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Recently I endured a very humbling experience when my 10 year old son narrowly beat me in a 50 yard footrace. Of course I did what every self-respecting man does when faced with defeat at the hands of a 10 year old – I made excuses. “I wasn’t warmed up properly” I complained, “and my old lawn dart injury slowed me down.” My son, taking pity on what he termed his “slow, decrepit father”, agreed to run a second race and even offered to give me a head start. Shoving my ego aside, I accepted the head start and narrowly beat my son in the second race. I then did what every self-respecting man does when he wins a competition – completely “forgot” that I had received a head start and boasted how I had easily bested my son in the race. I have doubts that my son will ever grant me another head start again.
Having a head start can often times mean the difference between winning and losing the investment race. In investing, dividend paying stocks give investors an excellent head start in achieving positive returns and ultimately winning the investment race.
Keeping It Positive
Investment returns include two components – the positive or negative movement of the investment’s price and the income received from the investment over time. While the investment price movement receives all the attention of the financial media, investment income also plays a major role in giving portfolios a head start toward positive performance. An often quoted statistic indicates that the S&P 500 Index has achieved an average annual total return of 10% since 1926. What is not often revealed is that approximately 40% of the 10% annual total return is the result of re-invested dividends from stocks in the index.
Dividends also reduce the reliance of portfolios on positive stock price movements to produce returns. As has been experienced recently, stock prices can remain flat for a period of time. Dividend paying stocks give portfolios a built in return regardless of stock price movement, and thus can give investors a “head start” toward positive investment returns in difficult market environments.
Dividend paying stocks have also proven to be less volatile than non-dividend paying stocks over time. A calculation of the standard deviation (a measure of an investment’s volatility) of dividend paying versus non-dividend paying stocks from 1985 through 2005 reveals that dividend paying stocks were approximately 37% less volatile over this time period. Additionally, during this same 20 year period dividend paying stocks achieved an average annual total return of 10.79% versus an average of 9.43% for non-dividend paying stocks.
Dividend paying stocks have clearly enjoyed excellent investment performance, and dividends can also provide a quick financial checkup for the health of a company.
A Healthy Checkup
Dividends offer an insight into the current financial health of a company. Dividends are paid after a company accounts for operating expenses and future plans for growth. Thus, the payment of a dividend indicates the company’s cash flow is healthy enough to pay not only for basic expenses and plans for business expansion, but also to pay revenue to shareholders.
This superior financial “health” can often lead to superior performance. Since 1972, companies which were growing or initiating dividend payouts have achieved an average annual total return of 10.1% versus only a 5.6% average annual total return for companies who either eliminated or reduced dividends. Obviously, a strategy which includes dividend paying stocks can be of benefit, but what are the potential traps?
Chasing Yield
Many investors are tempted to choose dividend paying stocks strictly based on the stock’s dividend yield. A stock’s dividend yield is calculated by dividing the annual dividend per share by the stock’s price per share. The higher the yield the better the dividend paying stock, right?
Investors can fall into the trap of chasing dividend yield and ignoring the underlying reasons for the attractive income. If a company maintains its annual dividend per share while its stock price is declining, the dividend yield of the stock will actually improve as the stock price falls. However, the declining stock price may actually be a warning sign of poor company financial health and the inflated dividend yield may actually mask this potential risk. Investors must continue to employ prudent investment selection when selecting dividend paying companies, or utilize mutual funds and other managed investment vehicles to assist in the selection of the most favorable dividend companies.
Dividend paying stocks, while not the media darlings of their non-dividend paying, high growth counterparts deserve a place in the portfolios of almost every investors. As always, diversification remains the key, and portfolios which include both dividend paying and non-dividend paying stocks will be appropriate for most investors. However, the winning combination of healthy returns and the potential for lower volatility gives portfolios which include dividend paying stocks a healthy head start toward investment success.
Sources: American Funds, Thornburg Funds, Ned Davis Research
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