The Argument for Dividends

Suggest dividends to someone and watch their reaction. Depending on their age, they may seem put off by the concept (if they are young) and willing to embrace the notion (if they are near to retirement). For one group, dividends imply old age; for the other, dividends suggest steady income. Are either one of these two groups of investors correct in their assumption?

Both are wrong to some degree. Dividends are the result of company profits. To appease shareholders that wonder what a business plans on doing with the profits they have made, the company awards a share of those profits to its shareholders. This is called yield.

The word yield, often associated with bond investing can confuse both the younger group and the older. The youngest believe that yield might be fine and a nice return on their investment. But they also look to the stock to move as well. Older investors believe that yield means safety when in fact, the strength of the yield is still calculated against the performance of the stock.

Companies who pay dividends are under no obligation to do so. But these businesses may have reached a point in their life cycle where they can no longer grow. Their market share may be all that they need to achieve those profits. So the stock price may languish in one spot for long periods of time, giving the investor the feeling that the risk is no longer present. It still is but the dividend can mask that health. Too high a payout (in relation to the stock price) can suggest increased risk that the dividend may need to be reduced or eliminated. Too low a dividend may suggest that the stock price is moving too much.

In a down market, dividend paying stocks can outperform the overall market (in part because of the dividend yield). In a market on an upward path, the dividend paying stocks and the mutual funds that invest in them, will lag behind, even lose more money that the index that is benchmarked to them.

Older investors might confuse them for bond funds. They are not. They appear to be fixed because of the trading range of the security, but bonds are different in several ways. The yield on a bond is fixed. 

The yield on a dividend paying stock is not. Bond investors are always first in line should the company default. Dividend investors, like equity shareholders in non-dividend paying stocks, get nothing in that situation.

The question is: should you buy a dividend focused mutual fund? Yes. But you do need to be cautious and understand that what you hold in your other investments and mutual funds may cross over and that we all know is the first cardinal sin of investing: all your eggs in one basket. These types of funds can cost more in some cases than the index funds you may own that pay dividends as well (S&P 500 returns are driven by dividend paying companies).

There is also the chance that your dividend paying mutual fund has gone overseas looking for yield. In 2012, this is a risky bet as the European crisis continues to unfold.

And because of that risk overseas (and any market downturn), the risk in these investments, the risk the dividends will need to be cut, is still there. The key is time. No equity investment performs as good in the short-term as it does in the long-term. Funds that invest in dividend paying stocks tend to have steadier performance results over a five or ten year period.

Looking for dividends should have no age barrier. Young people with time on their side, could actually benefit more than if they simply sought securities that grow without dividends. Older investors could see some better yields than a simple bond investment. There is and always will be risk. But dividends pay you, often handsomely to take it.

(this article was reprinted by permission from bluecollardollar.com)