Why Dividend Stocks are Your Best Bet in Investing

Dividend stocks offer four huge advantages over other investments and should be a part of everyone's financial plan.

Is it any surprise that dividend stocks have been one of the most popular investing strategies since the first payment was made to owners of the Dutch East India Company over 400 years ago?

While investing in other stocks may offer the dream of getting rich when the investment sells, regular dividends provide something tangible you can spend or reinvest.

Two major stock market crashes in less than a decade have made dividend investing even more popular and necessary. Investors have seen their price appreciation wiped out multiple times, with dividends being the only remaining value.

With interest rates at historic lows and bonds paying almost nothing after inflation, investors have also found new hope for income in shares of companies with healthy dividend yields.

Dividend stocks may be one of the only valid paths to financial freedom. The safety and reliability of dividends turn you into an owner, collecting income off the assets rather than simply a renter of other people's assets.

The four principal advantages of dividend stocks:

  • Powerful returns on compound interest
  • Ability to reduce inflation risk
  • Safety when the stock market crashes
  • An income stream and financial freedom!

The Power of Dividend Stocks and Compounding Returns

Maybe the most substantial evidence in favor of dividend stocks is the actual return in the market. The graph below shows the annual compound return to four groups of stocks in the 37 years to 2010.

Shares of companies that paid dividends but did not regularly raise their payments provided investors with a 7.1% annual return over the period, well above the 1.8% yearly return from companies that paid no dividends.

Dividend Stocks Returns

But companies that regularly increased their dividend payments did even better, returning an average of 9.3% over nearly four decades!

In dollar terms, if you had invested $10,000 in a portfolio of dividend stocks in 1973, by 2010, you would have more than $268,500 in your account.

Compare that to $126,500 in the portfolio of companies that paid dividends without regular pay increases and just $19,350 in the portfolio of non-dividend stocks.

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The out-performance of dividend-paying stocks makes sense on a financial level. For a company to pay dividends, it must make a detailed projection of its cash flow and plan for sales and growth projects, sometimes years in advance.

Once a dividend is set, a company dares not cut the payment for the signal of weakness it sends to investors. For this reason, a dividend payment is a limitation on the use of cash and helps discipline management.

Free cash flow is like a narcotic to management, clouding their judgment and often leading to overconfidence. Management sees all the money rolling in and thinks about building its legacy through pet projects, executive perks, and billion-dollar acquisitions. A high and increasing dividend payment keeps management grounded and limits the amount of trouble they can get into.

With management constrained by the dividend, they're only able to go with the most profitable projects and have to think twice before giving themselves massive bonuses and perks.

Dividend Stocks as an Alternative to Low Rates and an Inflation Hedge

The Ten-year Treasury bond, the instrument against which all other bonds are priced, hit a record low of 1.39% in 2012. Inflation that year increased by 1.7%, so the U.S. government was charging investors a third of a percent to hold their money each year over the next decade.

That doesn't sound like any way to meet your financial goals!

Since the market uses the rate paid on risk-free treasuries to price other bonds, the yields on all fixed-income investments have come down to the point that you might have trouble meeting investment goals with a portfolio of bonds.

Even corporate bonds only pay a 2.6% yield after accounting for inflation, with no prospect for price appreciation if held to maturity.

Dividend investing has come to the rescue for many people living off the income from their investments.

Many dividend-paying companies have been in business so long that they are nearly as safe an investment as the U.S. government. Some even have a better credit rating!

Since companies can generally increase prices along with inflation, dividend stocks offer protection against inflation that you won't find in bonds. Bonds lose their value with inflation and higher interest rates, but dividend stocks hold up and even increase in value.

Besides the tendency for dividend payments to increase with inflation, several groups of dividend stocks offer additional protection against rising prices. Utility companies, the classic defensive dividend stocks, are sometimes contractually allowed to raise the rate on their services by an inflation adjustment above and beyond an allowable rate of return. The adjustment may lag a year or two but will even out over many years and compensate for higher prices.

Other popular categories of dividend-paying companies exclusively invest in real assets. Companies that hold real assets like energy infrastructure and real estate carry a natural inflation hedge because the assets maintain their value against rising prices.

But isn't inflation dead? Prices rose just 0.8% last year and have averaged just 1.7% over the previous five. Before you shrug off the need to protect your assets against losing purchasing power, look at the graphic below.

Dividend Stocks and Inflation

Even at a low rate of 2.0% inflation, the value of your money halves in 34 years. Imagine getting to retirement, and your money buys half as much as you were expecting.

Low inflation over the last decade may be the exception rather than the rule. In the 30 years to 2000, the average annual inflation rate was 5.2%, more than double its current rate. Tack on historic programs of monetary stimulus by central banks worldwide, and you've got a recipe for higher prices in the future.

While we may not see the 7.1% rate of inflation experienced in the 70s, we are likely to see rates closer to 3% over the next several decades.

At a moderate 3% annual rise in prices, your dollar is worth just two-thirds of its value in 10 years, and it takes just 23 years to halve its value.

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Dividend Stocks Yield Provides a Safety Net

All the data on dividend stocks and market-beating returns is just icing on the cake. Like many investors, dividend stocks are my ‘sleep-at-night investments.' Studies show that dividend-paying stocks are less sensitive to market changes and outperform the general market even more, when stock prices come down.

Over the two decades to 2012, dividend stocks within the S&P 500 posted an annualized return of 11.3% against 10.4% for stocks that paid no dividends. Again, the icing is on the cake, but the dividend-payers also did it with lower risk and price volatility.

Shares of stocks that paid no dividends were 20% riskier than dividend-paying stocks. Not only did the dividend-payers beat the non-paying stocks by nearly a percentage point annually, but they did it with much less risk.

While stock prices may rise or fall in any given year, dividend returns will always be positive. That dividend check is money in your pocket and can't be taken away even if stock prices collapse. Over the 85 years to 2012, stocks in the S&P 500 increased an average of 24%, with 5% of that from dividends. During years when stock prices fell, the average loss was 15%, but dividend payments still offered a positive 3% return.

When the market is rising, dividend stock returns are good and add to total returns. When the market is falling, returns to dividend investing are great and cushion you from more significant losses and panic-selling

Dividend Stocks for Income and Financial Freedom

Finally, dividend investing provides a stable source of income for millions of Americans.

Americans are increasingly relying on dividend income for their everyday needs. Data from the Bureau of Economic Analysis shows wages and dividends as percentages of total personal income over the three decades to 2013. Wages and salaries have sunk to just half of the total personal income, while dividend payments have grown to more than 5%.

More than $757 billion was collected from dividend payments in 2012.

Dividend Stocks and Income Investing

If you look at the graph not as the country's income but as a representation of your income, one other thing becomes clear about dividends.

Dividends are your path to financial freedom.

As a young investor, you rely heavily on your salary to pay the bills, and dividend income is probably relatively small. Over the years, as your portfolio grows, dividend income grows and becomes a more significant part of your total income. Dividend investing can help you reach the financial freedom to depend less on wages and more on the fruits of your labor.

What are dividends?

Running a company is a constant choice between growing the business and taking hard-earned profits. If profits are used to invest in more equipment and other business necessities, they could lead to more profits in the future. Profits paid out to the owners may not add to business growth, but they are the ultimate reason for creating and running that business.

A dividend is those profits paid out to the owners of the business. While small companies may have one or a few owners, very large companies raise money by selling shares and distributing ownership over thousands of owners.

The decision to return profits or invest in the business isn't necessarily an either/or decision. Most successful businesses make enough yearly to produce a little profit and invest in future growth.

For most companies, dividends are paid every three months according to a fixed amount for every share you own. Some companies pay dividends once, twice, or even twelve times a year, but these are the exception rather than the rule.

Most companies pay a relatively constant dividend because many investors depend on that cash flow for living needs. For this reason, management often plans several quarters to ensure they have the money to pay for growth projects and a consistent or rising dividend.

Besides regular cash dividends, a company may have excess cash that it no longer needs. The Board might approve a ‘special' or one-time dividend payment in this case. Paying out this dividend is the same, but it is usually much larger than the regular dividend payments.

How the dividend stocks process of paying a dividend works

The Board of Directors is a group of people elected to represent you as an owner of the company. When management decides it will have sufficient cash for growth projects, the Board of Directors votes to declare and pay a dividend. The entire dividend process includes four important dates.

The declaration date is the day the company announces the dividend to the public. On this date, the company will also announce a date of record and payment date for the dividend.

The date of record is the date that determines which shareholders will receive the dividend.

The ex-dividend date is the first day the stock trades without the dividend. This means that anyone who did not own the shares before this day does not receive the dividend payment. In a confusing twist, the ex-dividend date is usually before the record date. This is because of the time it takes for share ownership to be recorded with the company, usually two business days.

For example, if the date of record for a dividend payment in shares of McDonald's (MCD) is on Friday, the ex-dividend date will likely be Wednesday of that week. If you sold your shares on Wednesday, you would still receive the dividend payment because your sale would not be recorded with the company until after the date of record, when it has determined who gets the payment.

The payment date is the day you will see the dividend appear in your account according to the amount and how many shares you own. For example, if you own 100 shares of the Coca-Cola Company (KO) and the company pays a $0.30 quarterly dividend, then you will receive $30 on the payment date.

Types of dividend stocks

More than 800 publicly listed companies trade on the New York Stock Exchange, the Nasdaq, and the American Stock Exchange that pay dividends. The list of dividend-paying stocks is so extensive and diverse that your biggest challenge is going to be choosing the best for your portfolio.

Fortunately, dividend stocks can be categorized to narrow the field of options for your own investment needs. The groups are not exclusive, so that some companies may be in multiple categories, but the list will be a good start to thinking about different types of stocks.

The table below shows the dividend yield, average annual return over the last decade, and the risk on some popular income investments.

Dividend Stocks and Investing Options

The return and risk on these income investments will differ year to year, and the chart shouldn't be used as a plan to load up on those with the biggest returns.

While dividend stocks offer a lower income yield than corporate bonds, they offer the opportunity for price gains as well. Bond prices may decline sharply on higher interest rates, eating into the dividend yield. Bond prices fell in 2014, and investors lost money while dividend stocks saw their prices surge by more than 20% over the year.

As rates increase closer to long-term averages over the next few years, bonds and bond funds could get even further. For an increase of just 2% in the rate on the Treasury bond, the price drops approximately 17%, with losses felt across all bond investments.

Not only do dividend stocks pay a higher yield than stocks across the general market (S&P 500), but they also have a higher total return and do it with less risk!

While I have made the distinction between investments in MLPs, REITs, and dividend stocks in the table, all three are an essential part of an overall dividend strategy. Combining the high yields and relatively low risk from all three asset classes can help smooth market fluctuations and provide strong and stable income.

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