At first glance, dividends may not seem so important when it comes to generating wealth from the stock market. As such, many novice investors ignore dividends completely and, instead, invest in speculative growth stocks, in an attempt to get rich quickly.
However, when you dig a little deeper into how dividends actually work, it becomes apparent that they’re actually quite a powerful force in investing. Here’s a look at three key reasons I believe it’s important to have some exposure to stocks that pay dividends in your portfolio.
For starters, dividends provide investors with a passive income stream – the ‘holy grail’ of personal finance.
When you invest in dividend stocks, you’ll pocket cash payments on a regular basis, and you can do whatever you want with them. Pay your bills, take a holiday, buy a luxury watch, or simply reinvest them. The choice is yours. Build up a large enough portfolio of dividend stocks, and you could potentially live off your income stream alone. The key point here is that dividends can provide a great deal of financial freedom.
In contrast, growth investors can’t spend unrealised capital gains, can they?
This brings me to another point. Investing with a focus on dividends tends to take a great deal of the hassle out of investing.
While the traditional ‘buy low, sell high’ idea of growth investing sounds easy, in reality, it’s often not. Growth investors are constantly stressing about when to sell to lock in their gains, and when share prices fall, they panic because their gains have disappeared. In other words, growth investing tends to require a lot of work on behalf of the investor to ensure that profits are locked in.
However, with dividend investing, investors don’t need to worry as much about when to sell, as it’s more of a long-term approach to investing. Dividend investors can simply kick back and relax, knowing that they’ll receive regular cash payments into their account for doing absolutely nothing. In this approach to investing, the focus is more about being a long-term business owner, and getting paid as an owner on a regular basis.
Another benefit of this approach is that it can help investors stick to their long-term investment strategies. Short-term share price movements become a lot less relevant when your focus is on building a portfolio that constantly churns out dividends payments. As a result, dividend investors often tend to stay calmer than growth investors during market volatility, because lower share prices (and higher yields) become an opportunity, instead of a risk.
A large chunk of total returns
Finally, another key point is that dividends actually tend to make up a significant proportion of the total returns generated from the stock market. Indeed, some studies have calculated that over the long term, reinvested dividends can make up around 70-80% of total returns.
This won’t be the case at all times, and there will be times when growth stocks power ahead and generate the bulk of gains for investors (look at the US market in recent years). However, over the long run, dividends do tend to make up a significant proportion of total stock market returns, especially during bear markets. As a result, they shouldn’t be ignored, in my view.
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