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3 Reasons Dividends Rule

Successful investing is about what you keep, more than what you make, and this year's new dividend tax laws made it much easier for investors to make more money where it counts: after taxes. Long-term capital gains tax rates have also fallen, from 20% to 15%, but to lock in that "benefit" you need to sell stock. Investors in great companies at good prices rarely want to sell, so that leaves the dividend tax break as the most immediate and perhaps most relevant new tax benefit staring investors in the face.

Several other positives sweeten the pot for dividend investors and, combined, they all cry out: "Why doesn't your portfolio have a greater focus on high-yield, high-quality stocks?"

Here are three reasons why you should improve your portfolio with some strong dividend payers.

  • Dividend-paying stocks outperform nonpayers

The common notion is small companies provide the greatest total return over decades, but on average and in head-to-head combat, it's actually dividend-paying companies that outperform nonpayers (most of which are smaller). Since 1970, dividend-paying stocks have returned 1.4% monthly compared to just 0.9% for non-paying companies, and this 0.5% monthly difference sure adds up.

Over the last 75 years, dividends accounted for a whale-sized 40% of the S&P 500's total return, and over more than a few decades, only dividend receivers saw any return at all. Naturally, 2000 to 2002 was a three-year period where this held true.

But dividends don't only provide greater returns in poor markets; they also play a large role in the strongest markets. During the bull market of the '90s, dividends were still responsible for 20% of the market's total return, and dividend-paying stocks kept pace with their nonpaying counterparts.

  • Dividend payments grow annually at many companies, becoming an ever-increasing stream of income for long-term investors

The most powerful aspect of dividends is the propensity of good companies to increase the dividend every year. When you buy a growing company that yields 3%, you're not just locking in a 3% annual yield. If the company increases the dividend 12% annually, then within seven years you'll have an effective yield of 6% on your original cost basis. In seven more years, you'll be yielding 12% on your original investment each year.

This math gets lost on most investors, because it doesn't readily show up in a stock quote. The stock may keep rising over those years and the quote will still say it yields just 3%. But longtime shareholders could be yielding 6%, 12%, 50%, or more of their initial investment through the annual dividend, assuming they own the stock long enough and the dividend payment increases each year.

According to Standard & Poor's, so far this year the average dividend-paying company has increased its dividend by 18%, and companies such as Johnson & Johnson (NYSE: JNJ  ) , General Electric (NYSE: GE  ) , and dozens of others have made a habit of double-digit yearly increases for decades. In addition, when you reinvest these growing dividends in more stock, your returns can compound all the more.

  • Dividends provide stability and can aid management decisions

Although this isn't as exciting as making more and more money each year via increasing dividends, it's still notable that dividend-paying stocks are responsible for only about 10% of the stock market's total volatility, meaning these stocks are much more stable than non-payers.

This is logical. A dividend yield usually helps put a price floor beneath a stock. If shares of a half-decent company decline to the point where its yield goes from 3% to 5% (something like BellSouth (NYSE: BLS  ) , it's very likely that investors will come flocking for the higher yield -- and probably they'd start coming at 4%, too.

Finally, dividends can make for more prudent management decisions. When managers know they must pay 30% of free cash flow to shareholders in a dividend, and increase the dividend annually each year or face disappointment, they're likely to make smarter and more deliberate decisions about the business, whatever the question: Should they launch a new product, or enter a new market? Make an acquisition? Whatever they do, they still need to pay the dividend (or face a falling stock), so they better make good decisions.

Don't miss the dividend train
Dividend-paying companies outperform nonpayers, and in a less-than-soaring market (which may be our market for the next several years), dividends become even more important. Also, dividends at good companies typically increase annually.

Pfizer (NYSE: PFE  ) yields 2%. If the dividend is increased 12% annually, within seven years your effective yield on shares bought now will be 4%. Seven more years, and it's 8%.

Finally, alongside regular income, dividends provide stability to a portfolio and can even improve management decisions, resulting in higher long-term price appreciation.

These benefits and many others are the heart of the new Motley Fool Income Investor, in the pages of which Mathew Emmert provides two strong dividend-paying investment ideas each month. And with the first issue, subscribers receive a special report detailing seven investments paying at least a 7% yield (7 Paying 7, it's called -- you can see those opportunities with a free trial).

Consider dividends today. Years from now, you'll be glad you did.

Jeff Fischer once managed the Motley Fool's Drip Portfolio, which focused on dividend reinvestment plans, and he owns several dividend-paying stocks, including J&J, Pfizer, Mellon Financial, and others.The Fool has a disclosurepolicy.

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Jeff Fischer

Jeff Fischer (TMFFischer) is advisor at Motley Fool Pro and co-advisor at Motley Fool Options.

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