'Dividends can provide a floor' during market downturns, says investment manager. Here's why

Getty Images
Key Points
  • The Dow Jones U.S. Dividend 100 index is down just over 12% in 2022, compared with a 23% slide in the S&P 500.
  • From 1930 through 2021, reinvested dividends have accounted for 40% of the total return of the S&P 500, according to Hartford Funds.

This week, the broad stock market entered bear territory, defined as a decline of 20% or more from recent highs. As of midday Friday, the S&P 500 currently sits 23% below its peak on January 3.

But depending on which stocks you hold, you may not be feeling the bear's wrath just yet. Take investors in dividend stocks. The Dow Jones U.S. Dividend 100 index, for instance, features stocks of 100 financially healthy companies that have paid dividends for at least 10 consecutive years. So far in 2022, the index is down just over 12%.

"Dividends can provide a floor," says Eric Diton, president and managing director of The Wealth Alliance. "During periods of turbulence, knowing you're receiving that income can help investors ride through difficult times."

Here's why investing experts say adding some exposure to dividend-paying stocks can help shield your portfolio during sliding markets.

Why dividends can help when markets slide

A quick refresher on how dividends work: Many companies that earn an excess profit choose to return some of that money to their investors, as a sort of thank you, in the form of regular cash payouts. Retired investors who live off profits from their portfolio can use those cash payments as a form of income. For longer-term investors, dividends are typically reinvested, which is why dividends are factored into the total return of indexes, stocks, ETFs, and mutual funds.

To figure out how a stock's dividend contributes to total return, you have to know its dividend yield. You find that by dividing the amount of money an investor receives from a single share in a year into the stock's share price. If a stock pays $1 in dividends annually and trades for $100, it yields 1%. On aggregate, the S&P 500 currently yields about 1.6%.

What are dividends and why some companies don't offer them

Video by Jason Armesto

How does that factor into returns? Say you have a stock that goes up 7% in a year, and yields an additional 2%. Assuming you reinvest your dividends, the total return you've earned is 9%. When markets slide, assuming the dividend remains the same, it can act as a ballast, points out Robert Gilliland, managing director and senior wealth advisor with Concenture Wealth Management.

"If you buy a company that doesn't pay a dividend, and the stock goes down 10%, you're total return is -10%," he says. "But if it pays 3%, assuming taxes aren't an issue, you're getting -7% because you're receiving that income."

Over long market cycles, providing cushion during downswings and extra return during bull runs has helped dividend-paying stocks outperform, says Diton. "From 1930 through 2021, 40% of S&P 500 returns have come from dividends," he says. "And in every bear market since World War II, dividend stocks have outperformed handily."

How to add dividend-payers to your portfolio

Not all dividend-paying companies, or dividend investing strategies are the same. Some investors, especially those investing for income, seek companies offering higher yields. Some growth-oriented investors look for companies that aggressively increase the amount of their payout. More conservative investors often favor companies with long histories of slow and steady dividend growth.

The common theme among them is that they are looking for dividends that are sustainable. That's because if a company's dividend is cut or suspended, that can be a red flag to investors, who often send the stock price tumbling after an announcement like that.

To find sustainable dividends, hunt for companies with high earnings and robust cash flows that pay out a relatively low portion of their profits in the form of a dividend, says Diton. "If the payout ratio is high, that's a reason for concern," he says.

What is an ETF and should you invest in one?

Video by Jason Armesto

Another red flag: a company taking on debt in order to pay the dividend. "Ideally you want to see a company paying dividends with a pristine balance sheet," Diton adds.

If you want to take a diversified approach to adding dividend-paying stocks to your portfolio, there are plenty of mutual fund and ETF strategies that geared toward dividend investors. Be sure to check the prospectus of any fund you're considering buying to see what kind of financial criteria are used to add stocks to the portfolio.

Regardless of how you choose to buy them, adding companies with long histories of financial health and steady dividends you could reduce your odds at owning the kinds of stocks whose returns could be harmful to your portfolio, says Diton.

"There are plenty of bad companies out there, and you can manipulate things like earnings pretty easily. But you can't fake cash. Cash is king," Diton says, "If you're not making money, you're not going to have the cash to pay dividends over time. If a company pays and consistently raises its dividend, it's not a guarantee, but you can much more confident in the fortitude of that company."

The views expressed are generalized and may not be appropriate for all investors. Past performance does not guarantee future results. The information contained in this article should not be construed as, and may not be used in connection with, an offer to sell, or a solicitation of an offer to buy or hold, an interest in any security or investment product. Carefully consider your financial situation, including investment objective, time horizon, risk tolerance, and fees prior to making any investment decisions. No level of diversification or asset allocation can ensure profits or guarantee against losses.

More from Grow: