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Dividend Stocks Explained

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  • Dividend Stocks Explained

    In 1934, Benjamin Graham and David Dodd wrote in their classic "Security Analysis," "The prime purpose of a business corporation is to pay dividends to its owners." It was common thinking that the possibility of stock price increases was speculative, so the main reason to own stocks was to partake in a steady flow of dividends.

    But 66 years later, at the end of the 18-year bull market of 1982 to 2000, many investors had almost no interest in dividends. The incredible rise in share prices during that long bull run dwarfed dividends' contribution to total returns. Nobody would seriously say that the prime purpose of owning shares was to get dividends.

    As we all know, that bull turned into a bubble, and the bubble burst over the three years from 2000 to 2002. When the dam gave way, it ruined the retirement plans of thousands of people, and it sobered up many investors.

    Since 2002, there has been a rekindling in appreciation for dividends and dividend-paying stocks. Investors realize that a dividend stock portfolio can lower risk, grow principal, and steadily increase income over time.

    With good dividend-paying stocks, you can actually have both growth and income. Dividends are stocks' secret weapon. Studies show that dividends have accounted for nearly half--or more--of the total return of the stock market over very long terms.

    That may surprise you, considering how little publicity dividends get. There is no widely reported dividend index that receives the attention bestowed every day on the Dow, the S&P 500, and the NASDAQ indexes.

    But all of those indexes reflect price changes only. As such, they give a very incomplete picture of "how stocks are doing." No wonder dividends pass under so many investors' radar.

    Common misperceptions are that dividend stocks are--

    --slow-growing and boring;

    --an indication that a company cannot think of anything better to do with the money; and

    --good only for retirees needing income.

    These notions are all incorrect. The fact is, dividend-paying stocks are attractive as a core investment for anybody, of any age.

    In fact, dividend stocks may just be the best investment that anyone can own. Here are seven reasons why:

    1. Dividend stocks offer a good total return. Remember, total return is the real target, not merely price appreciation. Total return = price appreciation + dividends.

    2. Dividends are lightly taxed. The current maximum Federal tax rate on dividends is 15%.

    3. Dividend practices tend to persist. Dividend-paying companies are usually solid and well established. The best of them cut their dividends seldom and raise them often. Dividend increases often come at a much faster pace than many people ever experience salary increases. (See #5 below.)

    4. You do not have to sell the stock to get the dividend. It is simply sent to you. You can do with it whatever you like: re-invest it, save it, or spend it. (See #7 below.)

    5. Unlike bonds, dividend yields can rise over time. And the best dividend stocks do just that. According to Morningstar, stocks in the S&P 500 have been raising their dividends an average of 17% annually over the past three years. No bond does that, and neither does your local bank.

    6. Also unlike bonds, your principal can increase over time if it is invested in stocks. Bonds are "fixed" investments: At the end of the bond's term, you get back your original inflation-ravaged dollars. Stocks, on the other hand, are historically the only asset class that outstrips inflation.

    7. You can do anything you like with your dividends. Those dollars are not "trapped" inside the ownership of the stock's share. If you are young, you can re-invest them, perhaps in the same company, to build your wealth faster. This brings the "miracle of compounding" into play. If you are a retiree, you can spend the dollars as month-to-month income. Or anyone can do anything in between: re-invest some and spend the rest, etc.

    Owning dividend stocks is exciting, rewarding, and fun. Most investors--of any age or stage in life--would be wise to have a significant portion of their investments in dividend-paying stocks.

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