Dividend stocks are shares of companies that pay dividends, which are the investor’s cut of the profits that companies earn. Dividends are distributed to the owners of the company, the shareholders, with each holder of common stock entitled to a payment proportionate to his or her ownership in the enterprise.
Some companies do not pay dividends, whether or not they make profits, and from an investor’s point of view, they have rather different characteristics from stocks that do. Some companies that do not pay dividends are growing fast, and need all their capital. Others are in trouble, and really need their cash.
Still other corporations reward investors with stock buybacks rather than dividends. Stock buybacks can serve as the equivalent of dividends, but with far better financial consequences, or they can be an illusory way of seeming to reward outside investors.
Whether a stock that pays dividends is better for a given investor than a company that does not is a complicated question. The answer depends upon the investor’s personal circumstances, on the general characteristics of dividend paying stocks, and on the specific nature of a certain stock.
Reasons to buy dividend stocks
When an investor receives a dividend, he or she receives actual cash that cannot be lost in the market or the economy. When companies retain money that could be used to pay a dividend, they may or may not do well with it. The investor may receive more money down the road because the company has done well with the money they have kept. On the other hand, the company may fritter the money away (it happens), or lose it in a prolonged downturn or sudden disaster. A dividend payment eliminates some of a stockholder’s uncertainty. Actual cash is a sure thing.
For this reason, among others, when the market declines stocks that pay safe dividends are more likely to retain their value, or to recover it if they do decline. Down markets are frightening, and the certainty of a dividend takes away some of the fear.
As of 2010, dividends are treated relatively benignly by the U.S. tax code. They are actually taxed at a lower rate than money a taxpayer earns, if he or she retains dividend stocks for a reasonable period.
This policy actually encourages investors to buy and hold dividend stocks, a sane and reasoned investment policy for investors with many other things on their minds than watching the market.
However, tax codes to do change. As it stands, the government will tax dividends earned in 2011 at a higher rate than currently obtains. The higher rates may well make dividend stocks less interesting to investors, though of course tax policies are certain to keep changing.
Reasons to avoid dividend stocks
The people who run giant corporations are likely to be able to earn a better return on your money than you can. They have a successful business, if you have chosen your stock well, and they work hard at it each day. Therefore, your money is more likely to grow reliably if you let them manage all of it, than if you demand that they give you some every three months.
Stocks that do not pay dividends, or that pay small dividends, are putting all or nearly all, the profits back in the enterprise. Theoretically, this money will grow throughout your working life, and then help support you when you retire. Money they pay you in a dividend would not have the chance to grow at that rate.
In an ideal world, companies have life cycles. They grow rapidly when they are small and scrappy, and don’t pay a dividend. Then, when they mature, they pay a reliable dividend to long time shareholders. Many companies have followed his pattern, and have made holders secure. Of course, investors do have to choose the right company to hang onto, and this is certainly not an ideal world.
Another reason to avoid certain dividend stocks is that high dividends can signal danger. Perhaps the stock price has recently dived because of a serious problem. Such a stock might yield 10 percent for a while, and then yield nothing.
Some utility stocks pay good reliable dividends, and investors seeking safety have long sought them out for that reason. However, some utilities have to borrow heavily, and can therefore suffer if rates rise. Utility stocks must be vetted as carefully as any other investment, and cannot simply be bought because of a seductive dividend.
Most seasoned investors do not chose a stock simply because it pays a hefty dividend. The search for growing dividends can be more rewarding in the long run, and the purchase of a reliable stock with a worthwhile stock buyback program may lead to surer financial gain.
Some dividend stocks are worth an investor’s notice, and some stocks that have never yet paid a dividend are great choices. An investor must think carefully about his or her specific goals, and the best ways to achieve them.