollar value. This means that the publicly traded company tells investors that it will pay a predetermined amount of dividends.
For example, if XYZ Incorporated declares to investors that it will pay a $0.50 quarterly dividend for the next calendar year, that means that investors will receive a $0.50 cash payment for every share of XYZ Incorporated stock they own every three months for the next year.
It’s also important to consider the ex-dividend date if you are planning on purchasing a stock for coming dividends. The ex-dividend date of a stock is the cut-off for inclusion in its next dividend payment. The day before the ex-dividend date is the last day you can purchase shares to be eligible for the next dividend payment. Shares purchased on or after the ex-dividend date will not take part in the next dividend payment.
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How Your Portion of Dividends Is Calculated
Dividends are paid equally on a per-share basis, no matter what the declared dividend is. For example, let’s say XYZ Company declared a quarterly dividend of $0.50 per share and there are currently 500 million outstanding shares of the company. This would make the total dividend payment to shareholders $250 million per quarter.
So, if you own 100 shares of XYZ Company, you will receive a payment of $50 every three months — the $0.50 dividend per share times your 100 shares.
Dividend Investing Pros and Cons
Dividend investing has been a popular strategy for many years. It’s the buy-and-hold strategy your grandfather told you about when he gave you your birthday check. In many ways, dividend investing has been the darling of the retirement-investing community due to reliable movement in the market combined with decent income.
Nonetheless, although there are plenty of reasons to be excited about the dividend investing strategy, there are also plenty of drawbacks that should be considered if this is the route you think you’re going to take.
Pros of Dividend Investing
As mentioned above, dividend investing has been the darling of retirement savers for years, and for good reason. Some of the most important benefits to consider if you plan on chasing down dividends include:
1. Dividends Can Offer Tax Advantages
Income from investing is still income. In the United States, no matter how income is derived, it’s taxed. These tax dollars keep our roads paved, schools open, and the basic government services that provide the foundation of the great country that the United States has become.
Nonetheless, nobody wants to pay more than their fair share, and when there’s an opportunity to reduce your tax burden, it’s well worth taking it. Dividend investing is one of those opportunities.
Income earned in the stock market is subject to the capital gains tax. How you invest determines the rate you pay in capital gains taxes. For example, profits from investments held for less than one year are taxed at your ordinary income tax rate. So, for example, if you earn between $85,526 and $163,300 in 2020, your tax rate will be about 24%, both on your income and your capital gains on investments held for less than one year.
Once investments are held for a year or longer, profits from these investments are taxed at the capital gains tax rate. The maximum capital gains rate is just 15%. If you make less than $78,750 per year, your capital gains tax rate is 0%.
In terms of dividend investments, there are two major tax advantages:
- Long-Term Style. Dividend investing is a long-term style of investing. As such, it’s natural to hold a strong dividend stock for well more than one year. This means that, when you do eventually sell shares, your gains will be taxed at the capital gains rate rather than your current income tax rate, offering a steep discount from Uncle Sam.
- Dividend Taxes. Dividends paid on stocks purchased after the ex-dividend date are taxed at your ordinary income tax rate. However, if you own the stock for 60 days or longer and the stock was purchased prior to the ex-dividend date, the dividend payments become qualified dividends. Qualified dividends are taxed at capital gains rates, offering up the same steep discount that you experience with profits from long-term investments.
2. Dividends Increase the Rate of Compound Gains
Your ultimate goal in investing is to build your wealth, regardless of your current level of wealth. Dividends are a great help with that. In fact, Grace Groner was an average American who invested her way to millions. A major part of the strategy that led to her amassing a multimillion-dollar fortune was dividend reinvestments, which gave Groner the ability to exaggerate the most powerful force in the stock market: compound gains.
When you earn dividends on an investment, you can use those dividend payments to purchase more shares. Those additional shares begin earning dividends too. The money earned through dividends that have been reinvested is a perfect example of the power of compound gains, and they shouldn’t be discounted.
Over the course of the life of your investment portfolio, compound gains can add hundreds of thousands or even millions of dollars to your overall portfolio value, depending on the size of your portfolio. By reinvesting your dividends, you add fuel to the compound-gains fire.
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3. Dividends Provide Stable Income
As you near retirement or enter into the golden years, stable income becomes important. After all, you want to make sure that your retirement is a comfortable one that gives you the ability to budget for the lifestyle you enjoy.
Dividends help many to achieve that goal.
While $0.50 per share doesn’t sound like a lot of money, if you invest for your retirement and amass 100,000 shares of a stock that pays $0.50 per share quarterly, you’ll receive a payment of $50,000 every three months.
That works out to $200,000 per year in stable income. According to The Week, only the top 5% of income earners in the United States earn $200,000 per year or more. So, over the long run, investing in dividend stocks for your retirement could lead to golden years built on an extremely sturdy financial foundation.
Cons of Dividend Investing
There are plenty of reasons to consider adding dividend investments to your portfolio. On the other hand, there is no such thing as the perfect investment. Every rose has its thorns, just like every investment has its drawbacks. The most important drawbacks to consider if you’re thinking about taking a dividend-based approach to investing include:
1. High Dividends Generally Mean Slow Growth
Buying stocks that pay high dividends puts you in a bit of a give-and-take situation. Stocks that pay dividends are generally well-established companies with the ability to foresee revenue and earnings well into the future. Of course, the market knows this, and prices it in when determining the value of the stock.
With this relatively stable view of what these companies are going to be doing ahead, these stocks aren’t going to see much momentum. Instead, they tend to see slow, steady growth over a long period of time.
So, while you get to take dividends into account, you have to be willing to give up the potential for the momentous upside that investors dream about.
2. Dividends Can Be Reduced or Eliminated
Dividend investing is often looked at as a low-risk strategy. As a result, many make the mistake of buying dividend stocks and not looking back at them for a year or longer. The problem is that, like valuations, dividends can change.
If a publicly traded company that pays great dividends sees headwinds ahead in its sector, the company’s management may decide to keep more of their profits in house in an effort to weather the storm. Instead of cutting costs by reducing the number of employees or closing facilities, a company will generally opt to cut dividends first.
As a result, it’s not rare to see reductions or complete eliminations of dividend payments over time. Investors who fail to keep tabs on the dividends they’re being paid and the valuations of the stocks they’re invested in at least quarterly can end up in what they believe are stable income investments that aren’t actually producing any income.
3. Not Enough Options for Adequate Diversification
Not all stocks pay dividends. Those that do decide what percentage of their profits they’re going to give back to investors, meaning that companies that do pay dividends will not all pay dividends equally.
As you start to look for stocks that pay high dividends, you’ll find that they are nestled in a couple of sectors — such as utilities, energy, and consumer staples — with a handful of stocks in each of these sectors being the strongest options for income investments.
The problem here is that the limited number of companies offer compelling dividends also limits your ability to diversify. Diversification is an important aspect of your investment portfolio because it protects you from the risk of significant losses. With fewer options in the high-dividend stocks arena, many experts argue that proper diversification is difficult to do if you have a portfolio that’s 100% focused on chasing down dividends.
No matter what your age, your appetite for risk, or your portfolio goals, high-dividend stocks should be included somewhere in your portfolio. These stocks can act as hedges against higher-risk bets within your portfolio, or take center stage as buy-and-hold opportunities that offer income to boot.
However, there is no type of stock in which all opportunities within the market are created equal. It is vital to take the time to research the underlying companies represented by the investments you make, regardless of whether you’re investing in high-dividend stocks or some other opportunity in the stock market.