A dividend sounds like a pretty simple financial animal, and it is. If you own shares in a company and it pays a dividend, you get a check periodically, usually each quarter. The size of the check depends on the size of the dividend and how many shares you own. But don’t let the simplicity fool you. The advantages of owning dividend-paying stocks go well beyond that nice check you get every three months.
Nobody wants to invest in a company only to discover the firm is in financial trouble. Choosing a dividend-paying stock improves your odds of picking a winner because companies that pay dividends on a regular basis are consistently making a profit. That’s especially true if the company has a history of increasing dividends from time to time. Growing dividend payouts also tell you that the company’s executives are confident that the firm’s good performance will continue. They have an incentive to exercise fiscal discipline and prudent management because the investors who are attracted to a dividend-paying stock are likely to unload their shares if a company cuts dividends.
Dividend-paying stocks provide stability and a steady income stream. The share prices of firms with long track records of paying dividends tend to be less volatile than average. This is particularly valuable during periods when markets are unstable or experiencing a downturn. You also reduce your original investment risk with each dividend payout you get. Look at it this way: if you buy a share for $50 that pays a $2 annual dividend, $2 of the original investment is returned to you each year. Hold a dividend-paying stock long enough and you’ll get all of your original investment back via dividends. Including dividend-paying stocks in a portfolio is also a strategy for diversifying equity investments, so you reduce risk by holding stocks with varying characteristics.
Dividend-paying stocks tend to provide above-average returns. For example, Standard & Poor’s defines “Aristocrats” as stocks that have a 25-year history of annual increases in dividends. Aristocrats delivered an average 11.04 percent return each year from 1990 to 2012 compared to 8.23 percent for stocks overall, according to Heritage.com. When dividends are reinvested, you have a combination of potential growth in stock price with the compounding effect of reinvesting the income dividends provide. Over the long term, this combination can yield consistently good returns.
Preferred shares are a specialized form of stock. Unlike dividend-paying common stocks, preferred stocks feature guaranteed fixed dividend rates. Preferred dividends must be paid before any common stock dividends are paid. Preferred shares carry less risk in part because of this guarantee, but also because preferred shareholders must be paid first in the event the company is liquidated. The price of a preferred stock tends to behave like a bond price. That is, when interest rates go up, a preferred stock price is likely to decline -- and when interest rates drop, preferred share prices tend to go up. The end result is that preferred stocks usually offer good current income with less risk than common stocks.
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