There is a certain sense of delirium that surrounds dividend stocks. In the financial markets, where money can be won or lost in seconds, a dividend payout seems like one of the few sure bets. Sometimes it is, but investors often get so swept up in choosing the stock with the highest yield that they overlook one crucial caveat: there is no such thing as, well, a sure thing. So should you be on the hunt for a "dividend darling"? We dish on dividends here.
Making money 101
There are two ways to make money on a stock: The one that people are most familiar with is appreciation. This type of stock growth can be the stuff of investing legend, such as when stocks like Microsoft Corporation exceed all standard expectations and projections, making investors who buy in at the right time deliciously rich. How rich, you ask? Well, if you had purchased 100 shares of Microsoft on the first day it began trading, you would now be sitting pretty on about $750,000! (Don't get too excited. Investors don't hit this kind of return often, but the possibility of it is what keeps the markets going.) [More: 6 Canadian dividend stocks for a cold market]
The second way to make money from a stock is through dividends. Dividends usually come in the form of cold, hard cash, which is deposited into investors' brokerage accounts, or even sent to them in the mail. Now that we have your attention, it's important to understand that dividends aren't a sure thing. Companies can - and do — cut their investors off. Nevertheless, dividend payouts tend to be more predictable than the market swings that can dictate a stock's appreciation, at least in the short term. Plus, dividends provide income, which often means you don't have to sell any shares to enjoy your spoils.
Why some companies pay
Not all companies pay dividends and there's a lot of banter in the investment community about whether they're a good thing. When companies pay a dividend, this is money they're not reinvesting into their own future growth and development. Opponents suggest that rather than lining investors' pockets, those dividend cheques could be helping the company become even more profitable. According to this line of reasoning, dividends can be a drag on a stock's appreciation.
On the other hand, many of the companies that pay dividends are large, established companies, such as banks, telecommunication and natural resource companies. This suggests that dividends are often paid by the investing world's version of a railway train: rugged, dependable and enduring. [More: 10 stocks with a fashionable edge]
Start-up companies, on the other hand, are the ever-evolving rocket ships: they travel further and faster, but also carry more risk.
Want an example of a company that exemplifies both? Let's consider Mr. Gates' baby again.
After years of explosive growth, Microsoft began paying a small dividend in 2003. So, while it took off as a high-flying growth stock, once it hit the moon, its prospects for continuing that kind of growth were grounded.
Throwing money around
According to die-hard dividend fans, having some money to throw around is actually a positive sign for companies; their generosity is a reflection of solid performance, and the company's belief in its ongoing profitability. Dividend investors also argue that they themselves can find better uses for that cash than a company could (hmmm...such as investing in other undervalued stocks or maybe back into the dividend-paying company anew).
The pros and cons of cold, hard cash
For investors, the main advantage to dividend-paying stocks is that they provide income in a way that other stocks cannot. And because they tend to be paid out by large, stable companies, they can often provide a relatively dependable return for investors who aren't keen on taking the wild ride that stock appreciation can provide. Furthermore, just because a stock pays a dividend doesn't mean it won't appreciate, affording dividend-stock investors the potential for double rewards. [More: Buying stocks: Is it time to get greedy? Why contrarian investors see opportunity amongst chaos]
And that's not all ...
For Canadian investors, dividends from eligible Canadian stocks also provide one additional perk: the Dividend Tax Credit. This credit treats dividend income more favourably than other forms of investment income. It may not sound like a sexy way to boost your returns, but then neither is turning part of your payout over to the government.
Dividends: Do or don't?
Investors should choose dividend stocks just like any other stocks — based on the profitability and future potential of the company. After all, a dividend on a losing stock will be little more than a consolation prize.
And while the standard payouts on dividends aren't as exhilarating as finding a high-flying stock, the truth is that sexy sometimes sneaks up on you. Stock appreciation may be the drama queen of the stock market, but dividends have been methodically boosting overall market returns by about 50 percent over the past 50 years. There's something seriously seductive about that. [More: 6 ways to reduce risk in your portfolio]
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