September 24, 2019 Written by: Laura Webb, CFP®
Anyone that knows me knows that the color I wear most frequently is black.
Yes, my closet is a sea of black with a smattering of other colors. Same with my shoes – mostly black with a variety of heel sizes and styles. There are so many reasons why black is my clothing choice of color: it goes with almost everything, it can take you from your workday into your evening events, and it’s easy to accessorize and match with the right black shoes. I was thrilled when I saw this quote from Karl Lagerfeld – “One is never over- or underdressed with a little black dress.”
Just like I view black as a staple part of my wardrobe, I view high-quality dividend-focused stocks as an essential part of a well-diversified investment portfolio no matter one’s age or stage of life.
Let’s go back to the basics. Not all stocks pay a dividend. A dividend is a distribution of a portion of a company’s earnings to holders of its stock. When a company makes money, it has the option to share that profit with its stockholders or retain that money as earnings, which it’s then free to reinvest. Companies that can pay dividends are typically well-seasoned, large capitalization and mature companies. They are choosing to pay a portion of the company’s earnings to those that buy their stock.
Not all companies pay dividends. Frequently, companies that are more growth-oriented choose to reinvest their earnings hoping that their shareholders will be rewarded when their stock price increases.
Now, we all want the value of our investments in stocks to grow. However, at this age, I also like the idea of getting paid while I wait, to share in some of the earnings now in the form of a dividend, AND potentially benefit from the growth of that stock in the future. Plus, if we choose a company that also focuses on growing those dividends, then we have the opportunity to not only benefit from income now, but also the growth of that income stream and the potential for appreciation of the stock over time.
If you don’t need the income now, there can be an even greater benefit of reinvesting those dividends over time. Dividends positively contribute to your total return. In fact, from 1998 to 2018, dividend-focused stocks have provided better-annualized returns than overall stocks, as evidenced in the graph1 below. In the graph, the high-yield dividend-paying stocks (in dark blue) had an annualized return of 8.8% in the 20-year period, and dividend-paying stocks (in red) was 7.6% where stocks (in the light blue) only returned 6.6% annualized for the same time frame.
I have found that over time, just like my little black dress, I am not overdressed or underdressed when I choose a high-quality dividend-focused company or a mutual fund to invest in. Those dividend-focused investments give a strong base to build upon – one in which I can add color knowing I have a strong foundation. Those dividends give me income to either use now or to reinvest. In turn, that income helps enhance total return or gives some downside protection, and it also has the potential to grow and offer some advantages for long-term growth.
And finally, “Women who wear black have colorful lives”. –Neiman Marcus
- Morningstar “Dividend Investing” presentation 2019.
Impact of Dividend Reinvestment Over Time
For many investors, the only reward that matters is an increase in share price. But if you look beyond capital gains, you might find a dividend offering significant benefits. A dividend can (1) provide regular income, (2) grow over time through reinvestment opportunities, and (3) offer tax benefits. Prior to the 2003 Jobs and Growth Tax Relief Reconciliation Act, dividends were taxed at ordinary income-tax rate levels. Now investors pay significantly less taxes, ranging from 0% to 20%.
Despite these advantages, dividends seem to be an often overlooked component of total returns. The image illustrates the impact that reinvested dividends have on investment returns over time. These paying investments can add value to a portfolio, but keep in mind that it is possible to lose money by investing in them, and that companies cannot always guarantee their dividend payments.
This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. Past performance is no guarantee of future results. Returns and principal invested in stocks are not guaranteed. Dividends are not guaranteed and are paid at the discretion of the stock-issuing company.
About the data
Stocks with dividends reinvested—Ibbotson® Large Company Stock Index; Stocks principal only—Ibbotson® Large Company Stock Index Capital Appreciation Index.
The foregoing information has been obtained from sources considered reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of Laura Webb and not necessarily those of Raymond James.