Unraveling the Mystery of Dividend Stocks

As you approach retirement, you may hear more about dividend-paying stocks. That’s because they provide income, which many retirees seek. What are dividend-paying stocks, and what role can they play in your portfolio?

When a company earns profits, it can either invest those profits back in the business or pay those profits to its shareholders. When paid to shareholders, these profits are called dividends.

A dividend-paying stock is the stock of a company that generates consistent dividends. Such companies are usually well-established, mature, and stable, and their stock prices tend to be less volatile than those of fast-growing companies in new industries, such as technology. Those newer companies seldom pay dividends; instead, they invest their profits in ways that will allow for future growth. How much income can you realize from dividends? As of April 2018, the average dividend yield of the Standard & Poor’s (S&P) 500 Index was around 1.90%. It has ranged from 1.11% (in August 2000) to 13.84% (in June 1932).

Dividend-paying stocks present a double benefit: Because many dividend-paying stocks are less volatile and generate income, they appeal to investors seeking to generate steady growth as well as investors who want to build a steady income flow during retirement. Additionally, even though they provide income, dividend-paying stocks do not necessarily provide low returns. Dividend-paying stocks are particularly appealing when purchased in tax-deferred accounts, such as 401(k) plans and individual retirement accounts (IRAs). In a non-tax-deferred account, the dividends would be taxed as ordinary income. In a tax-deferred account, the dividends are not immediately taxed. They compound over time until they are taxed at withdrawal. According to a 2016 white paper from Hartford Funds, 81% of the total return of the S&P 500 Index going back to 1960 can be attributed to reinvested dividends and the power of compounding interest.

Consult with your financial adviser to determine how these stocks will work best in your portfolio.

How to Search for Quality Stocks

When stock markets are volatile, many investors turn to high-quality stocks. What are they, and how might they be used in your portfolio? High-quality stocks are stocks of companies with outstanding characteristics based on a set of clearly defined criteria, such as balance-sheet strength and good management.

Because finding a high-quality stock among the thousands that trade on exchanges can be a daunting undertaking, high-quality investors often focus on certain criteria. These criteria may include return on equity (ROE), return on assets (ROA), and return on capital employed (ROCE).

As complicated as these criteria sound, they essentially speak to a company’s ability to generate earnings from its investments. ROE indicates how much profit a company has earned relative to shareholder capital. ROA indicates how efficient a company’s management is at using assets to generate earnings. Finally, ROCE indicates how efficiently a company is using its capital investments, which include all long-term funds used by the company. An increase in these three measures suggests that a company is growing.

That said, these measures may not be the only indicators of a company’s prospects. Other criteria – such as growth of the industry in which a company operates – can also affect a stock’s performance, and thus merit close scrutiny.

How important is quality in a stock? Very. Benjamin Graham, who is often called the founding father of value investing, has said that the greatest investment losses result not from buying high-quality stocks at high prices, but from buying low-quality stocks at low prices.