With increased fears of a possible recession, investors seeking steady income may turn to stocks paying quarterly dividends, which are part of company profits sent back to investors.
Historically, dividends have significantly contributed to an asset's total return, sometimes providing a boost during economic downturns.
From 1973 to 2021, companies paying dividends earned a 9.6% total annual return, on average, beating 8.2% from the S&P 500 Index, and eclipsing the 4.79% yield from non-dividend payers, according to a 2022 Hartford Funds study.
Still, investors need to scrutinize their picks before adding dividend payers into their portfolios.
"People sometimes chase dividends, and they don't understand the risks," said certified financial planner Scott Bishop, executive director of wealth solutions at Avidian Wealth Solutions in Houston.
Why dividends are attractive in tough economic times
"Dividend-paying companies are typically going to have higher levels of free cash flow," said Dave Sekera, chief U.S. market strategist at Morningstar. And they may be valued more modestly, he said.
"Both of those have definitely been attractive for investors this year as we see the economy softening, interest rates rising and inflation still running hot," Sekera said.
Dividend payers tend to be large, mature companies, producing products and services still needed during a recession, explained Kashif Ahmed, a CFP and president at American Private Wealth in Bedford, Massachusetts.
"Nobody needs a Rolex every day, but we all need toilet paper," he said.
Some companies, known as the "dividend aristocrats," have a history of increasing dividends annually, even during previous recessions. And many companies are slow to cut dividends, providing some investors with reliable cash flow.
Be critical when chasing high dividend yields
While a higher dividend payout may be appealing during a flat or down market, it's important to assess what you're buying before adding new assets to your portfolio.As Bishop pointed out, there can be risks.
There are two parts to a company's dividend yield: the annual dividend per share and the current share price, Bishop explained. If the dividend yield is far above similar companies, the stock price may have dropped for various reasons.
People sometimes chase dividends, and they don’t understand the risks.
Scott Bishop
Executive director of wealth solutions of Avidian Wealth Solutions
"You shouldn't just look at dividend yield," Bishop said, explaining why it's essential to understand the financials of the company.
And for those unwilling to analyze each company, dividend-paying funds may offer more diversification than individual stocks.
Keep dividend payers in tax-friendly accounts
Whether you receive income from stocks or bonds, you'll need to be strategic with what kind of account you use to hold those assets, Ahmed explained, especially if you're an investor in a higher tax bracket.
Generally, it's better to keep income-producing assets, such as dividend-paying stocks, mutual funds with annual payouts or bond coupons, in tax-friendly accounts, like a 401(k) or individual retirement account, he said. Otherwise, you may owe yearly taxes on capital gains.
Dividends have investors' attention: Dividend funds have added $43 billion in 2022 as of late June, according to SPDR Americas research. Still, investors need to scrutinize their picks before adding dividend payers into their portfolios.
In some cases, a high dividend yield can indicate a company in distress. The yield is high because the company's shares have fallen in response to financial troubles. And the high yield may not last for much longer.
A dividend is a reward paid to the shareholders for their investment in a company's equity, and it usually originates from the company's net profits. For investors, dividends represent an asset, but for the company, they are shown as a liability.
JPMorgan Chase & Co.'s ( JPM ) dividend yield is 2.33%, which means that for every $100 invested in the company's stock, investors would receive $2.33 in dividends per year. JPMorgan Chase & Co.'s payout ratio is 26.98% which means that 26.98% of the company's earnings are paid out as dividends.
Dividends are payments a company makes to share profits with its stockholders. They're one of the ways investors can earn a regular return from investing in stocks. Dividends can be paid out in cash, or they can come in the form of additional shares. This type of dividend is known as a stock dividend.
9 In other words, dividends are not guaranteed and are subject to macroeconomic and company-specific risks. Another downside to dividend-paying stocks is that companies that pay dividends are not usually high-growth leaders.
Dividend capture can be an effective short-term trading strategy in certain markets, but it's not a plan to gain long-term wealth. Dividend harvesting can provide steady and reliable income without worrying too much about volatile market gyrations or confusing technical analysis.
Reduced Retained Earnings: Paying dividends reduces the amount of earnings retained by the company, which could otherwise be reinvested for growth or used to pay off debt.
Depending on the underlying stock and how long you've held it, you might be taxed federally at long-term capital gains rates (anywhere from 0% to 20%) or at ordinary income rates (between 10% and 37%). You also have no control as to when a dividend is paid, or if it's paid at all.
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