Dividend Basics for New Investors
“Price is what you pay. Value is what you get.” –Warren Buffet
Warren Buffet, one of the greatest investors of our time, is a huge fan of dividends. At its core, a dividend stock is simply a stock that pays out a cash dividend, typically on a quarterly basis. To truly understand what this means and why you should purchase a dividend paying stock versus a non-dividend paying stock is the more important question. The definition of a dividend, according to Investopedia, is “a distribution of a portion of a company’s earnings.” Practically speaking, a dividend is a way that a company shows appreciation for its shareholders by giving them something in return — typically cash.
When analysts discuss stocks, there are generally two types that are mentioned: growth and value. A growth stock is an up-and-comer, a little known company that could take off, like buying Apple or Home Depot in the early 1990s. Nowadays, both of these companies pay a dividend (and are more in the value category). A value stock is one where you generally will not see huge gains in the stock’s value but is either underpriced or has some other way of returning on your investment.
Price and Value
Back to Buffet and his quote. When you buy a stock, the reason for it is to make money. Whatever price you pay for that stock will not change. The value, however, can change. The market is very volatile and dividends can be the easiest way to steadily predict that value. If you never sell a stock, then the price of that stock matters little. The cash dividend, however, matters greatly, as that will define your eventual return. If you hold a dividend stock for ten years, and that stock consistently pays out 2.5% of the price you initially paid, you’ve already earned back 25% of your investment. As dividends are normally declared in actual cash values by the companies offering them the percentage of the stock price (known as the “yield”) matters little to the investor once the stock has been purchased.
A dividend fund, however, works differently. Whereas the actual cash paid out year after year is more important for the individual dividend stock picker, with a fund the yield becomes crucial. A divided fund is a mutual fund based around the same concept of creating value through quarterly cash returns, and will therefore invest most of its money in dividend stocks. However, an actively managed mutual fund is much more likely to make constant changes to its portfolio, buying and selling specific stocks in order to constantly be increasing the fund’s total yield as a percentage of its price.
To choose a dividend stock versus a dividend fund is a matter of personal preference and tools like this robo comparison chart can better help you in defining your needs and outlook as an investor. For some investors, the ability to choose their own stocks and hold onto them for long periods of time (ten years or more) with a predictable return or even as a source of passive income is crucial. Others may prefer to use dividends to try and obtain the highest yield percentage year after year or as a diversification method and cannot or will not choose the stocks themselves. For these investors, a dividend fund makes a lot more sense.