Diversification is one of the key pillars in investing. Not only should you have diversification in industries or company size, but part of having a well-diversified portfolio also includes having stocks that pay out dividends. Younger companies don't usually pay out dividends because they need to reinvest the money back into the company to continue growing, but older, well-established companies typically pay out dividends to reward shareholders for holding onto the stock.
Here are four reasons why you need dividend stocks in your portfolio.
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1. They can provide sizable retirement income
If you're intentionally investing in dividend stocks, it can pay off huge in retirement as an additional source of income. With the ideal savings amount to retire comfortably consistently rising and Social Security paying out $1,666 on average monthly, it's become more important that people have multiple sources of retirement income. Building a good dividend-paying portfolio takes time, but it's well worth it.
If you were to accumulate $1 million in a fund -- which isn't as far-fetched as it may sound, thanks to compound interest -- with a 2.5% yield, that would pay out $25,000 annually. It would likely be paid out quarterly, but when budgeted right, that's over $2,000 monthly.
2. They can hedge against short-term volatility
Stock market volatility is inevitable. Short-term changes in the market shouldn't worry you if you're a long-term investor. It definitely shouldn't worry you if you're investing in great dividend-paying companies. With Dividend Aristocrats, which are S&P 500 companies that have increased their yearly dividend for at least 25 consecutive years, you can be confident that you will get your dividend payment, regardless of what's happening with the stock price or broader economy.
If a stock drops below the price you bought it, that's an unrealized loss -- it's only on paper. If it pays out dividends, an unrealized loss doesn't matter much because you're getting paid for holding onto the stock.
3. Payouts can be tax-free in a Roth IRA
Normally, when you purchase dividend stocks in your brokerage account, your dividends are taxed in one of two ways. If it's a qualified dividend, it'll either be taxed at 0%, 15%, or 20%, depending on your income and filing status. If it's a non-qualified dividend, it'll be taxed at your regular income tax rate.
The best benefit of a Roth IRA is the ability to take tax-free withdrawals in retirement, including dividend payments. Being able to have your investments grow without facing taxes can easily save you thousands per year, leaving you with more money to enjoy your retirement instead of paying Uncle Sam on the back end.
4. They tend to outperform non-dividend paying stocks in the long run
When you purchase a stock and sell it for a profit, it's considered a capital gain, but that's only one piece to the puzzle. The total return on investment also includes any money made from dividend payouts. Looking at the total returns of stocks shows that dividend-paying stocks typically outperform non-dividend-paying stocks in the long run. One study found that over a typical 25-year period including both bull and bear markets, stocks that didn't pay dividends returned around 4.2% annually, while dividend-paying stocks returned around 9.7%.
In fact, dividends tend to make up a good portion of total returns for many stocks. Since 1930, dividend income has accounted for 40% of the total return of the S&P 500 (an index that tracks the largest 500 publicly traded U.S. companies). Of course, past results don't guarantee anything about future results, but it shows just how important dividends have been to investors regarding their return on investment.
