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Dividends have been a popular investment strategy for decades - but it can be hard to do the research, know what companies to invest in, or what products might be worthwhile. Image Credit: Pexels

Dividends can be a source of income for investors, they can also indicate growing companies whose stocks often constitute a solid investment.

And dividends have been a popular investment strategy for decades - but it can be hard to do the research, know what companies to invest in, or what products might be worthwhile.

Dividends can be a source of income for investors, they can also indicate solid, growing companies

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Before getting into what dividend investing is and why it's a smart strategy, you need a platform that you can invest on it on.

They are several commission-free platforms that allow you to easily build a dividend investing portfolio.

What are dividends?
Dividends are payments to shareholders of record as a specified date that are authorized by the company’s board of directors.

Dividends are a method of returning some of the company’s profits back to shareholders. Dividends are usually paid in cash and are generally expressed as an amount per share.

For example, a dividend payout might be Dh1 per share. Dividends can be paid at whatever interval the company’s board decides. Quarterly payments are common, especially among established companies.

Besides cash payments, stock dividends can be made. Under this scenario, shareholders will receive a designated number of shares for each share owned.
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An electronic display shows the Hang Seng index in Hong Kong. Photo used for illustrative purposes. Image Credit: NYT

Dividends are a significant component of returns

Dividends might seem insignificant at first glance, but historically they have made up a significant part of the total return of major stock market indexes.

A study of the impact of dividends on the S&P 500, the top US index that generally represents the global market, from December of 1960 through a little over a year back showed that 82 per cent of the index’s total return was due to reinvested dividends.

Dividends might seem insignificant at first glance, but historically they have made up a significant part of the total return

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Let’s say a hypothetical investor had invested let’s say the currency equivalent of Dh10,000 into the index on December 1, 1960.

What if you invested Dh10,000 in dividend stocks in 1960?
If all dividends received were reinvested and allowed to compound over time, the hypothetical Dh10,000 investment would have grown to Dh2,459,158.

Without the reinvestment of dividends, the Dh10,000 would have grown to just Dh431,397 over the roughly 50-year time horizon based solely on price appreciation.

Looking at the percentage contributions of dividends to the index’s total return by decade reinforces the importance of dividends.

(Note you cannot actually invest in an index, though there are numerous ETFs and mutual funds that attempt to replicate the performance of the index.)

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Picture used for illustrative purpose only Image Credit: Stock image

Certainly, the pendulum has swung back and forth between dividends and price appreciation in importance as a source of return on the stocks in the major benchmarks over different periods of time.

For example, the decades of the 1980s and 1990s saw high levels of price appreciation in a number of stocks. The tables were turned during the 1970s and the 1940s.

Certainly, the pendulum has swung back and forth between dividends and price appreciation in importance as a source of return!

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Over the time covered by this study, dividends made up over 40 per cent of the total return of the index.

Dividend Yield versus Dividend Growth

Dividend investors typically look to dividend stocks for one or both of two reasons.

Dividend Yield
Dividend yield is calculated by dividing the annualized dividend payout of the stock by the current share price.

For example, a stock that pays an annualized dividend of Dh2 per share with a current share price of Dh50 would have a dividend yield of 4 per cent.

If the price rose to Dh56 per share, the dividend yield would drop to roughly 3.6 per cent. The payout didn’t change, but the increase in the stock’s price would serve to lower the current dividend yield.

The annualized dividend payout that is generally used is the latest quarterly payout times four. The dividend yield will generally change daily with the price movements of the stock.

A high dividend yield can be a function of both an increased payout and/or a decline in the stock’s price.

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A chart on a screen on the floor of the New York Stock Exchange shows the rise of the S&P 500 index since 2009. Photo used for illustrative purposes. Image Credit: AP

In reaching for stocks with high yields, it’s important for investors to look beyond the dividend yield to ensure they understand why the yield is high and if the dividend payout is sustainable.

One sector whose stock often has a high yield is utilities and telecoms. They have stable cash flows and often have a near monopoly in their region.

One sector whose stock often has a high yield is utilities and telecoms.

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While the share price may not move much unless there is some sort of abnormal event, the dividend payouts are often pretty stable. This isn’t the case with all stocks with a high dividend yield.

Dividend Growth
Another take on dividend investing is seeking the stocks of companies with a solid record of increasing their dividend payout per share on an annual basis.

Companies that do this are generally well-managed and financially sound.

The ability to sustain and increase the dividend payout each year is a sign that the company is growing its bottom line and is generating solid cash flows.

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Whether you invest in companies with a high yield or those with growing payouts, dividend investing can be a solid way to generate a stream of income from your portfolio.

This might be a source of passive income as you approach retirement, for example.

Ways to invest in dividend stocks
For investors who are interested in dividend investing, there are a number of options to consider.

Note that none of these are mutually exclusive, investors can mix and match any of these into their overall investing strategy.

Individual Dividend-Paying Stocks

Investors can buy individual dividend-paying stocks. Whether or not this is a good strategy will depend upon each investor’s individual situation and their investment strategy.

A key consideration is whether or not you will be able to build a diversified portfolio of individual stocks going this route.

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There are many investors who look to build a stream of income by building a portfolio of individual dividend-paying names.

A caution to keep in mind is that even dividend-paying stocks are susceptible to movements in the stock market, though many are less volatile than the market as a whole.

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Savings grow exponentially when it is a habit Image Credit: Pixabay

Mutual Funds and ETFs

There are a number of mutual funds and ETFs that focus on dividend stocks either from a dividend growth perspective or a yield focus.

Here's an example of dividend-focused mutual funds!
Vanguard High Dividend Yield Index Fund (ticker VHDYX) attempts to replicate the performance of the FTSE High Dividend Yield Index.

The companies held in the fund usually offer higher-than-average dividend yields. There is also an ETF version of the fund. The recent yield of the fund was 3.3 per cent versus a yield of under 2.0 per cent for the S&P 500 index.

Vanguard Dividend Appreciation ETF (ticker VIG) includes companies that have increased their dividend payout annually for a minimum of 10 consecutive years.

This fund is focused on dividend growth versus yield growth. The fund is also available as a mutual fund as well. There are several other funds and ETFs that focus on the dividend stocks in some form.

There are a number of mutual funds and ETFs that focus on dividend stocks either from a dividend growth perspective or a yield focus.

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Investing in shares can potentially provide better protection against inflation than deposit accounts or bonds which aren’t index-linked.
Investing in shares can potentially provide better protection against inflation than deposit accounts or bonds which aren’t index-linked. Image Credit: Stock photo

So, what are the key takeaways?

Dividends are an important component of return for stocks. Companies that can continue to pay dividends annually can be excellent investments, especially those that are able to consistently increase their payout levels.

It is important for investors to understand the underlying financials of any stock they might be considering, helping ensure that the company is a solid investment for them.

Dividends are an important component of return for stocks. Be sure the dividend is sustainable.

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Be sure the dividend is sustainable. It’s also important to realize that even dividend-paying stocks can get hit when the stock market corrects itself.

Mutual funds and ETFs that focus on dividends can be a good alternative. Be sure that you understand the fund’s objectives and its expenses. Make sure that these objectives are consistent with your investing goals.