Investing

What dividends are and why they're important

Twenty/20

A dividend is a periodic payout of earnings that some companies and funds share with investors just for being a shareholder. Think of it as a little bonus on top of your regular returns, like the 13th bagel you might get for free as part of a baker's dozen.

If you've been investing for a while, you may have seen a dividend amount listed on your statement — or you may have even received a dividend check.

Dividends might seem small: In mid-2019, the average dividend payment for U.S. stocks was 1.87% of your investment, according to Siblis Research. But they can drastically impact your long-term investment performance. Here's what you need to know.

What a dividend is, and why companies pay them

Dividends are the little extra regular profit you earn by investing. And because so many companies pay a dividend — more than 80% of the members of the S&P 500 currently do, according to data from FactSet — you can actually earn money even when the market is down.

For example, if you had $1,000 invested in a fund that pays out the average 1.87% dividend, you'd earn $18.70, regardless of how the market had performed that year. Sounds nice, right?

Companies don't cut you in on the action purely out of the goodness of their hearts. Companies pay out dividends to encourage people like you to invest with them. The same holds true with exchange-traded funds (ETFs) and mutual funds.

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Investing comes with risks. Even when you buy shares of well-established companies or funds, there's no guarantee you'll see positive returns during your specific investing time horizon. That's because a rate of return is not promised and you could hypothetically lose money — although historically, the stock market has never fallen to zero and, despite bumps, has grown significantly over time.

Dividend payments help make stocks more attractive by ensuring you can receive some payment for staying invested.

Dividend-paying companies tend to be more established than many of the so-called growth stocks, so they're in a position to offer this sliver of their profits. And providing a dividend in and of itself may make a stock more desirable, driving up demand, and therefore the price, of a stock.

How often companies pay dividends, and who's eligible

Most U.S. companies or fund managers pay out dividends quarterly, or four times a year. There's no set rule, though, and individual companies may choose to give dividends once a year, twice a year, or at no set schedule, only offering payments when they've had a particularly good year or quarter.

You generally don't have to do anything — other than own the stock by what's known as the date of record — to get a dividend. These payments are the participation trophies of investing: You get them just for owning a stock. They also aren't usually prorated, meaning you get the same amount if you've been invested the whole quarter as you do if you invested the day before the quarter closed.

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Adding dividend-paying stocks to your portfolio

It may be tempting to invest all of your money in dividend stocks, but doing so may not provide the necessary diversification for your portfolio. Here's why:

  • Returns. Companies that pay a higher-than-average portion of their profits back to shareholders are typically more established, so their years of rapid growth are probably behind them. That means you may not get the same returns as the younger, faster-growing companies.
  • Industry reputation. Dividend payouts are also more common in certain industries, like utilities and telecommunications. Focusing on those companies may lead you to allocate too much of your portfolio to the same industry, and experts recommend buying stocks across a variety of industries or investing in index funds.

To balance out the risk in your investment portfolio, experts recommend a mix of dividend and nondividend stocks and funds. That way you benefit from the steady performance of more established companies, which may be less likely to fold unexpectedly, and the potential growth of newer, smaller companies. While they may be riskier than their time-tested counterparts, their value may multiply faster.

Why you should reinvest your dividends

When you open an investment account, you're usually given the option of taking any dividend payments as cash or reinvesting them, meaning you pay tiny fractions of stock with that money. Dividend payments are expressed as a quarterly amount — say, $1 a share — and that may seem trivial. However, there's an important reason to consider reinvesting those dividends: Small dividends can have a big impact.

Since 1960, a whopping 82% of returns for the S&P 500 have been from the growth of reinvested dividends, according to analysis by Hartford Funds. It calculated that if you started with an investment of $1,000 in 1960 and reinvested your dividends, you would have $200,000 more at the end of 2018 than you would by receiving dividends as cash every year. And that's even without contributing another dollar.

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In the last decade, people who reinvested dividends into S&P 500 funds saw more than 2% higher returns than those who opted for payment, according to a calculator from DQYDJ.com.

Dividends are the only way to increase the number of shares you own without investing more money. Reinvested dividends let you increase your account value by purchasing more stock (or shares of funds).

Because you're investing on a regular schedule (like once every quarter or so), you're able to take advantage of what's known as dollar-cost averaging — buying shares at a variety of prices. And the opportunity to invest when prices fluctuate will allow you to boost your long-term returns.

That's why experts recommend you reinvest dividends along the way. Historically, the market has trended upwards — and by using dividends to buy more shares, that allows your investment account to grow even more.

How to find dividend stocks and funds

You can research dividend-paying stocks and funds using fund research platforms, like Morningstar, Kiplinger, or the Securities and Exchange Commission websites.

Brokerages and investment companies may also identify their dividend-paying stocks and funds, and the percentage they pay out, on their websites. Like other investing styles — buying shares of small-, mid-, or large-cap companies, for example — the easiest way to invest in dividend-paying stocks is by buying ETFs that do the legwork for you.

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