Why Are Dividends Important?

Every investor needs to know the importance of dividends. Take advantage of them—they will help you become a better investor. Here’s why they are so important:

A dividend is a distribution (normally cash) of a portion of a company’s earnings, decided upon by the board of directors and paid to its shareholders. Dividends are usually paid out on a quarterly or annual basis. Receiving dividends is one of the ways an investor makes money. Bottom line, a dividend is your share in the apportioned profits of a company you own stock in. Attractive, don’t you think?

Why are dividends important?

First of all, if you are retired, they help supplement your income.

Secondly, according to Ned Davis Research, Inc., over the past several decades, 42% of the annual total return of the S&P 500 was derived from dividends. Get the implications?

Buy a non-dividend paying stock and you likely miss out on a lot of money.

According to the same research, dividend paying stocks have outperformed non-dividend paying stocks over the past forty plus years by 6% per year and with lower risk.

This is a very big deal! How big?

A gentleman approached me for investment advice in the latter part of 2009. He had a $1.2 million retirement portfolio made up of mostly individual growth stocks and mutual funds, which generally do not pay dividends. Prior to the Great Recession stock market meltdown of 2007-2009, his investment account was worth $2 million. Not only had he lost his shirt, but he also lost $800,000. One of the reasons for the 40% decline was that he was forced to sell more shares at a substantially discounted price in order to generate the $60,000 per year he needed to live on. Selling low is not a great investment strategy; it was wreaking havoc on his investments. To say the least, this man was in trouble.

To further illustrate, suppose I purchased a large number of shares of a company trading at $100 each. I plan on selling one share per month ($100) to supplement my income. Now, suppose my stock declines by 50% to $50 per share. In order for me to get my $100 per month, I now must sell two shares. I will run out of shares and the money much sooner if the stock stays depressed for a prolonged period of time.

Imagine working your entire adult lifetime to accumulate a good-sized nest egg only to lose 30, 40 or even 50% of your life savings in just a couple of years. Fortunately, I was able to help guide him back to solvency. By selling what he had in his portfolio and purchasing an assortment of income-producing investments, I was able to stop the bleeding. He was now able to live off the income (still $60,000) without having to sell any shares while maintaining his standard of living. $1.2 million x 5% (dividend income) equals $60,000 per year.

Here’s the really good news for my new best friend. His portfolio recovered more quickly because he was able to stop selling things in his portfolio at a discounted price.

Here are six additional reasons I favor dividend-paying stocks:

1. Companies that increase their dividends signal confidence in their future.

2. Buying dividend-growing stocks helps as an inflation hedge.

3. Dividends are less taxing: 15-20% vs. ordinary taxation.

4. Dividend paying companies generally represent mature, stable businesses.

5. They provide steady cash flow.

6. They have relatively solid profits.

Peter Lynch, author, investor, mutual fund manager, and an Andy Warhol lookalike is quoted as saying, “The reason that stocks do better than bonds is not hard to fathom. As companies grow larger and more profitable, their stock holders share in the increased profits as dividends are raised. The dividend is such an important factor in the success of many stocks that you could hardly go wrong by making an entire portfolio of companies that raised their dividends for ten or twenty years in a row.”

I don’t think my NBF would disagree with Mr. Lynch.

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Thanks and Blessings!