Advantages of Dividends to Investors

Advantages of Dividends to Investors

Dividends are important to investors for five primary reasons: they boost stock investing profits quite significantly, provide an additional metric for fundamental analysis, provide tax benefits, minimize overall portfolio risk and help preserve capital-buying power. In this read, we are going to delve deeper into these benefits, allowing you to see exactly why they are essential for you as an investor.

Profits Growth and Expansion

One of the best things about investing in companies that pay dividends is that the dividends tend to grow over time. Companies that are well established and pay dividends tend to increase their payouts from year to year. In fact, there are firms that have increased their dividend payouts for over two decades consecutively, also referred to as ‘dividend aristocrats’. Over the past decade ( as of January 2022), the compounded yearly growth rate of the total return for these companies was 2.72%.

Market risk or the inherent risk related to any equity investment is one of the fundamental aspects of investing in the stock market. Stocks are bound to either go up or down and there’s no guarantee they will increase in value. Yes, investing in companies that pay dividends does not guarantee profitability, but at least the dividend stocks provide a partial return on investment (ROI), that’s virtually guaranteed. It is particularly rare for companies that pay dividends to ever stop doing so, and in fact, most of them increase the amount they pay over time.

Unfortunately, many investors do not appreciate the level of impact dividends have on profits in the stock market. Between 1980 and 2019, about 75% of the S&P 500 returns came from dividends. This simply means that making dividend payments made the majority of what investors have received in ROI compared to what they would have received without dividend payments. 

Minimizing Risk & Volatility

Dividends are a vital factor when it comes to minimizing overall portfolio risk and volatility. In regards to minimizing risk, they also mitigate any losses that come from a stock price reduction. However, the reduction of risk-benefit goes beyond this basic fact. Historically, research has revealed that dividend-paying stocks tend to outperform those that don’t pay dividends during bear markets. Yes, an overall bear market drags down stocks across the board, those that offer dividends tend to suffer substantially less reduction in value compared to the non-dividend-paying ones.

However, this trend has changed in the recent past. In the last two decades, we have experienced three market downturns, with the dividend stocks outperforming during the initial two. However, in the Covid-19 related economic downturn, the dividend-paying stocks underperformed.

During the early 2000’s tech bubble burst and the 2008’s financial crisis, the dividend-paying stocks outperformed. At the same time, these stocks have shown to be less volatile compared to the rest. According to a Merrill Lynch study, dividend-paying stocks have a history of increasing steadily compared to the non-paying ones with less volatility. This study was done between 1990 and 2018.

Help in Equity Evaluation

Similarly to how the impact of dividends on ROI tends to be overlooked, the same can be said when it comes to dividends providing a useful point of analysis in stock selection and equity evaluation. Stocks evaluation with the help of dividends is usually a more reliable measure of equity evaluation compared to other commonly used metrics like price-to-earnings ratio.

Most of the metrics utilized by investors and analysts in stock assessments tend to rely on figures obtained from financial statements of companies. The potential issue with stock assessment solely based on a firm’s financial statements is firms can, and sometimes tend to manipulate these documents by misleading accounting practices in order to improve their appearance to the investors. However, dividends provide a robust indication of how a company is performing. That’s because a company needs to have real cash flow in order to make dividend payments.

Evaluating a company’s historical and current dividends payout provides a reference point in a basic fundamental analysis of the firm’s strength. Dividends show continuous, annual indications of an organization’s profitability and growth, regardless of what the stock price up and down movements over the course of a year say. A company with dividend payments that increase over time is a clear sign that it is steadily making profits and is less likely to have its financial health ruined by the occasional economic or market downturns.

Another pro of using dividends as a metric to assess a company is that since these payments only change once per year, they offer a more stable and solid analysis point compared to other metrics that are subject to the daily stock price fluctuations.

Preserving the Buying Power of Capital

Another area that dividends help but investors overlook is the inflation effect on investment returns. In order for an investor to get a real net gain from an investment, the investment needs to provide an adequate return to overcome the loss of buying power that comes from inflation.

For example, if you own a stock that goes up in price by 3% in a year, but the inflation rate is at 4%, then you have actually suffered a 1% in terms of capital purchasing power. Meanwhile, if the same stock has gone up by 3%, and also provides a 3% dividend yield, then you have made a return that outpaces inflation and shows actual gain in buying power. One of the best things about companies that make dividend payments is that most dividend yields outpace inflation. 

Dividends Have Tax Benefits

How dividends are treated when they come from a secure paying agent when it comes to taxes makes them a tax-friendly way to gain income. Dividends tend to be taxed at significantly lower rates compared to conventional income. According to the IRS, for people whose conventional income tax rate is between (35 to 37 percent), dividends are taxed at just 20%. For those whose income tax rate is below 35%, dividends are taxed at 15%.

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