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How do dividends affect my portfolio?
Category: Financial Planning
Theoretically, whether a company pays a dividend or not should have no bearing on their stock value or the value of your portfolio if you’ve invested in that company. But reality is a far cry from theory.
Dividends can be an integral component of your investment portfolio and understanding what dividends are and how to use them to your advantage can pay off in the long run.
What is a dividend?
A dividend is a distribution of a company’s retained earnings to its shareholders. Dividends are typically paid by large, mature, profitable companies with steady cash flows that do not require all of their cash reserves for ongoing operations. The consistent payment of a dividend by a company is a signal of strength and indicates to the market that the company’s board of directors is confident in the company’s position within its market. Many investors seek dividends, especially older investors that are seeking an income stream.
While most dividend payments are in the form of cash, dividends can technically be paid in a multitude of ways such as stock dividends or distributions of other assets that have measurable value. For the purposes of this article we are limiting the discussion to cash dividends.
What effect do dividends have on my portfolio?
If your investment goals are to seek ultra-growth, dividends may play only a small role in your portfolio. Start-up companies, new tech companies and biotech companies, which are often associated with aggressive growth portfolios are less likely to be dividend paying companies as their boards would favor retaining the company profits to fund their rapid growth. If your investment goals are more conservative, i.e. if you are close to or in retirement, then dividends can play a major part in your investment strategy.
For example, have a look at the following comparison. An investment in the S&P TSX (Canada’s largest stock index) over a 10-year period from 2006 through 2015 without dividends would have achieved roughly a 15% total return on investment. The same investment with dividends (reinvested) would have achieved roughly 54%. So as you can see, dividends can be a major contributing factor to your investment success.
What are the other benefits of dividends?
There are several. To start there are tax benefits. In a non-registered account, dividends from Canadian public companies receive preferential tax treatment to other forms of investment income such as rents, royalties, or interest. These tax benefits can be great especially to retirees who otherwise would not have much in the form of employment income to begin with. Dividends also provide investors with cash-flows without the need to trigger sales of stocks. If you require cash flows from your investment portfolio to fund your lifestyle, then selecting a portfolio that pays a steady stream of dividends can help you achieve that goal.
But are there downsides? Yes of course. For starters there is no preferential tax treatment to Canadian dividends if held within an RRSP, TFSA or other similar tax-free account. The gains will accrue like any other investment income. Second, dividends from foreign jurisdictions such as the United States or Europe will be treated in the same manner as interest from a tax perspective thereby eliminating any potential tax benefit. Third, dividends are paid only on equity investments (common shares, preferred shares or similar securities). Equity investments inherently fluctuate in value more often and in greater proportion than fixed-income securities such as corporate bonds. Some investors may not wish to have such fluctuations involved with their portfolios.
Dividends can be a great consideration for your investment portfolio but care must be taken to ensure dividend paying securities are properly placed among your various accounts and serve the purpose you wish to achieve.
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