Reasons to Consider Investing in Dividend Stocks

Illustration of money signs as a mobile


CSA Images/Getty Images

Dividend stocks, defined by the cash to shareholders as passive income, are a popular investment choice. Among investors who focus on dividends, there are two primary areas of focus: dividend growth and high dividend yield.

Like a growth stock, which is defined by growing earnings, dividend growth refers to a trend of increasing dividends. High dividend yield stocks, on the other hand, may or may not regularly increase their dividend amounts, but they're already disbursing dividends at a rate that exceeds the market average.

Whether they're looking for dividend growth or high yields, here are four reasons why many prudent investors love stocks with dividends.

Key Takeaways

  • Dividend stocks provide cash to shareholders, which can be a good source of passive income for many investors.
  • Investors like stocks with dividends because it encourages them to focus on long-term growth.
  • Additionally, the commitment to providing cash to its investors can prevent unnecessary spending on the company side.
  • For companies, providing dividends can help provide yield support, and reinvesting dividends can help accelerate bigger returns for investors.

The Psychological Advantage of Income

When you own a company that distributes some of its profits in the form of a cash dividend, it becomes easier to focus on things that matter like "look-through earnings." Instead of being overly concerned with the ups and downs of the stock market, you can focus on the connection between the success of the enterprise and the money that flows from the corporate treasury into your hands.

This, in turn, encourages investors to utilize a buy and hold strategy, which reduces frictional expenses and increases the odds of taking advantage of things like deferred tax liabilities and the stepped-up basis loophole. It may not sound like a major advantage, and it can be tempting to act on the trends of the day, but focusing on the long-term has benefited many investors, like in the case of Anne Scheiber.

Cash Commitment Reigns In Unnecessary Spending

Dividends usually represent a major cash commitment for a company (though less common, some companies do issue dividends as stock rather than cash). Whether the stockholders receive them as a check in the mail or as a credit to their brokerage account, these are cash payments being disbursed regularly by the company.

That helps reduce the amount of cash sitting in corporate coffers. While investors want a company to have cash flow, too much cash can burn a hold in the pockets of executives and end up being paid out as bonuses, higher salaries, and golden parachutes—guaranteed payouts for executives who are ousted from companies.

These payments are great for people on the receiving end of them. However, to use a hypothetical scenario, shareholders don't benefit when the company spends millions paying a CEO who was just fired after a scandal that caused the stock to tank.

Dividends take priority over bonuses and salary hikes. They're no guarantee against corporate mismanagement or excessive spending, but it does force executives to be relatively more selective in their spending.

"Yield Support" Helps Reduce Bearish Momentum

Aside from the straightforward dollar amount, it's also common to measure dividends by calculating the 30-day SEC yield. Simply put, it states the dividend payout as a percentage of the cost per share. For example, if a company issues stock at $100 per share and distributes a total of $3 in dividends per share annually, that company's yield would be 3%.

A 3% yield is pretty good, but now imagine that the stock market begins to slump. This company isn't spared from the slump, and the stock is now going for just $50 per share. The stock lost 50% of its value, but the company still pays an annual dividend of $3, so the yield effectively doubles. An investor in an overall slumping economy may seek out the stable income of dividends, and the company in this example now offers a 6% yield. That will help attract investors, thereby slowing the stock value's fall.

Other factors come into play, such as whether the company has a history of cutting dividends. If the company has cut dividends in the past, investors may be less confident that the company will maintain its 6% dividend yield. Excessively high dividend yields can sometimes detract investors if there's concern over whether the company will cut the dividend or lack the cash to pay.

Those concerns aside, this "yield support" helps slow a stock's fall and stave off the worst of bear markets.

Reinvested Dividends Accelerate Returns

Not only do high yields help attract new investors, but those dividends are also often reinvested by current shareholders, benefiting themselves and the company. Investors who reinvest their dividends, especially when a stock is at a relatively low point, serve the dual purpose of slowing downward momentum and acquiring relatively cheap shares. Investors can either manually reinvest their dividends as they come in or sign up for a dividend reinvestment plan.

Wharton professor Dr. Jeremy Siegel is a prominent proponent of the benefit of reinvested dividends. In an interview archived by the Financial Planning Association, Siegel highlighted this phenomenon in the case of Altria Group (formerly known as Phillip Morris). Public sentiment and lawsuit settlements kept this tobacco producer's stock price deflated, despite consistent profit. For shareholders who held on and reinvested their dividends, they enjoyed some of the highest returns of any public company. From 1957–2004 (the time of the interview), Altria was the best-performing company for investors, by Siegel's calculation.