Many investors approach the share market with the aim of getting rich quickly. As a result, they invest in higher-risk speculative companies and ignore larger, more established dividend-paying companies.
However dividend-paying stocks, while perhaps less exciting than growth stocks, have many key benefits, and in my opinion, deserve a place in every serious long-term investor's portfolio. Here's a look at some of the key advantages of owning companies that pay dividends.
One of the most obvious benefits of dividend-paying stocks is that they're an excellent source of passive income. As part owners of a company, shareholders receive a share of the company's profits in the form of a cash payout, on a regular basis. Whether you're looking to escape the 9-5 grind, or perhaps just desire an income boost, dividends can put you on the path to financial freedom.
Furthermore, at a time when it's rare to find a high street savings account paying more than 1% per annum, the dividend yields among many FTSE 100 stocks look particularly attractive right now.
It's no secret that compounding is one of the most important tools when it comes to building long-term wealth. Compounding is the process of generating earnings on an asset's previous reinvested earnings, and over time, results in the exponential growth of an investor's capital.
This is where reinvested dividends play a key role, as the investor can purchase more securities to generate more income in the future, capitalising on the power of compounding. Over the long term, reinvested dividends can make a huge difference to a portfolio's returns.
The bulk of long-term returns
So how much do dividends actually contribute to long-term total returns? You may be surprised by the answer. Indeed, some studies have shown that over the long term, reinvested dividends contribute up to 80% of total investment returns from the share market.
Looking at the FTSE 100 index, for the 10 years to the end of 2016, it returned just 15% without dividends according to Bloomberg. However, with dividends added, and more importantly, reinvested, the index's total return jumped to 67%. In other words, reinvested dividends generated 78% of the index's total return over the period.
Another benefit of dividend-paying companies, and a key advantage over bonds, is that many companies raise their dividends on a regular basis. This means that unlike the bond investor, whose 'fixed' income stream continually loses purchasing power to inflation, the dividend investor's income stream should grow at a rate higher than inflation, thus ensuring the investor can maintain, or perhaps even enhance, their standard of living over time.
Bear market protection
Lastly, dividend-paying companies can offer protection during bear markets or periods of market turbulence, as they tend to experience less volatility than high growth stocks. This is advantageous for several reasons. First, it can help the investor sleep well at night during periods of market panic. Second, receiving a steady stream of dividends on a regular basis, no matter what the market is doing, can really help an investor stick to their long-term investment strategy, and prevent them from bailing out of shares at precisely the wrong moment, when sentiment is low.
With a share market correction possibly not too far away, can you afford to ignore dividend stocks?