Some of the most essential ingredients to any successful, long-term investment strategy are dividend-paying stocks. A portfolio without many (or any) dividend stocks is likely missing out on valuable opportunities, whether that entails a passive income in the form of dividend payments or dividend reinvestment plans (DRIPs), which automatically reinvest dividend payouts back into your portfolio.
Many experienced investors already realize why dividends matter, but newer investors who want to make big returns more quickly could be overlooking the long-term value of dividend-paying stocks by pouring money into rapid-growth, hyped up stocks with no dividends instead.
Don’t make this mistake with your own portfolio. Whether you’ve been casually investing for years or you recently made the plunge into the world of hands-on investment management, it’s incredibly important to understand why dividends matter to investors of all incomes and levels of experience and knowledge:
Importance of Dividends
First and foremost, you might be wondering why dividends are so significant in the first place. While there are plenty of non-dividend stocks with excellent ROIs for their shareholders out there, dividend-paying stocks are unique because you get tangible returns in the form of quarterly (most common) payouts.
This isn’t to say dividend stocks are superior to their non-dividend paying counterparts in every way – there are dividend traps with substantial risks for investors, after all – but these types of investments are undoubtedly good signals of a company’s financial stability (and thus, its ability to sustain its operations over a long time frame).
How so? Because dividends play an influential role in how companies decide allocate their profits, whereas publicly traded companies without dividends have greater freedom to heavily compensate their executives and manage their assets in ways that might not always maximize the stock value for shareholders. These problems are more easily avoided with dividend-paying stocks because companies have greater obligations to either maintain or increase dividend payouts to their shareholders, and thus, they are more efficient when it comes to capital management.
Why Do Companies Increase Dividends?
If dividends force companies to listen and acquiesce to shareholders more frequently, then why would they willingly burden themselves with a practice like paying out dividends on their stocks? For one, dividends tend to attract investors without putting too much pressure on the company to grow (this is why companies in rapid growth mode tend to avoid paying dividends on their stocks – so they can keep more cash on hand for expanding business operations).
Additionally, dividend growth is a publicly visible indicator of a company’s good health; if cash hoards were running low then a company would not be able to afford dividend payments 4 times per year and would likely cut the dividend. Thus, the dividend growth rate is a critically important indicator of a company’s stability – which is something every investor should pay attention to.
Grow Your Wealth with Dividends
A recent study on the average returns for stocks between 1991 and 2015 found that non-dividend stocks earned a measly +4.18% average annual return, while dividend-paying stocks earned an average of +9.7% each year. This fact alone should encourage more investors to flock to dividend stocks, but there are plenty of other reasons why dividends matter for long-term financial success, including:
– Consistent returns with the ability to reinvest those returns 4x per year for maximum portfolio growth in a DRIP
– Long-term dividend growth potential for investors who care more about stability and the probability of dividends increasing over time (as opposed to high yields in the status quo but potential instability later on)
Of course, it’s worth noting that investing in dividends is not as easy as picking some stocks with high dividend yields and waiting for huge quarterly payments to roll in. Instead, there are many factors you need to evaluate before choosing the right dividend-paying stocks for your portfolio. These factors include: current vs. historic dividend yield, company’s annual earnings growth vs. dividend annual growth, and the dividend payout ratio (dividends vs. earnings per share).
Final Thoughts on Why Dividends Matter
When it comes to dividend-paying stocks, it should be less of a question about why dividends matter and more of a question about what dividends matter. After all, each dividend-paying stock is different; even those with similar returns (both historically and currently) may be in vastly different places within a few years, depending on their respective companies’ financial health and efficiency of the management.
For everyday investors, dividend stocks offer a clear and stable passive income opportunity, though you may also opt to automatically reinvest those dividends back into the company to maximize your returns over the next several years. The math favors the latter scenario (using DRIPs to compound your returns on investment), but there’s nothing wrong with cashing out each quarter, as long as you research the best dividend stocks for your dividend portfolio before jumping on the bandwagon.