Many investors overlook the importance of dividends when investing in the stock market. In my opinion, dividends are one of the most underrated aspects of stock market investing. Here’s a look at the key benefits of dividends.
Dividends are a great way of obtaining a passive income. Invest in a portfolio of high-quality dividend paying stocks and you’ll receive a steady stream of cash payments year after year. This is ideal for both retirees looking to generate an income stream in retirement or perhaps any individual looking for financial freedom.
But it’s not just retirees who can benefit from dividends. If the investor chooses to reinvest the dividends instead of spending them, they can effortlessly capitalise on the power of compounding, generating more dividends for the future.
Market rise and fall. As investors we have no control over this. However, when market panic arises, dividends offer an element of stability and control, making it much easier to stick to an investment strategy. Does it really matter if the share market falls 10% in the short term? Not if you’re receiving a steady stream of dividends every month.
A huge proportion of long-term returns
While a 3-5% dividend may not seem like much now, many studies have shown that over the long term, reinvested dividends can make up a significant proportion of total investment returns. How significant? As high as 80-90% believe it or not. For more details see my article on the contribution that dividends have made to the FTSE 100 index in recent years.
Rising dividends lead to rising prices
Dividend growth investors can also benefit from capital growth in the long term. That’s because companies that consistently increase their dividends will generally see their share prices appreciate over time, as a result of the larger dividends being paid out. Dividend growth and capital growth – who wouldn’t want that?
Bear market protection
While the share prices of dividend paying companies can still fall significantly, it’s likely that these kinds of companies will experience lower volatility than high-growth stocks. In effect, the company’s dividend payout offers a downside cushion. Furthermore, when the market is falling, dividends can make the difference between generating a positive and a negative return.
An insight into company health
Lastly, dividends provide investors with important insights into the health, growth and value of a company. Whereas earnings can be manipulated, dividends can’t be. The company either has the cash on hand to pay the dividend or it doesn’t. A company’s dividend growth also provides an insight into the growth prospects of that company. If the company raises its dividend by 10%, it’s a great sign that management is confident about the future.
Commitment to the dividend also keeps company management in check. If management know that they’ll need a certain amount of cash on hand to pay a dividend, there’s less chance of that cash being wasted on projects that may reward management at the expense of shareholders.
This article is provided for general information only and is not intended to be investment advice. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.