After 30 Years, Stock Market Pendulum Tilting to Dividends?

NEW YORK ( AdviceIQ) -- Just as a landlord counts on income from tenants, more and more stock investors lately look to high-quality dividend paying stocks to receive rent -- in the form of quarterly payouts -- while waiting out today's market volatility.

The market is up since spring, but before that was in a slump. Who knows what is next? Daily, the media tell us how the markets have shifted or what stock has gone up or down and by how much. However, the daily market gyrations have little long-term implications for most investors.

Just as a landlord would not check the value of his investment property every day, calm investors in high-quality dividend paying stocks can relax more than speculators trying to make fast trades and quick dollars.

For a long-term investor, the way to look at investments is in terms of total return. Its two main components:

Capital appreciation:

How much the stock prices goes up. This provides headline sizzle and, as such, is bantered about frequently with reports of: "The stock market gained/lost today," or "XYZ Company reported earnings and saw their stock go up/down today." It's the same story day after day with the media alternating the words gained/lost and up/down where appropriate. But is that really the whole story? For many it is not.

Dividends:

Income paying stocks provide cash (like rent) to an investor quarterly. Historically, dividends played a large role in an investor's total return. In fact, up until the early 1980s, dividends were the main factor when considering whether or not to buy a stock. Over the last three decades, dividends gave way to capital appreciation. Some experts think that the pendulum may swing back to dividends.

How much of a role have dividends played historically?

From 1926 to 2010, the average rate of return of the Standard & Poor's 500 stock index was 9.6%. Surprisingly, almost half of that return was from dividends, at a respectable 4.1% per year.

The S&P 500 is currently paying a dividend yield of about 2%. Yet it's not hard to find investments that focus on high-quality dividend paying stocks to boost your yield to 3% or more. If you don't want to pick those stocks on your own, you can find quite a few mutual funds and exchange-traded funds that concentrate on dividend paying stocks.

In a climate where you are lucky enough to earn 0.25% on your bank savings account, earning a dividend yield of 3% is a vast improvement -- assuming you have the time, are willing to endure stock-price volatility and understand that stocks don't carry Federal Deposit Insurance Corp. guarantees, as savings accounts do.

Companies are reporting record profits and cash on their balance sheets. Paying out a higher dividend to shareholders is a viable option for a company to make use of that cash. Companies are starting to do exactly this -- paying a higher rent to their shareholders.

But investing in dividend stocks is not without risk.

A best-case scenario is that you own a stock that appreciates greatly while being paid a quarterly dividend all along. The worst-case scenario is that your principal investment declines significantly and the company announces it can no longer pay a dividend. That is equivalent to a landlord losing tenants while seeing property value depreciate.

What factors should you consider when evaluating dividend-paying stocks?

Dividend payout ratio:

This is the ratio of dividends to earnings. Dividends are generally paid out of earnings. The company may pay some of these earnings to you as the shareholder and retain some to put back into the company. More mature companies tend to have higher dividend payout ratios.

  • Increasing dividend payout ratios are a sign of a company's strength and the management's belief it can continue making these payments. Otherwise, they would not increase the dividends.
  • Certain industries have historically paid higher dividends, such as utility companies.
  • Conversely, companies that cut dividends ratio usually indicate weakness. You want to approach these companies with extreme caution.
  • Exceedingly high dividend payout ratios may be too good to be true, so approach these with caution, as well.
  • Dividend yield:

    It represents the income from dividends divided by the share price.

  • This is the annual income the company indicates it will pay, based on the most recent dividend paid.
  • The yield will go up when the stock price goes down.
  • The yield will go down when the stock price goes up.
  • The yield can go up or down if the company changes the amount it pays out.
  • Tax implications
  • Under current law, qualified dividend-paying stocks are taxed at 15%, as opposed to a more common income tax rate such as 25% or 28%.
  • Qualified dividends are for stocks held for 60 of the 120 days before the dividend payment is announced. Otherwise, the dividends are taxed as regular income.
  • For those in the 0% to 15% income tax bracket, the tax rate on qualified dividends is 0%.
  • If you sell the stock, mutual fund or ETF at a profit, you may owe capital gains tax.
  • If you sell these investments at a loss, you may be eligible for a capital gains loss. That is used to offset taxes on gains from elsewhere in your portfolio.
  • The current tax law could change so pay attention to the legislative environment.
  • Dividend Reinvest or Cash

    Keep in mind you can use your dividend income to buy more shares of your investment, or you can have your custodian or broker pay the dividends in cash to you.

    Stock market volatility can be disheartening to anyone. Evaluate ways to cushion the roller coaster ride of stock price fluctuation with a steady stream of dividend income. Just as a landlord seeks to receive a positive cash flow from rent, an income and growth investor can seek dividend-paying stocks for positive cash flows.

    --By Scott Hughes, CFP, MBA, a financial planning advisor and president of Hughes Financial Services, LLC, in Herndon, Va., for AdviceIQ.

    Hughes Financial Services LLC, is a branch office of and securities offered through WFG Investments, Inc. (WFG). Member FINRA/SIPC. Scott Hughes is a Registered Representative of WFG.

    AdviceIQ is a network of financial advisors that writes insightful articles for the public about investing and wealth management. All articles are edited by AdviceIQ's editor in chief, Larry Light. AdviceIQ certifies that all its advisors have no regulatory infractions.

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