Dividend stocks, per definition, are stocks that pay a dividend (either in cash or in stock). A dividend is a regular payment made by a publicly traded company to its shareholders out of its profits. It can be expressed as a percentage or as $ per share.
When we talk about dividend stocks we are generally referring to stocks that pay a high dividend and are, therefore, a lucrative investment for several reasons, which will be discussed in this post.
Two Sources of Returns (Capital Gains & Investment Income)
When investing in dividend stocks you not only benefit from capital gains, when the price of the stock goes up but you also receive regular investment income through the annual, semi-annual or quarterly dividend payment. In that sense, dividend stocks are similar to bonds, where you receive capital gains through the bonds’ price increase and investment income through the coupon payments. Non-dividend paying stocks don’t offer you investment income, only capital gains.
Less Volatile Than Non-Dividend Paying Stocks
High dividend paying stocks are historically less volatile than non-dividend paying stocks. Dividend stocks tend to come from mature, stable, cash flow rich sectors such as utilities, basic materials, and telecoms. These are companies that are confident they can keep making their dividend payments due to the stable nature of their business. Also, it’s in their best interest to keep their dividend stable rather than to cut it. A cut in dividend sends a bad signal to investors about a company’s financial situation. That, in turn, would affect its share price, so dividend cuts are fairly irregular occurrences in high dividend paying stocks.
Also, when you are investing in dividend stocks a substantial amount of your overall return stems from the reinvestment income of the dividends. Hence, there is no strong urge to sell these stocks when there is adverse market volatility.
Benefit From Dividend Reinvestment Income
When you are holding dividend stocks in your portfolio and you decide to reinvest your stock dividend payments, then you benefit from dividend reinvestment income. You can set up a so-called DRIP (Dividend Reinvestment Plan) through your brokerage so that your dividend income is automatically reinvested in the same dividend paying stocks. That way your dividend income compounds over time and your overall returns increase.
Hedge Against Inflation
Dividend stocks are also considered to be a good hedge against inflation. Inflation plays an important role in investing as it decreased your real return. If your portfolio generates 7% return in a year, but inflation that year is 2%, then your real return is only 5%.
The reason why high dividend paying stocks are considered to be a good hedge against inflation is because when inflation goes up, company revenues tend to go up. And when revenues go up companies can increase their dividends, and therefore distribute more profits to their shareholders.
Dividend stocks offer strong overall returns with lower volatility than non-dividend paying stocks and can act as a hedge against inflation. Therefore, dividend stocks are a vital part of any diversified investment portfolio.
If you want to learn more about how to invest in stocks, sign up to my e-learning course Stocks for Beginners – A Guide to Investing in the Stock Market.