Tried-And-True Advice About Dividend Stocks

Tried-And-True Advice About Dividend Stocks

By Anna B. Wroblewska.

The dividend stock, the old faithful of the equity investment world, might seem a little bland at first. After all, dividend-generating companies tend to be older and less volatile than exciting high-growth companies.

But consider this bit of wisdom from legendary investor John Bogle: if you invested $10,000 in the S&P 500 Index when it was first created in 1926, you would have had $33.1 million dollars by September 2007 -- but only if you'd reinvested all your dividends. If you didn't reinvest them, your portfolio would have been worth only $1.2 million.[1]

Even if you only started investing in the S&P 500 in 1990, the benefits of dividends are pretty clear. The graph below shows the difference between the S&P 500 with reinvested dividends (the orange line) and the S&P 500 without those reinvested dividends between 1990 and today. It's a pretty wide margin!

It goes to show you that while they can be a great a source of income, dividends are also a potential powerhouse of long-term growth for your portfolio. That makes these stocks a potentially powerful tool for investors in all phases of life.

Dividends for growth

Reinvesting dividends over time means that your cash payouts are converted into shares. Over time, you'll accumulate a much larger position in the company -- which means even more growth from the compounding effect of those extra dividend payments.

One of the most effective ways to automatically reinvest your dividends in a cost-effective manner is through a Dividend Reinvestment Plan, or DRIP. These plans give you the opportunity to reinvest in shares directly with the company, which normally means lower transaction costs, the ability to buy partial shares, and even discounts on stock price. Once you're signed up, your DRIP runs on its own, requiring no additional effort from you.

Dividends for income

Dividend stocks are also powerful tools for retirement or other income needs. They generally pay more than preferred shares or bonds and aren't so sensitive to changes in interest rates.

Another great feature of dividend income is that it's taxed at a lower rate than other sources, meaning you can keep more of what you earn. You'll get the benefits of income that doesn't touch your principal and pay less to the tax man (more on this in a moment).

The risks of dividend investing

Of course, you'd be wise to remember that investing in dividend stocks still involves investing in stocks. The value of your shares can drop or the company's management might decide to withhold dividends if the business gets into trouble.

It's not a risk you should ignore. According to the Wall Street Journal, S&P 500 companies collectively reduced their dividend payouts by 24% in 2009. [2]

That means that you shouldn't count on dividends providing 100% of your income. Rather, use dividend income to complement income from other sources, and make sure you have the ability to adapt to a change in payouts.

Don't forget about taxes!

Keep in mind that you'll be charged taxes on dividends, even if you reinvest them back into company shares. Typically, the amount you're charged will depend on your tax bracket, ranging from 0% to 20%.

[infogram chart, if you're interested!] [3]

Choosing dividend stocks

There are as many theories about the best dividend stocks as there are investors, but generally speaking, dividend investors emphasize the virtues of stable companies that represent a strong value.

Many people thus turn to the slow and steady "blue chip" stocks. These companies have often paid dividends for a number of years and typically don't have high growth rates. They're the tortoises of the world -- solid and reliable.

Others choose to go the mutual fund or exchange-traded fund (ETF) route. If you do decide to go this way, it would be prudent to stay aware of fees. Bogle points out that the average domestic stock fund charges 1.4% and the average dividend yield of stock funds is 1.8%. That means your average fund investor is only earning 0.4% from dividends each year. [4]

Dividend stocks are the understated powerhouses of the stock market. If you can take advantage of their benefits as a source of growth or retirement income while staying mindful of the risks and costs, these stocks can be a great addition to your portfolio, no matter what your age.

10/16/14 4:27 PM