The Motley Fool

Dividends And Why They Are Important In Investing

Investors, for the most part, have a tendency to focus on capital gains rather than dividends. In my view, this preference stems from the mistaken notion that returns from investing should come primarily from changes in share prices, rather than in income generated from the underlying business. It is true that long-term growth in businesses can produce an overall higher share price as the price reflects the improved fundamentals of the business.

But we should not neglect the impact of dividends on total returns. We shall see why in the sections below.

Let us first look at what dividends are. Dividends are a sum of money paid out by a company to its shareholders out of its profits or financial reserves. They are a discretionary (voluntary) form of payment, meaning that the company is not legally obligated to pay out a dividend to shareholders. This is unlike interest payments (known as “coupons”) to be paid on debt taken up by the company, which are legal obligations to creditors. Putting this in perspective, this means that a shareholder would not be able to sue a company for not paying out dividends, as it is not a contractual obligation. However, the good news is that there are well-run and profitable companies that have a track record of consistently paying dividends and some will even increase them annually as the business grows!

So how attractive are dividends and how do they factor in the total returns for a stock?

Total return is defined as the capital gain (i.e. increase in share price) of a stock plus its dividend. According to this study, dividends have contributed to 82% of the total return for the US-based S&P Index since 1960. From my personal experience in investing in the Singapore stock market for over a decade, dividends have contributed more than 50% of the total returns for my portfolio. So, in my case, a significant part of my total portfolio returns consist of dividends received and compounded over the years.

Dividends represent a cash return from owning a business and is the main source of cash flow which an investor relies on unless he sells away his shares. The cash received can be reinvested in shares of other good companies which also pay dividends over time, thus the investor would be making use of dividends to generate even more dividends.

It is said that Albert Einstein once remarked that compound interest was the eighth wonder of the world, and there can be no better way to compound one’s wealth than through the consistent reinvestment of dividends over the long-term.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.