The following was contributed by a fellow reader, Joseph Hogue, CFA. Read more about him after the article.
After six years of higher stock prices, it looks like the next couple of years could be a tougher road for investors. Questions on global economic growth and rising interest rates in the United States have led to volatile stock prices throughout 2015.
But one part of the stock market should continue to provide great long-term returns for your portfolio. Shares of dividend-paying companies won’t be immune to any wider stock market weakness but there are some powerful reasons to hold on tight to your investments in these companies.
What Dividends Mean to Investors
One of the best reasons to love dividend investing is what it means for investors and for the company itself.
Companies can ultimately do two things with profits, hold them for reinvestment in the company’s growth or share those profits as a dividend to investors. For younger companies, reinvestment and growth tend to be the focus with dividends waiting until further into the future.
When a company starts paying a dividend, it’s a message that management wants to prioritize investor cash return and sales will be sufficient for growth and dividends. For many companies, it’s a milestone that they have established their business and everyone can start reaping the rewards.
Besides sending a signal to investors, the dividend policy may even help the company run more efficiently. When the company sets its dividend amount, it is committing to pay out that much every quarter. That promise of payment can be a strong restraint on management excess and decision-making for projects.
Without the restraint on cash flow, management may decide it needs more perks or that it wants to invest in projects that boost its ego rather than the bottom-line.
There is evidence that this efficiency in management may lead to better returns for investors as well. The table below, from data provided by Kenneth French at Dartmouth, shows the annual return on non-dividend paying stocks against those paying out a regular dividend over 20-year holding periods from 1928 through 2013.
Not only do dividend-paying stocks generally provide a higher return but they do it with less volatility and risk.
Dividend Investing as a Source of Passive Income
Researching for my book on passive income sources and the myths behind some of the strategies, it became clear that dividend investing was one of the best ways to create a steady source of income.
Since dividend-paying companies are typically more mature than others in the stock market, sales and earnings are usually going to be smoother. Investors aren’t compelled to check in on the stock everyday to see if shares have surged on new growth or plummeted on some management misstep.
The cash flow from dividend investing is nearly immediate with most stocks paying dividends every three months.
While the potential might not be as high as other passive income strategies like real estate or blogging, companies generally try to increase their dividend payout each year. This leads to a continuous and growing source of income for investors.
Though the passive income potential of dividend (income) investing fell short of bonds overall, the average return on dividend stocks is well above fixed income investments.
Dividend Investing as the Great Income Diversifier
The final reason to love dividend investing comes from an earlier post here on Money Manifesto. After nearly a decade as an investment analyst, two things have become crystal clear.
- The economy will rise and fall, taking stocks and possibly your job with it.
- No one can predict when the economic cycle will turn. The best you can do is to diversify your investments and your income to be ready when it happens.
It’s exactly Lance’s point when he talked about three keys to prepare for the next recession in a post last year. Having multiple sources of income, one of which could be dividends, is one of the best ways to protect yourself in the event of a layoff or just lower earnings.
While the average dividend yield from companies in the S&P 500 is just above 2%, some funds focused on dividend-paying companies provide higher payouts. The Vanguard High Dividend Yield ETF (NYSE: VYM) pays a 3.2% dividend yield and gives you instant diversification across 437 companies including General Electric and Microsoft.
The one sure thing is that the stock market will both rise and fall. Whether it does the former or the latter over the next year won’t change the outlook and solid reasoning to hold a portion of your money in dividend stocks.
Besides being a great source of passive income and a way to guard against a recession, dividend stocks could provide some of the best returns in your portfolio.
Joseph Hogue, CFA is an investment analyst and author of The Passive Income Myth: How to Create a Stream of Income from Real Estate, Blogging, Stocks and Bonds. Join the community on PeerFinance101 for more tips on investing, managing debt and reaching your financial goals.