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Ever seen your investment statement and wondered what those dividend payments are?

Dividends are like the routine of everyday life. They are mostly underappreciated, not too exciting, but are foundational to your investing experience.

What are dividends?

Dividends are cash payments that publicly traded companies make to investors that own shares of their stock. This is a type of compensation for being an owner of the stock. The amount of the dividend is approved by the board of directors. Some companies pay monthly or quarterly dividends, while others pay semi-annually or annually.

Not every company pays a dividend. It can depend on where the company is in its development. Young or high-growth companies often reinvest most of their earnings to help with future growth.  Companies like Google, Amazon, and Tesla have yet to pay a dividend. 

If a company runs into financial trouble, it can suspend its dividend to keep more money for its operations. After the government-imposed shutdown of 2020, Disney suspended its semi-annual dividend as it coped with disruptions to several of its business units.

What’s so special about dividends?

At first, dividends might not seem like that big of a deal. As of October 2021, the current dividend yield of the S&P 500 is only 1.35% after hovering around 2% for the past decade. If you invested $100,000 in an S&P 500 index fund, this translates into roughly $1,350 per year of dividends. Not much to get excited about!

But dividends have played an outsized role in the historical performance of stocks. One study showed that since 1970, the compounding return from reinvested dividends accounted for 84% of the total return of the S&P 500!

Dividends not only have a place in your portfolio—they deserve more recognition than they are given. How can you unlock the secret of dividends and put them to work for you?

The secret to investing in dividends

1. Focus on dividend growth

When evaluating dividend-paying stocks, it’s tempting to look at the highest yielding stocks. Simply looking at the yield is overlooking an important part of dividends—the ability for companies to grow their dividends.

Dividend growth is a concept that is not well understood by investors. I think this is because the dividend yield has trended downward in the last 40 years.

The dividend yield is a function of two things: the dividend and the price per share of stock. If a stock trades for $100 and it pays a $5 dividend, the yield is 5% ($5/$100 = 5%). What if the price increases to $120 per share? Now the yield is 4.1% ($5/$120 = 4.1%). So, during periods when stock prices rise faster than earnings, the dividend yield decreases because you are paying more for the stock.

The downward trend in the overall yield has masked the fact that companies have been able to increase their dividends over time. In his 2010 letter to shareholders, Warren Buffett illustrated one of his stocks’ abilities to increase its dividend year-after-year:

Other companies we hold are likely to increase their dividends as well. Coca-Cola paid us $88 million in 1995, the year after we finished purchasing the stock. Every year since, Coke has increased its dividend. In 2011, we will almost certainly receive $376 million from Coke, up $24 million from last year. Within ten years, I would expect that $376 million to double. By the end of that period, I wouldn’t be surprised to see our share of Coke’s annual earnings exceed 100% of what we paid for the investment. Time is the friend of the wonderful business.

Coca-Cola is a great example of a company that has increased its dividend—for 59 years! Over the past three years, its dividend growth rate is over 10%.

Don’t get caught up in finding the highest yielding stocks. Yield doesn’t tell the whole story. Focus on the fact that you can invest in quality companies with a history and expectation of growing their dividends. A smaller dividend yield today in a “dividend growth” fund can mean a much higher yield in the future as your income stream grows.

2. Reinvest dividends while accumulating wealth

Are dividend stocks just for retirees? Should you invest in high-growth companies while you are young and then switch to dividend stocks?

I believe dividend payers can have a place in the portfolio of any investor. Again, dividends have accounted for a large portion of the stock market’s return over time. The secret to investing in dividends as someone who is building wealth is to reinvest the dividends in your portfolio. In other words, let the dividends remain in your portfolio so you can use them to buy additional shares.

Dividends can be reinvested in one of two ways:

  1. You can sign up for a dividend reinvestment plan (DRIP) if your custodian allows it for that particular fund or stock. In a DRIP, your dividend will automatically purchase additional shares (even if it’s fractional shares).
  2. Let your dividends remain in the account as cash (not automatically buy additional shares). When your cash account gets large enough, you can use those dividends to rebalance your portfolio by purchasing any funds or stocks whose overall value is lower than your target amount. This is my preferred method because it allows me to keep the portfolio in balance without having to sell shares.

Whatever method you use, once the additional shares are purchased with the dividends, you now have the power of compounding returns working for you. Additional shares you purchase will increase the amount of dividends you receive next quarter. Multiply this by years and decades and you can see why Warren Buffett was so excited about his investment in Coca-Cola!

The change in the price of the S&P 500 index was profitable, but not nearly as profitable as reinvesting those dividends.

3. Consider dividends over bonds for retirement income

Building a dividend portfolio can be a great alternative to bonds when generating retirement income.

Bonds are “safer” in the sense that their values don’t fluctuate nearly as wildly as stocks. However, bonds also pay a fixed coupon rate regardless of inflation and your need for an increasing stream of income. If you own a bond that pays 3%, you are locked into that 3% for the duration of the bond. If your cost-of-living spikes (like it has recently), you’ll continue to receive the same amount of money from your bond, but your purchasing power will continue to dwindle.

Dividend-paying stocks are excellent ways to increase your income along with inflation. Your income is not fixed like a bond and can grow annually at a high rate of return.

But aren’t stocks too risky for retirees?

Stocks can (and do) crash more than 20% about every five and a half years. A secret about dividends is that companies (for the most part) continue to pay them, regardless of what their stock price is doing. So, if your goal is to generate retirement income, you can rest easier when you are focused on your relatively stable dividend stream—not the volatile stock price.

What would happen if the price of Coca-Cola dropped by 30% this quarter but the management continued to pay and grow its dividend? Eventually the yield would look so good that investors would be crazy not to buy it.

That’s the thing about a growing dividend stream—it puts upward pressure on the stock price. Any volatile months or quarters in the share price can be short-lived if the dividend continues to be paid.

Are dividend stocks the best way to fund retirement?

Dividend stocks are a great option for funding future retirement goals. They are not the only option, as it depends on your investment style, income needs, and risk tolerance. Since most people will fund their retirement in part by stocks, knowing the secrets behind dividends can help you have a better understanding of what you are investing in.

To unlock the secrets of dividends, remember the following:

  • Focus on the growth of your dividends, not just your starting yield.
  • Reinvest the dividends while you are accumulating.
  • Consider dividend stocks for retirement income.