Why Are Dividend-Paying Schemes Better Investment Options?
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Investing in different instruments for growing one’s wealth or for the intent of building a passive income, has become an integral part of financial planning. However, efficient money management is as important as investing itself. Choosing the right investment option at the right time is the need of the hour, but so is using the returns optimally and smartly.
With a wide range of options to choose from, an investor today can be overwhelmed with choices. The basic question that has bothered the investor community since time immemorial is whether to choose a dividend-paying option or a growth-focused one. However, making the right pick is not that difficult.
One’s investment objective should be the key factor while making the right decision. Experts suggest that the dividend-paying option can be a more viable option for people who intend to reap regular income from their investments or for people who are nearing retirement, as it ensures a regular income flow. While people who have a greater time horizon at their disposal and have a higher risk appetite can opt for growth-oriented schemes.
This article focuses on the former. Here’s what you need to know if you wish to take the route of dividend-paying investments.
Table of Contents
What is a Dividend?
Dividend refers to the reward that the company pays to its investors for investing in it. It is generally paid in cash and is given out of the company’s earnings. Stocks, mutual funds, bonds, and exchange-traded funds (ETF) are a few financial instruments that pay a dividend.
How are Dividend-Paying Options Helpful to an Investor?
Post the 2008-09 financial crisis, most traditional or regular sources of income such as government and corporate bonds seemed to have lost their shine in the eyes of the investors. But it was dividend that held its fort even during the turbulence. This is because dividends are a real earning for an investor and even creative accounting techniques cannot manipulate the same. For years many people have overlooked the significant impact of dividends on stock market profits. But research reveals that since 1926 dividend payouts have constituted almost half of the stock investing profits in companies that make up the S&P 500 Index. Here are some important aspects of dividend-paying investments:
Risk Involved
Investments in stocks, mutual funds or any other financial instruments come with their own set of risks along with inherent market uncertainties. In such a volatile environment, stock prices can fluctuate in a blink of an eye and it doesn’t guarantee an appreciation in the value of the holding. Dividend-paying options go a long way in mitigating the overall portfolio and price fluctuation risk. This is because investing in a dividend-paying stock or scheme helps recover a part of the investment made while waiting for the total invested value to appreciate. It has been observed that during a downturn, dividend-paying options usually suffer significantly less decline in value than the non-dividend-paying ones.
Dependable Returns
An inherent risk of investing is the permanent loss of the invested principal. A longstanding record of paying regular dividends is an effective indicator of the sound financial strength and sustainability quotient of a company. These organizations are generally more mature and stable than others. Furthermore, in times of turbulence, they tend to perform better than speculative ones. Consequently, this also helps in capital preservation. Regular dividend payment history is a key indicator of the company’s strong cash position and regular cash inflow. This, in turn, creates a demand for the stock or the scheme in the market, thereby resulting in an appreciation in the value of the stock or the scheme.
Another key advantage of investing in a dividend-paying option is that the amount of dividend tends to increase progressively over time, irrespective of the fact whether the stock prices increase or not.
Overcoming Inflation
Dividend-paying options also help in hedging inflation as compared to fixed-income investments. These options let investors accumulate income that further increases and retains the purchasing power of the invested principal. A good investment must provide a return that takes into consideration the impact of inflation. For instance, let’s assume that the price of a stock has increased by 4% over the course of a year and during the same period, inflation stood at 5%. Then, owing to inflation, the investor who holds the stock has a net loss of 1%. However, if the same stock had offered a dividend yield of 3.5% during the period, then the investor would have a net gain.
Understanding Taxes
Dividend incomes are subjected to special tax rates as compared to income from other investment avenues, thereby allowing the dividend holder to retain most of the income received. In the US, qualified dividends are subjected to tax at a substantially lower rate (between 5% and 15%) than ordinary income. According to the 2011 guidelines of the Internal Revenue Services, individuals with an ordinary income tax rate of 25% or higher are taxed at only 15% on qualified dividends, while for individuals with an ordinary income tax rate below 25%, qualified dividends are completely tax-free.
Reinvestment Options
Dividend-paying options provide investors with a unique opportunity to reinvest the dividend income earned in the scheme or stock again. This is an effective way of growing one’s portfolio and accumulating more shares or stocks. Dividend Reinvestment Plan (DRIP) is one such example of a reinvesting scheme. Reinvesting can greatly boost dividend growth investing returns in the long run while taking advantage of the market conditions.
To Sum it Up
Dividend-paying options have surely some visible advantages over the growth or non-dividend-paying options. But it has its own set of restrictions too. For example, restricted growth or dividend-paying options see less price appreciation compared to the growth stocks, which can attract or dissuade an investor to invest in the option. You must have a clear understanding of your goals before you invest in either of the two. If you wish to know more about investing in dividend-paying investment instruments, consult top financial advisors and get guidance on how to manage your assets more effectively.
