Chapter 5: Intro to Bonds and Fixed Income
As you might have seen, some companies pay out something called dividends. But what are these, and how do they work?
What are dividends
Dividends are payments made by a company to its shareholders, usually from its profits. They are typically paid on a regular basis, such as quarterly or annually. When a company earns a profit, it can choose to reinvest that money back into the business or distribute a portion of it to shareholders in the form of dividends.
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Dividends are measured in yields but are paid out in cash per share. For example, a common payout might be $6 per share, but it's measured against the company's share price to compare different dividends. A $6 dividend can be excellent if the stock price is $80 but less impressive if the stock price is $600. These payouts are always measured on a yearly basis, regardless of whether the company pays out every quarter or once a year. Companies can split their dividend into multiple parts to distribute it more frequently throughout the year.
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The company will first announce an ex-dividend date, which is the date you must own shares to be eligible for the dividend. Then, the company will announce a payout date when you will receive the dividend as long as you owned the stock on the ex-dividend date, regardless of whether you sell the shares afterward or keep them.
What advantage/disadvantages does dividends have
Advantages
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Dividends are very reliable and stable even through market volatility because they are based on actual earnings, not share price. As long as the company's earnings remain strong, which they often do, the dividends will continue to be paid out. This makes dividends a dependable source of income for investors.
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Dividends provide a separate income stream compared to other strategies where you have to sell part of your holdings. It can be challenging to decide how much to sell and manage the associated administration, but dividends are automatically distributed as a certain percentage of your holdings. This hands-free approach is a positive aspect, offering simplicity and ease for investors.
Disadvantages
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A dividend-paying company typically won't have as much growth potential because it pays out funds to shareholders instead of reinvesting them into the business. Growing revenue is a much more powerful driver of stock price increases than dividends, so companies focused on growth often choose to reinvest their profits to fuel further expansion.
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Dividend-paying companies generally don't offer the same yield potential per year as other investment strategies might. This means you need a larger amount of invested capital to generate enough income to live on or to achieve your desired income level.
Where could dividend investing be useful
Dividend investing is particularly well-suited for situations where reliability and ease of management are more important than achieving the highest possible returns. This strategy focuses on investing in companies that regularly pay dividends—cash payments to shareholders—providing a steady stream of income over time.
One of the best examples of when dividend investing shines is during retirement. In retirement, the focus often shifts from growing wealth to preserving it and generating a reliable income stream to cover living expenses. Dividend-paying stocks can provide that steady income, reducing the need to sell off investments to fund your retirement. This income can supplement pensions or Social Security, acting as a "wage booster" that helps maintain your lifestyle without the volatility of relying solely on the stock market's ups and downs.