Few names in investing are as synonymous with stock market success as Warren Buffett. Through his company, Berkshire Hathaway (NYSE: BRK.B), Buffett has managed to amass a fortune of over $100 billion. The most impressive part, though, in my opinion, is just how relatively simple his investing strategies have been.
Buffett is the poster child for value investing and holding on to stocks for the long run, but he's also made a pretty penny focusing on specific types of stocks: Ones that pay dividends. Although Berkshire Hathaway itself doesn't pay dividends, most of the companies it owns a stake in do.
The one thing investors should have in common with Buffett is an appreciation for the power of dividends.
Buffett likes financial stability
Younger companies focused on high growth don't typically pay dividends because they need to reinvest all profits to keep growing at above-average rates. However, older, more established companies rely on dividends as a way to reward investors and make up for where they may lack in stock price appreciation.
It's a lot easier for a small-cap company with a $250 million market cap to double in size (and stock price) than a large company like Coca-Cola with a market cap of over $250 billion.
To get to a point where a company can comfortably pay dividends and consistently increase them, it must be financially stable and able to generate a good amount of free cash flow. That's largely why Buffett loves dividend stocks; they check off two of his main investment boxes.
You can't predict how a company's stock will perform, but if you're investing in companies with strong fundamentals and financial stability, you can expect your quarterly dividend to be there.
Reinvest your dividends when possible
Dividends can play a huge role in an investor's total returns, especially when reinvested. In fact, reinvested dividends accounted for 84% of the S&P 500's total return from 1960 to 2021. At the end of 2022, this number dropped to 69%, but it's still a huge chunk nonetheless.
A dividend reinvestment program (DRIP) is where your brokerage company takes dividends you're paid and automatically reinvests them into the stock that paid them. Instead of receiving quarterly cash payouts, you'll essentially receive additional shares.
DRIPs are good because they add to the effects of compound earnings, something Buffett has credited for his wealth creation.
Suppose two people invest $500 monthly into a fund that averages 8% annual returns and a 2% dividend yield over 20 years. Here's how investment values would compare with one person taking dividends as cash payouts and one reinvesting them:
| Reinvest Dividends? | Investment Value |
|---|---|
| No | $274,500 |
| Yes | $343,600 |
Data source: Author calculations / rounded to the nearest hundred.
The investor who received dividends as cash payouts would've made just over $38,000 over 20 years, but it's still far less than the roughly $69,000 difference in investment value.
I recommend reinvesting dividends until retirement to maximize your number of shares and then begin receiving them as cash payouts. It can serve as great supplemental income. Every $100,000 in dividend stocks is $2,000 in annual income with a 2% dividend yield.
In our above scenario, it's a difference between receiving around $5,400 and $6,800 annually in dividends, respectively.
Dividends are one piece of the puzzle
The power of dividend stocks is undeniable, and they can play a significant role in an investor's portfolio, but they shouldn't be the only stocks you invest in. Having a well-rounded stock portfolio means investing in companies of all sizes, industries, regions, and growth potential.
There are plenty of great companies that don't pay dividends and plenty of bad companies that do. You don't want to do yourself a disservice and use dividends as the sole criteria for investing in a stock. They should be one piece of the puzzle.
By incorporating dividend stocks as part of a broader, diversified portfolio, you can build a solid foundation that aligns with your risk tolerance and financial goals.
