Put Your Money To Work With The Power Of Dividends

A dividend is a portion of a company’s earnings that is distributed to its shareholders. The more shares you hold, the larger the portion you are entitled to. The amount and schedule of the distribution is determined by the company’s board of directors (a group who is elected by the shareholders). While no company is required to pay a dividend, many older, well-established companies do so, in order to return value to their shareholders. The primary stock investments that I recommend on this site (i.e. board market index funds and ETFs like VTSAX and VTI) typically pay a dividend (Note: The periodic disbursements you receive when you hold a bond are called interest payments. These payments are different from dividends).

In order to receive a dividend payment, all you have to do is purchase a stock or fund that pays one. Once you own the security (stock, fund, etc.), you’ll begin receiving periodic dividend payments (typically quarterly) which won’t stop until you’ve sold (assuming the board doesn’t vote to stop paying the dividend). When you receive your dividend payment, you can choose to have it deposited directly into your account as cash or you can direct your broker to automatically reinvest it by purchasing additional shares of the underlying company’s stock. I highly recommend the second option as it is an extremely powerful tool for compounding the growth of your portfolio. In fact, it’s estimated that 40% or more of the overall returns of the stock market may be due to reinvested dividends!

Going back to our analogy, reinvesting dividends would be equivalent to empowering your “employees” (i.e. shares of stock) to continually increase the size of your workforce by hiring additional employees (i.e. buying more stock) over time. Not only will these new employees work just as tirelessly as your existing employees to grow your wealth, they will also take it upon themselves to hire even more employees (i.e. reinvested dividends generate dividends, which are then reinvested, producing more dividends, which are reinvested…and on, and on, and on…). Once everything is set up, this automatic, compound growth happens without any additional effort whatsoever on your part.

How about a quick example?

Dividends are independent of the movement of a stock’s price, so even if Tiffany’s holdings had increased or decreased in value, she would have still received the same $5 per share ($500 total). Since we know, over the long-term, the stock market always goes up, short-term stock market pullbacks are great opportunities for additional growth. Let me explain...

Imagine that the day after Tiffany purchased 100 shares of XYZ for $10,000, the price of the fund dropped to $50 per share. That’s a huge 50% drop in value, but what would it mean from a dividend perspective? If Tiffany once again, reinvested all of her dividends, by the end of the year she would have purchased 10 additional shares (i.e. $5 x 100 = $500, enough to purchase 10 shares at $50 per share).

The drop in price would have given her the opportunity to buy more shares of the same fund but at a steeply discounted price. Instead of ending the year with 105 shares, she would own 110 shares! Long-term, the price of the fund would recover and the value of her portfolio would be that much greater. This would all be accomplished with zero additional effort from Tiffany.

This is a prime example of why I never panic when the market drops. As a long-term investor, any short-term drops (even very steep ones) are just opportunities to hire more of the same great “employees” for my financial firm, at a cheaper price. When dividends are being reinvested, this whole process happens easily and automatically.  I don’t know about you, but I’m a huge fan of getting more for less, especially when it requires little to no effort on my part.

Let’s summarize some of the things we’ve learned about dividends.

1. Dividends are a passive source of income that you receive just by owning shares of a company’s stock. They can be received directly as cash (or sometimes other forms of payment) or automatically reinvested.

2. The size of a dividend payment is independent of the price of the underlying stock so you are likely to receive the same amount even when the price of the stock drops.

3. Automatically reinvesting your dividends can turbocharge the long-term compound growth of your investment portfolio. This is especially true during short-term market pullbacks when every reinvested dollar goes a little further.

By this point it may seem like dividends are the perfect investment. While they are indeed great, there are a few negative aspects as well.

1. Companies can change their dividend policy at any time.  They are not obligated to pay any particular amount per share or to continue paying once they’ve started. In the past, some companies have reduced or eliminated their dividend payments during tough financial stretches, such as those experienced during severe market downturns.  For example, many companies cut their dividend during the 2009 recession. (Note: Dividends can also be increased at any time.  Many companies increase their dividend regularly)

2. Paying dividends tends to result in slower overall growth for a company. Instead of using the cash to grow the business, a company paying dividends sends that cash directly to its shareholders. This puts money in your pocket but also limits the ability of the company to grow its business. This can translate to a slower increase in the stock’s price.

3. Dividends are taxed. Though there are methods of avoiding taxes on qualified dividends once you’ve retired, while you’re still employed, owing taxes on the dividends you receive can sometimes be costly. Even with the lower tax rate you’ll pay on most dividends (0-20% on qualified dividends), owing additional taxes is never an exciting prospect.

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We use Personal Capital regularly to analyze our investment fees, track our investments, and project our net worth. We also periodically review our progress toward retirement with their retirement planning calculator.

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