The Theory of Dividends: What Makes It the Ultimate Tool for Investors
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There are several types of investors out there with different investment preferences and strategies. Some prefer high risk and high reward investments that can help them get a considerable gain in a short span of time. Although risky, investment choices such as trading shares in the market, can help you cover short term expenses and bring in earnings on your invested capital that can be hard to earn elsewhere. But despite these alluring claims, these options may not suit all types of investors. For those who prefer low risk investment products, the dividend route can be more appealing. Dividend stocks can seem a bit tricky at first, but as long as you understand the theory of dividends, you can make them an essential part of your monetary inflows.
This article talks about how dividends are the ultimate tool for investors.
What is a dividend?
When you invest in a company, you become its shareholder. A dividend is a payment that the company pays you for your investment. So, for instance, if company ABC announces a dividend of $10 for 1 share, and you hold 20 shares at the time, you will earn a dividend of $200. The more shares you own, the higher would be your dividend income.
What should investors expect from dividends
Dividends can be an integral part of your income. Normally, companies pay dividends four times in a year. This translates to four income opportunities in a year and the chance to earn money that can cover several types of expenses. There are also some companies that pay monthly dividends, making them ideal for retirees who may be looking for a continuous source of income. But other companies may pay dividends only once a year. Moreover, some dividends can have a different payment amount each time. It helps to know these things in advance to make the right investment choice in the first place.
Another important thing to note is that there is no fixed limit or threshold that companies use for paying dividends. The amount of dividend that a company generates would depend on the size of the company, its profit margins, annual turnover, industry type, market conditions, etc. If you invest in a small or upcoming company, you may not receive high dividends, as in such a case the primary focus of the company would be to focus on its growth and development. Therefore, investing in a well-established business could be a better choice as the chances and frequency of higher dividends are a lot more.
Telecom stocks generally have a high dividend that can range between 4% and 5%. Real estate investment trusts (REITs) or royalty trusts that primarily deal in mortgage securities can offer dividends as high as 10%.
How can dividends benefit investors
Dividends can offer many benefits to investors, such as:
- They reduce overall risk: Dividends can help reduce the overall risk from a portfolio by a great margin. There have been several studies to show that dividend paying stocks have performed better than non dividend paying stocks in a period of bear market trends. This means that even in a poor market, dividend paying stocks can offer some benefits to your portfolio. This can be great for investors who like to maintain a moderate to low risk on their portfolio. The dividends can ensure that even in times of volatility, their invested capital is able to generate some returns.
- They offer tax advantages: Unlike income from other investments, dividends can provide you with many tax advantages. Since dividends are a steady source of income for most investors, their tax treatment is also different. The tax rates for qualified dividends can range from 5% to 15%. The lower the income range, the lower is the taxed rate. Taxes rise with an increase in income. However, even then, the range is quite low as opposed to the 25% or more tax charged on several other kinds of investments.
- They help counter inflation: Dividends can help counter inflation with a high return percentage as compared to other products. An investment is considered to be successful not only when it gains a profit but also when it is able to retain its value along with the increasing rate of inflation. Dividends are generally able to leave the rate of inflation behind and provide investors with a profit that stands the test of time and remains over the margin even after deducting the rate of inflation.
- They offer a stable income: The income from dividends can offer stability and flexibility to investors. Dividends can be used as the primary source of money in retirement. It can also be used as a secondary source of income that can be reinvested for further growth. Either way, the stream of money remains steady.
What are some important things to note about dividends
As beneficial as it can be to invest in dividend paying stocks, there are some flags that you should be aware of, such as:
- You may not always receive dividends: Even when you invest in a dividend paying stock, the company may not always pay you a dividend. Companies are not obligated to pay their shareholders. So, there could be a time when you may not receive a dividend from a company that may have paid you in the past. This can be a cause of concern, especially in times of financial inadequacies and economic turmoil. Although these situations are rare, consistent losses, internal growth aspects, political or economic instability in the country, etc. can affect the performance and annual turnover of a company, and in turn, negatively impact its ability to pay its shareholders.
An important measure that can help dividend investors gauge such a possible situation in the future is the pay out ratio. The pay out ratio is a measure of how much a company pays in dividends. This figure is always seen in association with the company’s profits. So, if the pay out ratio is more than the company’s profits, there is a good chance that stakeholders may not receive their dividend income, as the company would suffer a loss.
- High yield stocks are not always the best: Most investors go by numbers and pick a high yield stock, thinking it would benefit them the most. However, there are two sides to every story. While a high yield paying stock does translate to higher earnings for you, it may be a short lived income source. If a company is paying high yield dividends, it means that it’s payout ratio is high. When the payout ratio is high, it can imply that the management of the company is incurring more expenditure on paying shareholders rather than spending on its growth and expansion. A poorly constructed financial plan can soon force the company into losses, ultimately affecting the shareholders. Hence, it is important to look at all aspects and not be allured by high figures at first glance.
- Dividend paying stocks are 100% safe: Dividend paying stocks are a safer bet as compared to other stocks but they are not 100% safe. As stated above, the company is not obligated to pay you a dividend. Moreover, economic conditions, market fluctuations, demand and supply, etc. can affect the profits of the company that can in turn affect your portfolio’s performance. Therefore, it is critical to know that dividend paying stocks are low risk but not zero risk.
Are dividends the ultimate tool for investors
A simple yes can suffice to answer this question, however, it is still important to know and understand what dividends bring to the table. Dividend stocks are generally considered to be a safe option for people who want to generate real income from their portfolios. Real income in this regard, refers to realized gains. While stock market prices may escalate, your real gains are only credited to your account when you sell the stocks you own. However, in the case of dividend stocks, regular dividends are paid to you.
This makes dividend stocks a real winner among the list of many investments. They are tax efficient and provide steady gains, thereby lowering the risk and volatility of your portfolio. However, they are not guaranteed income and can vary over time. Having said that, past performances do indicate that dividend stocks have performed better than non dividend paying stocks even in bear markets.
The final consideration to investing in dividend stocks should be made after a careful study of their merits and disadvantages. A financial advisor can help in this regard.
To sum it up
Dividends are the ultimate tool for investors, if used wisely at the right time and stage. Moreover, it is also important to use dividends for further wealth creation opportunities to truly maximize their gains. An ideal diversified portfolio contains well distributed risk and dividend stocks.
If you are looking to invest in dividend paying stocks, you can contact a financial advisor in your area who can help you to pick the right options.