Why Dividends are Important to Investors

As a retail investor, the importance of dividends cannot be overstated. While stocks that don't pay dividends might have their merits, prioritizing dividend investments can provide you with many benefits that can contribute to long-term wealth creation. In this article, we'll explore why dividends are important for retail investors and how they can enhance your investment strategy.

What are dividends?

Dividends are regular payments (either quarterly, half-yearly or annually) made by companies to shareholders. These payments can be made on a quarterly, half-yearly or on an annual basis. The source of these payments are the consistent profits generated by the company. Dividend payments are an important source of passive income to investors and represent tangible returns on the investment made into the company.

Dividends are an important measure of a company’s profitability.

When a company pays a dividend, it signifies that it has sufficient profits and/or free cash flow to distribute to its shareholders. This act serves as a positive indicator of a company's profitability and a reliable gauge of its financial health. Companies that are financially unhealthy are generally not in a position to reward shareholders with dividends.

Dividends are a reliable income stream for investors.

As the saying goes, “A bird in hand is worth two in the bush”. Dividends provide a reliable, tangible, and regular source of income to investors. This aspect of investment return is of particular importance to retirees or income investors, more so than the promise of future capital appreciation from non-dividend paying stocks. It is infinitely more satisfying to receive regular dividend payments from your stock investments rather than having to wait patiently for a future payout from capital gains that may or may not materialize.

Dividends as a reliable measure of a company’s financial health

Earnings per share (EPS) is one of the most commonly used yardsticks for stock valuation. However, EPS can be manipulated through creative accounting techniques and can be unduly influenced by one-time accounting gains or deferred charges, distorting the true financial picture of the company. On the other hand, dividends offer a more accurate measure of a company’s financial health. Dividend payments are the distribution of a company’s actual profits to its shareholders and provide a reliable and transparent measure of its financial well-being.

Dividends can reduce risk and volatility in your portfolio.

Dividends play a crucial role in mitigating risk and reducing volatility in your investment portfolio. The predictable income generated by dividends acts as a stabilizing force during market downturns, helping to put a floor to the stock price. In a bear market, dividend payments provide a reliable source of income, cushioning the impact on your overall portfolio.

Dividends off long-term growth potential through compounding

Dividends have the power to significantly enhance your long-term investment returns. By reinvesting dividends, you can take advantage of the compounding effect, where your dividend income is used to purchase additional shares. Over time, this reinvestment can lead to substantial growth in the value of your investment. The compounding effect allows you to harness the power of time and create a snowball effect of wealth accumulation.

Dividend-paying stocks outperform in the long run

Extensive research supports the notion that dividend-paying stocks outperform their non-dividend-paying counterparts in the long run. According to a study by Hartford Funds, dividend-paying stocks achieved average annual returns of 9.18% from 1973 to 2022, while non-dividend payers averaged annual returns of -0.60%. This compelling evidence showcases the potential for superior long-term performance through dividend investing.

Conclusion

In summary, there are many reasons that dividends are important in investment decisions. Dividends provide investors with a steady, reliable, regular source of income that represent the tangible return on their investment. Nothing can be more reassuring to an investor than receiving regular dividend cheques in the mail.

We conclude this article with the following pearls of wisdom from John D. Rockefeller and John Burr Williams:

“Do you know the only thing that gives me pleasure? It’s to see my dividends coming in.”

– John D. Rockefeller

“A cow for her milk, A hen for her eggs, And a stock, by heck,

For her dividends.

An orchard for fruit, Bees for their honey, And stocks, besides,

For their dividends. “

–  John Burr Williams