Dividend stocks can be a key part of an income-generating portfolio. While one might first think of bond funds for income, dividend stocks offer an opportunity to participate in the potential market growth in addition to receiving earnings paid out by the company.
What Is A Dividend?
A dividend is a piece of a company’s profits that gets shared with stockholders as a bonus for investing in the organization. These are usually paid out quarterly and the value is based on how many shares an investor holds. A very basic example: if someone has 1000 shares of a stock that pays out $0.25 per share, then they would get paid $250 every time they are distributed.
While they are not guaranteed, if companies promise a certain amount, it’s not uncommon for dividends to still be paid in a down year. The stock price may fluctuate up and down on any given day, but the dividends tend to remain more stable over time.
Who Should Invest?
Considering the main focus of dividend stocks is creating income, it is easy to see how they could benefit pre-retirees and retirees the most. However, even for an individual who doesn’t need the extra cash, there is the option of reinvesting dividends back into the holding. This functions like additional investments into your portfolio and helps create more compounding growth.
As the graph below shows, when comparing the S&P 500 return without dividends versus when reinvested, the gains were significantly higher. So, even if an investor is in accumulation mode and not in need of income, dividend stocks can still play a part in an investment strategy.
*Data sources: Morningstar and Hartford Funds. Note: Reinvesting does not offer any tax benefits. Whether they are cashed out or reinvested, dividends may be taxable depending on the account type.
What’s the Catch?
If dividend investing is so great, then why doesn’t everyone do it? There are a number of factors that might deter someone from this strategy. For one, while companies that pay dividends usually indicate financial strength, they generally don’t see as much growth in their value during a strong bull market. An investor who wants higher returns might benefit more from growth stocks, particularly in a bull market.
Second, dividend stocks still carry investment risk. Compared to more secure income options, like CDs or bonds, market volatility can cancel out the benefit of dividend earnings over the short term. If the purpose of a portfolio is to provide income and stability for near-term goals (over the next 1-3 years for example), a holding with less investment risk might make more sense.
Finally, certain sectors tend to have more dividend-paying options than others, which can lead to a potential lack of diversification if that is the primary focus. A well-rounded portfolio may have exposure to more, or all, sectors.
Is It Worth It?
In certain situations, an individual may benefit from either higher dividend stocks or higher growth stocks, but in reality, it is possible to build a collection of holdings that encompass both. Different investment styles have their periods of boom and bust.
The most important thing is to consider your specific situation, time frame, and goals, and decide if dividend investing is right for you.