During the 1990s, there was an intense focus on capital appreciation as companies sought to foster growth and keep up with an unprecedented bull market. Profits were often reinvested at the expense of dividends, which fell steadily. More recently, however, companies have been eager to demonstrate sound fundamentals and strong balance sheets and provide shareholders with tangible benefits in exchange for their commitment to a stock. The result has been a noticeable increase in dividend payments. Last year, 1,949 dividend increases were reported to Standard & Poor's Dividend Record, 11.7% more than in 2004 and 10.6% above the 10-year average. Is there a place for dividend-paying stocks in your portfolio?
Focus on Total Return
Even though dividends are not guaranteed, they can have a meaningful effect on investors? total return. Last year, for example, price appreciation was below the long-term averages of major U.S. market benchmarks, but dividends improved the results, contributing 1.9% of the S&P 500's 4.9% total return. It was a similar story for the Dow Jones Industrial Average. Without dividends, the Dow posted a loss of 0.6% in 2005. With dividends, it returned 1.7%.
Last year was not unusual. Historically, dividends have provided a significant contribution to equity returns, accounting for approximately one third of the total return of the S&P 500 since 1926. Even during the 10 years that included the height of the bull market ending in March 2000, dividends accounted for almost a fifth of the U.S. market's total return, despite the overwhelming focus on capital appreciation. Moreover, dividends have acted as a counterbalance in down markets, providing investors with a degree of positive return. Looking at only the years since 1926 when the S&P 500 experienced a loss, the average return from dividends was 3.7%.
Growth in Long-Term Portfolios
Dividend-paying stocks have other attributes that you may want to consider. One of these is their potential for providing long-term growth in addition to a stream of income. This growth-income combination may be appropriate for investors anticipating long retirements. Longer life expectancies mean that many people who stop working around the traditional age of 65 face potentially 20 years or more of retirement. If their portfolios are to be in a likely position to generate sufficient inflation-adjusted income over lengthy payout periods, they may need to include the growth potential of stocks.
Diversification also enters the picture. Because they are income-producing investments, dividend-paying stocks may help diversify the income-oriented portion of a portfolio. Keep in mind, however, that equities involve greater risks than fixed-income investments, such as bonds. The investment returns and principal value will fluctuate such that, upon redemption, your shares may be worth more or less than the original cost.
Tax treatment is another point in favor of dividend-paying equities. Under current law, qualified dividends are taxed federally at a 15% tax rate. To qualify for the 15% rate, dividends must be distributed by a U.S. corporation or certain foreign corporations. In addition, investors must meet holding period requirements.
The 15% tax rate on qualified dividends is the same as that levied on long-term capital gains and is more favorable than the ordinary income tax rates charged on bond interest income. If you are considering investing in equity income securities, you should be aware that, unless extended by Congress, the 15% rate on qualified dividends will expire after December 31, 2008, and taxes will revert to rates in effect prior to 2003. Dividends would then be taxed as ordinary income up to a maximum rate of 38.6%.
Taxes alone should never drive your investment decisions. Instead, the next time you look at the makeup of your portfolio, take a few minutes to review the role that equity-income investments play in total return and in dampening the effects of stock market volatility. If providing income for retirement is your priority, you may also want to think about using dividend-paying stocks to supplement fixed-income sources of income.
This article is not intended to provide specific investment or tax advice for any individual. Consult me, your financial advisor, with questions.
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