When planning for your long term financial goals, investing in dividend-paying companies might be a great option. Stocks that pay dividends tend to be more stable during market fluctuations and price swings, and they may be eligible for more enticing tax breaks. Moreover, they can provide a passive income for investors.
American companies such as Microsoft, Johnson & Johnson, and Chevron are known for their attractive dividend payouts, but there are many more that are worthy of consideration and different ways in which to take advantage of them.
We’ll explore some of the ins and outs of the concept of dividends below so that you can decide whether to focus on them as part of your investment strategy going forward. Let's dive in!
What are dividends and why would a company issue them?
A dividend is a payment made by a company to its shareholders as dictated by the board of directors. Dividend payments are often made quarterly or biannually and might take the form of cash payments or stock reinvestments.
They’re a popular way for investors to make a passive income from their portfolio without having to sell any of their holdings, but not all companies offer dividends, and it's certainly not an obligation, legal or otherwise. The individual company’s board decides whether to distribute a dividend at any time or it may reinvest profits back into the company for the purpose of expansion for example.
For a recent example, at the time of writing, Johnson & Johnson's Board of Directors just declared a cash dividend of $1.13 per share on the company's common stock for the first quarter of 2023. Stockholders of record as of the close of business on February 21, 2023 will receive the dividend on March 7, 2023. Therefore, an investor owning 1,000 of these shares prior to the ex-dividend date, for instance, will earn a cash dividend of $1,130.
Dividends are a way for companies to show appreciation for their shareholders, and they generally also demonstrate that the financial position of the company is solid enough to attract more investors. It's good for business and good for investors.
You’ll find that many individual stock brokerage accounts provide their clients access to company information and price data for the purpose of research, including dividend amounts and distribution dates. There are also plenty of financial and news sites that do this too, so it's easy to find out a company’s dividend history before deciding to buy any shares.
How do they affect the price of stocks?
Psychology is a factor
Dividends can have an effect on the value of a company’s stock price, but the direction of that influence, whether it be positive or negative, will depend on how the market reacts to the agreed dividend amount.
A reasonable measure of a company is the history of its dividend payouts. Their ability to consistently provide- let alone increase- dividend payments, even in the face of recessions and other challenging economic conditions like the recent pandemic, is a highly positive indicator.
The market may conversely see dividend payments as an indication that a company's development potential has reached a plateau. This is especially true if the dividends are paid out at a time when there are few chances for the company to re-invest capital into its operations or spend cash on other activities.
How it usually goes:
Like our earlier Johnson & Johnson example above, the dividend amount and payment date must be declared by the issuing company before dividends are distributed. The ex-dividend date, which is the final day to buy shares and still receive the dividend, is also announced.
Naturally, after the announcement, you’d expect that the share price will increase as investors purchase more with the mind to earn the dividend. They may even pay a premium for it, and the price will continue to rise.
It can be such a major incentive for some investors that they buy a certain company’s stock just for the sole purpose of collecting dividends. When executed properly, buying shares before the ex-dividend date and selling them again on the day of record may actually provide a tidy return. This is also part of why the stock price might drop following the payout.
Different strategies, different outcomes
There's a couple of main ways you can capitalize on company dividends.
One is the ‘dividend capture’ strategy that is sometimes used by day traders to maximize their profits from stock trading. As you might imagine, it's an active trading strategy that requires frequent buying and selling of stocks and holding them for only long enough to capture the dividend the company pays before selling. Holding the underlying stock for a single day is possible depending on the company’s policy.
There are those that would argue this approach doesn't alway work too well, as stock prices can potentially increase by the dividend amount before the declaration date, or because the potential to obtain risk-free gains will be reduced by market volatility, taxes, and transaction fees. However, agile portfolio managers often take advantage of this strategy to get rapid returns.
In contrast, the more conventional approach is to focus on buying and holding stable dividend-paying stocks to generate a steady income stream over a long period of time. Dividend stocks, particularly those from companies that raise their dividends on a regular basis, have traditionally performed better than the market over the years and with lower volatility.
As a result, dividend stocks are a good choice for every portfolio since they provide diversity and a certain level of stability.
In summary
How you choose to invest and take notice of dividends largely comes down to the type of investor you are and your tolerance for risk.
Some companies that pay dividends are solid investments, and some- especially newer dividend-paying companies- are not. You’ll still need to do your due diligence on what you’re buying either way before you make a purchase.
Always ensure that your investing approach aligns with your long-term objectives and never risk more money than you can afford to lose.
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