INVESTORS TEND TO FOLLOW the ups and downs of the stock market closely, watching â and hoping â for price gains. But many overlook another potential source of returns: the dividends that many companies can pay their shareholders.
Investors should always look at both price gains and dividend income when considering their total return, says Kirsten Cabacungan, an investment strategist in the Chief Investment Office for Merrill and Bank of America Private Bank. There are a couple of reasons why dividend-paying stocks can be particularly useful. First, the income they provide can help investors meet liquidity needs. And second, dividend-focused investing has historically demonstrated the ability to help to lower volatility and buffer losses during market drawdowns.
Below, Cabacungan offers more insights into the role that dividend-paying stocks could play in your portfolio.
Hey there dividend curious investors! If you’ve been scratching your head wondering whether dividends are actually worth your time and money, you’re not alone. This question has crossed my mind countless times in my investing journey and today I’m gonna break it down for you in simple terms.
What Even Are Dividends Anyway?
Let me start with the basics. Dividends are basically cash payments that companies make to their shareholders, typically on a quarterly basis. Think of them as a “thank you” from profitable companies sharing some of their earnings with you for being an investor.
As Kirsten Cabacungan, an investment strategist at Merrill and Bank of America Private Bank explains, “Generally, it’s larger, more mature companies that return capital to their shareholders in the form of dividends.” Smaller companies and startups often need to reinvest everything back into growth, so they typically don’t pay dividends
But here’s the catch – dividends aren’t guaranteed. Even reliable dividend payers sometimes have to cut or suspend their payments when times get tough. We saw this happen during the pandemic when some previously reliable dividend payers had to temporarily reduce or completely stop their dividend payments because of earnings losses.
The Two Big Ways Dividends Can Be Profitable
When we talk about dividend profitability, there are really two major benefits to consider:
1. Regular Income Stream
The most obvious benefit is getting regular cash payments. This is super attractive if you’re:
- Retired and need income to cover living expenses
- Looking for ways to generate passive income
- Wanting to decrease reliance on selling assets for cash
For retirees especially, dividend stocks can be a lifesaver for creating predictable income without having to sell off your investments.
2. Protection During Market Downturns
This is the benefit many people overlook! Dividend-paying stocks tend to be more stable during rough market periods.
As Cabacungan points out, “Companies that have consistently increased their dividends tend to be more stable, higher-quality businesses, which historically have weathered downturns and are more likely to have the ability to pay dividends consistently.”
In other words, companies with strong dividend histories are often financially healthier and less volatile. This can mean fewer heart-stopping plunges when the market goes crazy.
Not All Dividend Stocks Are Created Equal
Before you rush out to buy the highest-yielding dividend stock you can find (I’ve made this mistake before!), listen up. There are different types of dividend payers, and the differences matter a lot:
High Yield vs. Dividend Growth
Some companies offer eye-popping high yields (sometimes 5%+ annually), while others offer more modest dividends that grow steadily over time.
A common mistake I see all the time is investors chasing extremely high yields without considering why they’re so high. As Cabacungan warns, if a company “has leveraged excessive debt to fund the dividend, it could come at the expense of future profitability and hurt growth prospects.”
Sometimes a yield looks super high simply because the stock price recently crashed – not because the company is generous! This is often called a “yield trap” and I’ve fallen for it more than once in my early investing days.
Growth-Oriented vs. Income-Oriented Approaches
Your strategy should match your goals:
- Need income now? Look for reliable stocks with above-average dividend yields.
- Building wealth for later? Consider dividend growth stocks that have a history of increasing their payments over time.
The Math: Are Dividends Actually Profitable?
Let’s get down to brass tacks. When calculating profitability, we need to look at total return, which combines:
- Price appreciation (the stock going up in value)
- Dividend income (the cash payments)
Example Scenario:
Imagine you invest $10,000 in two different stocks:
- Stock A: Growth stock, no dividend, grows 8% annually
- Stock B: Dividend stock, 3% dividend yield, grows 5% annually in price
After one year:
- Stock A is worth $10,800 (8% growth)
- Stock B is worth $10,500 (5% growth) + you received $300 in dividends = $10,800 total
In this simplified example, the total return is identical! But the dividend stock provided cash flow without requiring you to sell shares.
When Dividends Really Shine: Market Downturns
Here’s where it gets interesting. During market corrections or bear markets, dividend stocks often demonstrate their true value.
Let’s continue our example during a market downturn:
- Stock A drops 20% to $8,640 (from $10,800)
- Stock B drops 15% to $8,925 (from $10,500) + you still received $300 in dividends = $9,225 total
In this scenario, the dividend stock outperformed by providing:
- Lower volatility (smaller price drop)
- Continued income regardless of price movement
This is why many investors, myself included, really love dividends during uncertain markets.
Taxes: The Profitability Consideration Most People Forget
I’ve gotta be straight with you – taxes can significantly impact dividend profitability. Dividend income is generally taxed in one of two ways:
- Qualified dividends: Taxed at lower capital gains rates (0%, 15%, or 20% depending on your income)
- Non-qualified dividends: Taxed as ordinary income (potentially much higher rates)
This tax difference can drastically change your after-tax returns. If you’re in a high tax bracket, dividend investments might be more efficient in tax-advantaged accounts like IRAs or 401(k)s where the dividends won’t be taxed immediately.
Different Ways to Invest in Dividend Stocks
If you’re convinced dividends might be profitable for your situation, there are several ways to add them to your portfolio:
1. Individual Stocks
Picking individual dividend-paying companies gives you complete control. You can focus on sectors you understand and companies with dividend histories that match your goals.
2. Dividend-Focused Funds
As Cabacungan notes, “Beyond individual stocks, there are numerous exchange-traded funds, index funds and mutual funds to explore. Some emphasize dividend yield; others focus on dividend growth or offer a mix of both.”
These funds provide instant diversification across many dividend payers, which reduces your risk if any single company cuts its dividend.
3. International Dividend Stocks
Don’t forget to look beyond U.S. borders! Many international equity indexes offer higher dividend yields than U.S. indexes, providing additional diversification benefits.
Real Talk: When Dividends Might NOT Be Profitable
I wouldn’t be giving you the full picture if I didn’t mention some situations where dividend investing might not be your best choice:
1. You’re in Growth Mode
If you’re young with a long time horizon, maximum growth might be more important than current income. The most aggressive growth stocks typically don’t pay dividends because they’re reinvesting everything back into expansion.
2. You’re in a High Tax Bracket Without Tax-Advantaged Space
If you’re paying high ordinary income rates on dividends in a taxable account, the tax drag can significantly reduce your after-tax returns.
3. Interest Rates Are Sky-High
During periods of extremely high interest rates, fixed-income investments might provide comparable income with less risk than dividend stocks. This isn’t the case currently, but it’s worth mentioning.
Dividend Red Flags: Watch Out for These Warning Signs
Not all dividend stocks are created equal. Here are some warning signs I’ve learned to watch for:
- Unsustainably high yields: Anything over 6-7% deserves extra scrutiny
- Dividend payout ratio over 100%: The company is paying out more than it earns
- Declining revenue or earnings: Can signal future dividend cuts
- Heavy debt loads: May limit the company’s ability to maintain dividends during tough times
- Recent dividend cuts: Often indicates deeper problems
The Dividend Aristocrats: The Gold Standard
If you’re looking for reliability, the “Dividend Aristocrats” are worth your attention. These are S&P 500 companies that have increased their dividends for at least 25 consecutive years.
This exclusive club includes companies that have proven their commitment to shareholders through multiple economic cycles, recessions, and market crashes. While past performance doesn’t guarantee future results, this track record says a lot about a company’s financial health and management priorities.
Building a Profitable Dividend Strategy
If you’re convinced dividends have a place in your portfolio (and for most investors, they probably do), here’s my approach to building a profitable dividend strategy:
- Determine your primary goal: Income now or growth for later?
- Consider your tax situation: Where should you hold these investments?
- Decide on individual stocks vs. funds: Based on your time, knowledge, and interest
- Start with quality: Focus on companies with sustainable payout ratios and histories of dividend growth
- Diversify across sectors: Don’t put all your eggs in one basket
- Monitor regularly: But don’t overreact to market fluctuations
The Bottom Line: Yes, Dividends Can Be Very Profitable
To directly answer the question we started with – yes, dividends can be extremely profitable when used correctly as part of a thoughtful investment strategy. They provide:
- Regular income without selling assets
- Potential downside protection during market turbulence
- Exposure to often high-quality, stable companies
- A significant component of long-term total returns
As Cabacungan wisely advises, “Work with your advisor to tailor your strategy to your individual needs, considering your short- and long-term goals and time horizon as well as your risk tolerance and liquidity needs.”
Whether you’re looking for current income or long-term growth, dividend-paying investments likely deserve consideration in your portfolio. Just remember that like any investment strategy, it’s about finding the right approach for your specific situation and goals.
Have you had success with dividend investing? I’d love to hear your experiences in the comments below!
Why should I consider adding them to my portfolio?
There are two key roles that dividend-paying investments can play: providing investors with income to help meet immediate cash needs â something that retirees might increasingly look to them for â and offering potential downside defense during market sell-offs. âCompanies that have consistently increased their dividends tend to be more stable, higher-quality businesses, which historically have weathered downturns and are more likely to have the ability to pay dividends consistently,â1Â Cabacungan says. Itâs worth noting that investors close to retirement may not be able to experience the return potential of a dividend-paying stock over time.
What exactly are dividends â and what kinds of companies offer them?
Dividends represent a payment by a company, typically made on a quarterly basis, to its shareholders from income generated by the business. âGenerally, itâs larger, more mature companies that return capital to their shareholders in the form of dividends,â Cabacungan says. Smaller and growing companies tend to reinvest earnings back into their business. Dividends arenât guaranteed, however. For instance, some dividend-paying companies temporarily lowered or suspended dividends in response to earnings losses as a result of the coronavirus pandemic.
Are Dividend Investments A Good Idea?
FAQ
Can you actually make money from dividends?
How much in dividends to make $1000 a month?
a month (or
annually) in dividends, you need to invest a varying amount of capital depending on the dividend yield of your investments.
For example, a 4% dividend yield requires approximately
in investment, while a 3% yield requires about
.
How much would $100,000 make in dividends?
| Portfolio Dividend Yield | Dividend Payments With $100K |
|---|---|
| 1% | $1,000 |
| 2% | $2,000 |
| 3% | $3,000 |
| 4% | $4,000 |
What did Warren Buffett say about dividends?
Buffett’s dividend test
“The test about whether to pay dividends is whether you can continue to create more than $1 of value for every dollar you retain,” Buffett said.