After investing in stocks for some time, I have come to a conclusion that I will only pick stocks which pay out dividends of at least 3%. Anything below that, you risk getting negative returns due to inflation. If you read my earlier post, I have discussed various Strategies for Stock Investment. Now I will elaborate more on why we should only invest in Stocks which pay consistent Dividends.

Returns Right Now

As the saying goes, a bird in hand is worth two in the bush, it is better to earn the income from dividend yield first than to wait for the price to go up. Either Growth or Value Investing both requires the price of the Stock to rise for you to receive gains. The trick is the 3 strategies are not mutually exclusive. A dividend paying stock could also be a Value Buy or Growth Stock. Why not look for an undervalued stock which also pays Dividends? Wouldn’t it be better to make money first while waiting for the price to appreciate? In fact, a Value Buy probably means the Dividend Stock is also trading at a high Dividend Yield. When we look at the Growth story, other than the rising revenues and profits, we also look at the potential growth of the dividends.

Long Term Income Stream

Buying a stock for its Dividend Payments also ensures a long term stream of income. Since you do not have to sell the Stock, the money making engine continues to make money for you as long as you stay invested. This of course is the most important, since our goal is to build Passive Income. Through compounding as explained below, we can also increase this income stream dramatically over time. Remember, Stocks are not static; they are organic organizations, as they grow, Dividends are also likely to be increased if the Company retains its pay-out ratio.





Compounding For Massive Growth

When you receive the Dividends in cash, you have the choice to either keep the cash or reinvest it. Certain companies also allow you to enrol into DRIPS, better known as Dividend Reinvestment Plans. DRIPS allow the Company to directly convert your dividends into more stocks normally at a discount to the current market price with no fees. It’s one of the best ways to maximize returns in a strong Company. Let’s say you buy a $10,000 worth of Stocks which pay out 5% dividend, you will receive $500 in dividends this year. If you reinvested the $500, it makes another 5% which is $25, bringing dividends this year to $525.  You reinvest the $525, which brings total dividends to $551.25. Simply put, you make more dividends on the dividends received, compounding and growing your value exponentially. Assuming all factors remaining constant, by year 20, you would be making about $1,200 in dividends a year versus $500 if you haven’t reinvested. By year 26, you would made 256% returns, almost double of 130% returns if you did not reinvest. That’s a pretty good return considering that you only invested $10,000 at the start and nothing else after!

Dividends Reinvested Yearly (Compound Interest)

Dividends Compounded YearlyDividends Not Reinvested (Simple Interest)

Dividends Not Compounded




True Measure of Performance

The standard measures of performance such as revenue and earnings can be manipulated and even faked. In the recent accounting scandals, many listed Chinese firms were thought to be overstating profits and even their cash balance! Dividends however, are real; once they are given out, its cold hard cash coming right into your pockets. Either they have it or they don’t. Companies which are not doing well will not be able to pay out good dividends year after year if they were not making good money. They would either have to pay Dividends out of dwindling cash balances or raise debt to finance the Dividend, neither of which is sustainable in the long run.

Unaffected By Short Term Volatility

Unfortunately, due to the way the market has transitioned, most people are almost entirely focused on short term price performance of the Stocks. The Stock exchange, the brokerage and your brokers make money by the number of transactions you make rather than on the returns you derive from the stock. Analysts are also focused on predicting near term figures and price targets to invoke reactions in investors to buy and sell unnecessarily. The result is an extremely volatile market which is driven by market rumours, breaking news, analyst reports which have no bearing on how much dividend you are receiving. The good thing is that you simply do not have to be too bothered by the price volatility, it’s something you learn to not take too seriously, while receiving your checks regularly.

With all those factors discussed above, I hope that you too will focus only on Dividend Stocks. If the market as a whole can place enough pressure on the Companies, we can force more Companies to increase Dividends rather than spend money on stock repurchases and unnecessary M & As.

 

For further reading, you may be interested in:

Dividend Basics

Dividend Stocks vs Gold

How to Pick a Top Dividend Company for Dividend Income Part 1