The Motley Fool

5 Reasons Why Dividends are Important When Investing in Stocks

If I said that you could get “free” money simply by owning some stocks, would that surprise you? Effectively, that is what dividends are – for owning a piece of a company and holding shares in it, management also shares profits with you by paying out dividends. So, what’s my point?

Well when I first started investing I didn’t, like many people, realise that buying stocks is not only about increasing the value of your initial investment. Naturally, I just wanted to multiply my money as quickly as possible! But it’s a short-sighted way to approach it.

Part of identifying successful stocks is also about having access to the dividends that companies pay. Although a company’s share price can go up (or down) in value, the company’s dividend policy can also have a significant influence on its fortunes.

Dividends can generally signal confidence in the company’s prospects by management. So if you’re thinking of a company’s stock, you may want to research on whether it pays dividends. Here, I give you a list of five reasons why I think why.

1. Dividends make up a large part of long-term returns

It is a little-known fact that over the long term, dividends actually make up a large part of the total returns that shareholders receive from their individual stock investments. Total returns take into account what would happen if you had reinvested your dividends into the stock every time you received some.

Companies that manage to grow their annual dividends over time are generally perceived by investors to be of better quality, with strong financial fundamentals, versus those that do not pay a dividend or pay a minimal one.

For example, in Asia, ex Japan dividends make up a significant amount of total longer-term returns. So if you’re investing for the long term, say your retirement, then you may wish to factor in dividends as part of your decision-making process when choosing what to invest in.

2. Dividends can provide an additional source of income

For most people, the salary from their job is their sole income – this used to be the case for me as well. Referring back to what I said at the beginning, dividends can potentially be an extra source of income.

As the great investor Benjamin Graham (and mentor of famed investor Warren Buffett) once said:

“Never depend on a single income. Make investment to create a second source”.

As different societies age at a faster rate though, age-related expenses also increase. It’s also widely-known that older investors are infinitely more keen on dividend-paying stocks.

No one can be too young to start though. Investing for dividends can be a smart way of helping you build up multiple streams of income over time.

The beauty of dividends is that they can also grow so as the company’s profits grow over time, there may be a good chance that the total dividend paid each year may also increase.

It would also be useful to study the track record of the company’s dividends to determine whether these dividend payments have been growing and, more importantly, sustainable in the future. Logically speaking, it would not make much sense to buy a company that has, say, a 9% dividend yield yet it keeps cutting its dividend every year.

3. Dividends can signal better corporate governance

While I mentioned earlier that the payment of dividends is often a good indicator of the financial fundamentals of a company, the same is also true of the company’s management.

Generally, management which is willing to share the company’s profits with shareholders in the form of dividends usually means they take into consideration minority shareholders or the “man on the street” retail investor (i.e. you and me).

And it’s a common misperception that companies in developed markets pay better dividends. According to the latest Janus Henderson Global Dividend Index, Asia Pacific ex-Japan companies actually paid out a record total of US$150.4 billion in dividends in the whole of 2018 – a 6.3% increase on 2017.

4. Dividends can support stock prices during market volatility

Dividend stocks are generally viewed as more “safe” than other stocks when the stock market declines. This is because as long as the company is earning enough money to pay dividends, you will receive a payout.

As a result, the stock prices of high dividend stocks do not tend to suffer as much as others in a down market (such as the one we are currently experiencing amid the coronavirus outbreak).

This is because if the “dividend yield” – in effect the amount you receive in dividends as a percentage of the stock price – is attractive enough then buyers will be drawn back into the stock.

5. Dividends make your money work for you

Making your money work for you is one of the key appeals of dividends. Compare this to putting your money into a deposit savings account. For example, a typical Hong Kong bank will more often than not offer you a measly interest rate for your money (usually below 1%).

Meanwhile, stocks that pay dividends have both the income aspect AND the potential for capital appreciation – basically what savings deposits cannot offer.

Dividends plus diversification

In summary though, it’s wise to remember that dividend stocks should be just one part of your portfolio. But before investing in a stock, investors should definitely consider what dividends the company pays out.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.