Everyone loves getting dividends, and who wouldn’t? Everyone loves getting money. But developing an investment strategy based solely on dividends could be a disaster waiting to happen. Today, let’s review dividends, why they are so beloved and what can cause issues with them.
First, what is a dividend? A dividend is essentially a distribution of the profits from a company. If I buy stock in a company, I do so with the intent for the value of that stock to grow so that I see a return on my investment. If a company pays a dividend, then I get payments of profits from the company as long as I own stock in the company. This helps me to get my money back faster and increase my overall return on my investment.
If dividends are such a great thing, then why don’t all companies pay one? Many companies pay dividends because they make nice profits, they see returning money to investors as a confidence builder in that company, and it may cause people to see that company as a good steward of investors' money. This in turn makes investors more likely to invest in that company, causing the stock price to go up.
Other companies simply don’t have a better way to use that money so they return it to shareholders, again to make shareholders happy and hopefully increase the share price by making those shares more desirable.
But not all companies pay a dividend, and many times shareholders may be happy about that. Instead of paying a dividend, the company uses that profit to innovate with products and services or acquire other companies. Many fast-growing companies don’t pay a dividend, because they need the cash to maintain their rapid growth. Having the value of your shares double or triple in value may be worth a lot more than a few percent dividend, which is why many growth investors don’t want dividends as much as they want pure performance.
All things being equal, two companies growing at the same rate, most people would prefer the one that pays a dividend so they get more return on their investments faster. In recent years, dividend investing has become a go-to way for investors to invest their money. They often look for companies that pay high dividends so their yield on the investments is as high as possible. This strategy isn’t without risk, however. If you screen stocks for those paying the highest yield (dividend to stock price), many times the stocks that show as having the highest yield do so because the price of the stock has gone down and the dividend has stayed the same. If a stock is priced at $10 and is paying a $1 dividend, then it is yielding 10%. That’s a nice return on your investment along with any potential increases in the stock price. If the stock falls to $5 but the dividend remains the same, it is now yielding 20%. One would argue that the return on your investment just improved because the dividend % return increased. In reality, the reason the yield went up in that example is because the stock lost 50% of it’s value. I would think that most people would not want to buy an investment that was going to lose 50% of its principal. So a stock with a very high dividend yield might not be an attractive stock to buy at all. Why is the stock going down so much in price? Is there a fundamental problem with the stock? These are the things that go into the evaluation of whether or not a stock is a good buy or not.
Another potential issue with a dividend focused strategy is that dividends while wonderful, are not guaranteed. Companies can and frequently do cut, or worse eliminate, their dividends when they need to preserve cash. In the 2nd quarter of 2020 we saw one of the steepest declines of dividends in history. In dollar terms, they reduced by $42 billion dollars year over year. I had a client who went from $400,000 a year in dividend income to $0 between 2008 and 2009. Like anything else, when all of your eggs are in one basket, it can be very risky to assume that dividends are the only way to invest. As I always say, it’s better to have a well diversified strategy than one that hinges on one or two options only.
Dividends are great and I love some stocks that pay them, but just remember that sometimes those high yields come at a cost and sometimes that cost can be simply too high to pay.
T. Eric Reich, CIMA, CFP, CLU, ChFC is president and founder of Reich Asset Management and can be reached at 609-486-5073 or firstname.lastname@example.org.
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This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation.