Your portfolio can increase in value because the prices of the stocks and bonds it holds are going up. Or it can grow by generating an income paid in the form of dividends.
So what are dividends, and how can they benefit you?
When a company earns profits, it often pays a share of those profits to its shareholders. These profits are called dividends.
Dividends are typically paid by large, well-established companies that generate profits regularly but are too mature to grow significantly. Fast-growing companies in new industries such as biotechnology seldom pay dividends; instead, they invest their profits in technology for future growth.
Dividends are a significant component of most stocks’ total return. Over the long term, half of US stock returns have been derived from dividends, according to the most recent data from investment research organization, Morningstar.
As of March, the average dividend yield of the S&P 500 Index was 2.04 percent – about in line with its 10-year average of 10.6 percent, according to FactSet Research Systems Inc. However, as FactSet also points out, 239 companies in the S&P 500 Index (48 percent of the index) were paying higher dividend yields on their stocks than they were paying coupons on their own intermediate-term bonds.
While dividend-paying stocks provide income, and therefore may be expected to show lower overall returns, in fact, many actually provide high returns. According to Ned Davis Research Inc., from 1972 through March 2013, S&P 500 Equal Weight Index stocks that grew their dividends returned an average annual 10 percent, and stocks that paid steady dividends had returns of 7 percent (compared to 2 percent for stocks that didn’t pay a dividend.)
Dividend-paying stocks and mutual funds are often particularly attractive for tax-deferred investments such as 401(k) plans and traditional Individual Retirement Accounts (IRAs) because the payment of taxes is deferred until withdrawal – after the dividends have compounded many times.