Why You Should Consider Dividends in Your Nest Egg

April 8, 2019

 

The older I get, the more conservative my investment approach becomes.  This strategy naturally falls in line with typical investment target accounts to protect your principal.   For example, retirement target accounts set up your retirement to shift from more risk to least risk as you get closer to your retirement date.  The idea is to protect your principal from further market risk or declines.

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In this blog, we will explore how dividends may help strengthen your retirement goals by:

  • What are dividends

  • Should I buy dividend stocks

  • Taxes


When I was in my twenties and became a day and swing trader, I took more risk in trading stocks than I should have.   Being more concerned about price appreciation and seeing my stocks rise earning significant gains, the downside of loss seemed impossible.  Prior to the dot-com crash, traders had the same mentality.  

As I approach forty, my views and trading strategy have vastly changed; however, the change derived from the knowledge and skills while working at Thornburg Investment Management where I learned the importance of dividend investing.  

Dividends are payments made on a schedule or cycle to the shareholders of companies.  If you own stock of a company that pays a dividend, you as the shareholder will receive a payment.  For example, AT&T pays a dividend every three months, and the amount usually increases every year as long as the company is profitable.  

Recently this telecommunications company paid $0.51 per share in the quarter.  
Therefore, if you owned ten shares of this stock, you received a payment of $5.10.  10 shares x $0.51 = $5.10.  The more shares you own, the more you're paid.  Another example, if you held a thousand shares, your quarterly payment would have been $510.  Because AT&T (Ticker: T) makes this payment quarterly, you would have received over the last twelve months, $2,010.  

This isn't to claim that all dividends are created equal and have no risk.  All stocks have numerous risk factors.  A firm like AT&T could one day face a share price decline from earnings or face systemic risk.  No one has a crystal ball which is why analysts review companies financial statements.  The stronger the financial statements, the healthier companies are.  

Receiving dividends can assist your nest egg to grow faster too if these are reinvested meaning your broker uses that dividend payment to buy more shares of that stock.  Money making money.  It can also deliver a source of income especially if you are retired.  Data has shown that dividend-paying stocks typically outperform stocks that do not pay dividends.

Fidelity writes "From 1958 through 2018, a portfolio with the top 20% of Standard & Poor's 500 (S&P 500) Index companies ranked by dividend yield and weighted by market capitalization outperformed the overall S&P 500 by 2.13 percentage points annually, according to Chicago-based Greenrock Research". 1

My previous firm, Thornburg, conducted similar analysis but during a shorter period.   By comparing the S&P 500 Index to only the S&P 500 Index dividend-paying stocks, Aristocrats, the analysis was performed from its inception of 1990 to 2018.  Over this eighteen-year period, the S&P 500 Aristocrats returned its investors 11.57% compared to the S&P 500 Index 9.27%.  

 Source: Thornburg Investment Management                                 


Should I Buy Dividend Stocks?
Earlier, I mentioned not all dividend-paying stocks are equal.  If you were to research companies that pay dividends, you will find stocks with a dividend yield ranging from 0% to 22% or more.  This doesn't mean the companies paying 22% are legit.  The yield may be high because the firm is facing financial troubles.

What Should I Do Then?
Ask your broker if your stocks pay dividends and if those dividends are being reinvested.  If you don't have a broker, research companies that have been around for a while and have strong financial backgrounds.  This means looks for firms with a lot of cash and minimal debt.  

 

Most telecommunication companies pay dividends.  You will also find blue-chip stocks that pay dividends as well.   These are firms like Johnson & Johnson who has a dividend yield of 2.64% as of the writing of this blog, or $3.60 a year.  

Taxes
The dividends received will typically fall into one of two categories when it comes to taxes.  Dividends are a type of investment income and will be labeled as ordinary income taxes or long-term capital gains tax rates.  

Taxes on dividends may fluctuate depending on the political environment but the longer you hold the dividends, the lower the tax rates usually are.   Dividends are usually taxed anywhere from 15-20% which is lower than most earned income tax rates; however, if the dividends are in a qualified retirement account, you may not have to pay taxes.  

What Now?
Determine if dividend investing is right for you.  Learning about dividend-paying stocks have helped grow my nest egg and will continue so for the next 20-30 years.   Before you invest or purchase dividend-paying stocks, be sure to consult with a financial planner or advisor to ensure this meets your long-term retirement needs.   

 

Note: Read Individual Retirement Arrangements (IRAs)

Prior to investing, consult with a financial advisor to understand the risks

 

The S&P 500 Dividend Aristocrats Index is equally weighted and measures the performance of large cap, blue chip companies within the S&P 500 Index that have followed a policy of increasing dividends every year for at least 25 consecutive years.

 

The S&P 500 Index is an unmanaged broad measure of the U.S. stock market.

 

 

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