Compared to growth stocks, dividend-paying stocks are often viewed as the investment equivalent of a minivan or sensible shoes - they serve a practical purpose, but they aren't flashy or exciting. However, an extended period of low interest rates has added a little sizzle to the notion of dividend investing.
To understand what role dividend-paying stocks might play in your portfolio, it is helpful to look at what you might expect from those stocks, and what some of the pros and cons are of having a stock pay a dividend. The following are some answers to fundamental questions about dividends:
- What is a dividend? A dividend is a cash payment made by a company to its shareholders, usually on a quarterly basis. This payment comes out of the company's earnings and is one way that the owners of a company get to share in those earnings. A company with an established dividend might continue to pay that dividend even during a temporary period of low or negative earnings, though a sustained drop in earnings is likely to result in the dividend being cut or even eliminated. Think about this as if you were running a business. You might want to reinvest most of the proceeds from the company into expanding its business, but you would also take a portion of the earnings out to live on. That portion taken out of the company is akin to a dividend.
- How much is a typical dividend? Currently, the average dividends paid by stocks in the S&P 500 total about 2 percent of the stock's value on an annual basis. That means if a stock cost $100, it would probably pay about $2 a year in dividends. The dollar amount of dividends changes over time, and the percentage yield varies as the market of companies changes.
- Do most stocks pay a dividend? Over 80 percent of companies in the S&P 500 pay dividends, but that index is made up of large, well-established companies. Among newer and smaller stocks you would see a lower percentage of dividend-paying stocks.
- Why don't some stocks have dividends? As an alternative to paying dividends, a company could reinvest all its earnings into the business in an effort to grow. This could include adding staff, physically expanding offices, or research and development. This is why fast-growing companies or those that are heavily focused on new product development may not pay a dividend. Also, not having the commitment of regular dividends gives a company some financial flexibility to help it weather erratic earnings patterns.
- What types of stocks are most likely to pay dividends? Among the industry sectors in the S&P 500, telecommunications stocks and utilities have the highest dividend yields. Telecom stocks pay an average of 5.35 percent in dividends, and utilities pay an average of 4.27 percent. These tend to be businesses with a steady, predictable stream of earnings, which enables those companies to make the commitment of paying a dividend. On the other end of the spectrum are information technology stocks, which pay an average dividend of just 1.42 percent. Tech companies are highly dependent on continually developing and upgrading products, which is why they prefer to reinvest their earnings in the business rather than pay them out in dividends.
- What roles should dividend-paying stocks play in a portfolio? Dividends can provide a fairly steady source of income in a portfolio, and this role has become more important with the steep drop in interest rates in recent years. Ten years ago, the S&P 500 had a dividend yield of 1.86 percent, which was less than half the 5 percent yield available on long-term Treasury bonds. Nowadays, the dividend yield on stocks is up to 2 percent while the long-term Treasury yield has dropped to 3 percent, making stocks far more competitive with bonds as a source of income. Compared with other stocks, dividend payers tend to be larger and more stable, so they could represent a relatively conservative segment of a portfolio, as opposed to the high risk and reward of growth stocks.
Even though they are not guaranteed, dividends do add an element of predictability to a portfolio. One way to think of dividend-paying stocks is that they give up some growth potential in exchange for that predictability. Given how low interest rates are today and how volatile the stock market can be, exchanging growth for predictability might seem a very worthwhile trade to many investors.