Often overlooked, dividends can add substantial value to the return on your
equity portfolio. Many investors view dividends as a source of income rather
than as a strategy to improve the total return of their portfolios; however,
dividends can provide a boost to returns and can help lessen the impact of
What are Dividends?
When a company makes a profit, the board of directors decides whether to
retain those profits for investment in the company’s future growth or to pay
out all or a portion of the profits to shareholders in the form of
dividends. As a common stock shareholder, these dividends are not
guaranteed, but a preferred stock shareholder’s dividends may be.
What to Expect
Dividends can be paid monthly, quarterly or semi-annually. Each cycle, the
board of directors declares if a dividend will be paid and how much that
dividend will be. The stated dividend amount is the amount per share that
will be paid to shareholders who own the stock as of a certain date.
The value of the dividends is most clearly illustrated by a stock’s dividend
yield, which is the percentage of the market price of a security that you
receive through dividends. For example, if you own shares of stock ABC that
are currently worth $50 and stock XYZ that are $100 and each stock pays an
annual dividend of $1, ABC’s dividend yield would be 2% and XYZ’s yield
would be 1%. In this example if you reinvest dividends, or purchase
additional shares with the dividends you receive, you would earn a return of
2% and 1% for investments in ABC and XYZ, respectively. This is in addition
to any return earned through share price appreciation. Alternatively, this
dividend yield may soften declines in share prices. In this same example, a
decline of 2% in ABC’s share price would be offset by its dividend payout.
Some investors view dividends as a source of income. This can be an
effective strategy for investors looking to generate income from their
investments, but because dividends are not guaranteed or fixed, there may be
alternative investments that better meet this goal. Another strategy for
using dividends is to increase the total return on your investment by
reinvesting the dividends.
Historically, stocks have averaged a dividend yield of 3.48%, as measured by
S&P 500 over the period 1926-2002. While the dividend yield of any single
security may vary over time, this long-term average has had a significant
impact on total return. For example, if you had made a hypothetical
investment in the S&P 500 of $10,000 at the beginning of 1982, this
investment would have grown to $123,100 by 10/31/2002 if you reinvested all
dividends; however, this same investment would have grown to just $62,300 if
you had taken the dividends as cash.
While dividends are frequently used as a source of income, their power as a
performance booster for total return is often overlooked. Consult a trusted
financial professional to see how dividend-paying stocks would fit into your
long-term financial plan.
C. David Petrucci, CFP®, is an Associate Vice-President-Investments and
Wealth Management Specialist with Legg Mason Wood Walker, Inc., a
diversified securities brokerage and financial services firm that is a
member of the New York Stock Exchange, Inc. and SIPC.