When you're looking for compelling candidates for your investment portfolio, it's hard to find a better category of stocks than dividend payers. Dividend stocks aren't just for retirees and income junkies; investors young and old, savvy and inexperienced, are making them a major part of their portfolios.
If you have yet to see the light, then here are nine reasons that dividend stocks are smart investments.
1. The promise of cash
First off, dividends are promised money. They're not quite guaranteed -- because on rare occasions, the company promising them may run into trouble and not be able to pay -- but the majority of dividend payers keep their promises to shareholders, paying set sums at regular intervals. (Dividends are typically paid quarterly, but some dividend stocks pay them monthly, some every six months, and some once a year.)
2. Pay in any environment
Another delightful feature of dividends is that when they're being paid by a healthy, growing company, you can count on them to come through in any economic environment. Even if the stock market dives or stalls for a few years and most of your holdings have lost ground, your dividend-paying companies will still be sending you regular infusions of cash. That can serve as a welcome ballast in stormy markets.
3. Dividends grow
As happy as you may be with that sum of money you receive each year from dividends, you have reason to be even happier: Dividends are generally increased over time. As long as the underlying company's earnings are growing, then it will be able to pay out bigger sums to its shareholders.
Dividend growth is an important consideration when you're choosing dividend stocks. If Company A's dividend is yielding just 2% and Company B's is yielding 3%, then Company A's dividend may still be more compelling if it's growing at a much faster rate. In that case, Company A will soon be paying out more than Company B.
Also keep in mind the concept of "effective yield," which reflects the yield you're currently receiving based on your original investment amount. For example, if a stock is currently trading at $100 per share and paying out $4 per year in dividends, then it's yielding 4% for those who buy now. But if you bought your shares years ago, when the stock was trading for only $50 per share, then your effective yield is a solid 8%.
4. Dividend payers outperform
Another advantage of dividend stocks is that they don't just reward you with cash payments that tend to grow over time. They also tend to outperform other stocks in terms of capital appreciation. According to Ned Davis Research, from 1972 through early 2016, dividend-paying stocks averaged an annual gain of 8.8% versus just 2.2% for non-dividend-payers. Indeed, from 1930 through 2014, dividends accounted for about 40% of the 10.3% average annual return of the S&P 500.
5. More stable companies
Here's one more reason why dividend stocks are smart investments: They tend to be companies that are more stable and reliable than others. After all, management has had to feel confident enough in the company's future earnings to be comfortable committing to a certain regular payout to shareholders. Dividend stocks often belong to established, proven companies with a track record of earnings -- generally not to companies growing rapidly and plowing every available dollar into furthering that growth.
6. Low tax rate
Taxes are another consideration. If you're generating interest income from bonds, there's a good chance it's being taxed at ordinary income tax rates. Most dividends, though, currently get more favorable tax treatment. If you're an average investor, you might be in the 25% or 28% tax bracket, but you'll only have to pay 15% in taxes on your dividend income. If you're a high earner, you'll face a 20% tax rate -- still quite preferable to your income tax rates. (Of course, tax laws do change from time to time, and this advantage might be gone one day.)
7. You can reinvest for more gains
For more powerful wealth-building, you can reinvest your dividends in the same stocks that generated them. One way to reinvest dividends is through a dividend reinvestment plan, commonly known as a DRIP. These are maintained by hundreds of major companies, and they allow investors to have their dividends automatically reinvested in further shares (or partial shares). This can require a lot of record-keeping for tax purposes, but it's a particularly effective way for those of limited means to build wealth -- and the wealthy can profit from them, too. Many brokerages will also reinvest your company's dividends for you at no charge.
To appreciate the power of reinvested dividends, note that had you invested in the S&P 500 in May, 1996, your investment would have appreciated by an annual average of roughly 5.9% over the next 20 years. If you had reinvested all the dividends you received, though, your average annual gain would have been about 7.8%!
8. Support in retirement
Finally, think of your retirement, because dividends can be especially handy there. Remember that the average annual Social Security retirement benefit is about $16,000 per year -- hardly enough to support most of us. But if you have a portfolio of about $400,000 invested in dividend stocks with an average yield of 4%, then you can look forward to another $16,000 per year -- with the expectation that that sum will grow from year to year as well.
It's hard to beat solid dividend stocks. They have the power to boost your wealth considerably over time.