Why dividend paying stocks are good

Understanding them should help you choose better dividend stocks. The biggest misconception of dividend stocks is that a high yield is always a good thing. Many dividend investors simply choose a collection of the highest dividend-paying stock and hope for the best. For a number of reasons, this is not always a good idea. For example, take a look at SureDividend's weekly list of monthly dividend-paying stocks.

When you screen this list by companies with the highest dividend yield, the top names are not always the top performers on a total return basis. On March 17, , Corpus Entertainment is the top dividend-yielding company, with a dividend yield of However, it has a ten-year annualized total return of So, while it had the "best" dividend yield, its total return was not that impressive.

Any money that is paid out in a dividend is not reinvested in the business. Therefore, the dividend payout ratio , which measures the percentage of profits a company pays out to shareholders, is a key metric to watch because it is a sign that a dividend payer still has the flexibility to reinvest and grow its business. Naturally, when it comes to high dividend payers most of us think of utility companies and other slow-growth businesses.

These businesses come to mind first because investors too often focus on the highest yielding stocks. If you lower the importance of yield, dividend stocks can become much more exciting. Some of the best traits a dividend stock can have are the announcement of a new dividend, high dividend growth metrics over recent years, or the potential to commit more and raise the dividend even if the current yield is low. Any of these announcements can be a very exciting development that can jolt the stock price and result in a greater total return.

Dividend stocks are known for being safe, reliable investments. Many of them are top value companies. The dividend aristocrats —companies that have increased their dividend annually over the past 25 years—are often considered safe companies.

Management can use the dividend to placate frustrated investors when the stock isn't moving. In fact, many companies have been known to do this. Therefore, to avoid dividend traps, it's always important to at least consider how management is using the dividend in its corporate strategy.

Dividends that are consolation prizes to investors for a lack of growth are almost always bad ideas. In , the dividend yields of many stocks were pushed artificially high due to stock price declines.

For a moment, those dividend yields looked tempting. But as the financial crises deepened, and profits plunged, many dividend programs were cut altogether. A sudden cut to a dividend program often sends stock shares tumbling, as was the case with so many bank stocks in Ultimately, investors are best served by looking beyond the dividend yield at a few key factors that can help to influence their investing decisions.

The dividend yield, in conjunction with total return, can be a top factor as dividends are often counted on to improve the total return of an investment.

Looking only to safe dividend payers can also significantly narrow the universe of dividend investments. Lower payout ratios should indicate more sustainable dividends—or a low payout ratio could mean that a company needs to increase its dividend. A steadily rising payout ratio, on the other hand, could indicate that a company is healthy and generating reliable returns in a mature industry.

This is the classic strategy for dividend investing. The focus here would be on slow-growing, established companies with a lot of cash flow that pay high dividends. These kinds of investments make sense when you are looking to generate income right away. The companies may not see as much growth in stock value as other companies with lower dividend yields.

Investors with a longer time horizon can focus on buying stock in companies that are growing quickly but currently pay lower-than-average dividends. Getting in early means investors can buy more shares and eventually earn more dividends. Dividend capture is a more active, hands-on approach to harvesting dividend income.

Instead, you swoop in and buy them right before the dividend is paid out. Then, after the dividend is paid, you have to decide when to sell. This gets complicated and risky because share prices are volatile and may be lower once the dividend is paid than when you bought them.

Share price declines like this can easily wipe out the money you earned from the dividend—or more. Every investing strategy involves risk, and dividend investing is no exception. The biggest risk is that dividends are never guaranteed. Companies can and do reduce and even eliminate their dividends.

But there are more subtle risks. Diversification should always be top of mind for any investor, and someone who focuses too much on dividends is likely to ignore some sectors and classes of companies they need for good diversification. Lack of diversification always exposes investors to increased volatility.

Dividend-only investors can miss out on high-value growth in those sectors that might not be paying dividends or that pay uncompetitive dividends.

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We do not offer financial advice, advisory or brokerage services, nor do we recommend or advise individuals or to buy or sell particular stocks or securities. It only makes one assumption—expected dividend growth—to compute the length of time to recoup your initial investment. Should you focus on stocks that have the quickest payback? Not necessarily. Ultimately, total return is what matters. It's great to have a stock pay back your initial investment in just 15 years, but it's better to own a stock that increases your initial investment 5-fold in 15 years.

Still, using dividend payback is a worthwhile concept for framing the risk-return potential of 2 stocks. The dividend payback matrix helps determine payback times in years based on dividend yields and dividend-growth assumptions. Dividend-paying stocks provide a way for investors to get paid during rocky market periods, when capital gains are hard to achieve.

They provide a nice hedge against inflation, especially when they grow over time. They are tax advantaged, unlike other forms of income, such as interest on fixed-income investments. Dividend-paying stocks, on average, tend to be less volatile than non-dividend-paying stocks. And a dividend stream, especially when reinvested to take advantage of the power of compounding, can help build tremendous wealth over time.

However, dividends do have a cost. A company cannot pay out dividends to shareholders without affecting its market value. Think of your own finances. If you constantly paid out cash to family members, your net worth would decrease. It's no different for a company. Money that a company pays out to shareholders is money that is no longer part of the asset base of the corporation.

This money can no longer be used to reinvest and grow the company. That reduction in the company's "wealth" has to be reflected in a downward adjustment in the stock price.

A stock price adjusts downward when a dividend is paid. The adjustment may not be easily observed amidst the daily price fluctuations of a typical stock, but the adjustment does happen.

This adjustment is much more obvious when a company pays a "special dividend" also known as a one-time dividend. When a company pays a special dividend to its shareholders, the stock price is immediately reduced. This downward adjustment in the stock price takes place on the ex-dividend date. Typically, the ex-dividend date is 2 business days prior to the record date. The ex-dividend date represents the cut-off point for receiving the dividend.

You have to own a stock prior to the ex-dividend date in order to receive the next dividend payment. If you buy a stock on or after the ex-dividend date, you are not entitled to the next paid dividend.

If this sounds unfair, remember that the stock price adjusts downward to reflect the dividend payment. Therefore, while you are not entitled to the dividend if you buy on or after the ex-dividend date, you are paying a lower price for the shares.

XYZ also announces that shareholders of record on the company's books on or before February 8, , are entitled to the dividend. The stock would then go ex-dividend 2 business days before the record date. In this example, the record date falls on a Friday. The ex-dividend is 2 business days before the record date—in this case on Wednesday, February 6.

Anyone who bought the stock on Tuesday or after would not get the dividend that dividend goes to the seller of the shares.