Would you agree that a big reason to buy a business is so that it can provide you with regular income, in the form of a share of profits?
Now, what if you could buy a business that would pay you this regular cash, but you didn’t have to actually work in it?
As a bonus, you could sell your share of the business any time. It all sounds pretty good.
Those are some of the benefits you get when you purchase shares of a mature business that pays regular dividends on its shares. Dividends are the cash payments that the company has decided to pay, which represent a portion of the after-tax profits. Since the company has paid tax, you get a tax break on the dividends paid to you by Canadian corporations.
Such dividends are typically paid quarterly, can be received in cash to fund your retirement, or reinvested in more shares.
The downside, one must always remember, is that the share price will fluctuate, and will go down at times. So, owning such shares is not a replacement for the portion of your portfolio that is being held for short term use, or for the stability that everyone needs from a portion of your portfolio in guaranteed investments.
My thesis here is that you consider an emphasis on dividend-paying stocks, for the majority of the equity (ownership) portion of your portfolio. We have experienced a great five-year rise in the stock market, with some tremendous returns from growth companies, small-cap stocks and technology.
After a period like that, investors tend to start chasing returns, and moving away from mature companies that pay regular dividends. If we are at a market top, then it might not be the right time to make that change. Hence, this reminder.
Here are some of the reasons why I like dividend-paying stocks, and why we systematically seek out companies that we expect to increase their dividends in the future.
If you look back over any time frame of historical returns for major stock indices, you will see that a large component of the total return comes from the reinvestment of dividends.
Dividends also smooth out the returns. If a company is paying a 3.5% dividend in a year when the share price has declined 3.5% in line with a market decline, your dividend keeps you even. On the other hand, a “growth” stock with no dividend has no such buffer.
Inflation protected income
Many companies increase their dividends, and many of those have increased them at greater than the rate of inflation. So, for example, if you retire with $20,000 and dividend income from profitable companies with increasing dividends, that $20,000 is very likely to rise each year at a rate faster than inflation. That maintains your purchasing power.
In times of market strife, the dividends are what carry you through. For example, in 2008, when stock prices dropped significantly, almost all mature Canadian companies continued to pay their dividends.
So, accumulating a diversified portfolio of dividend-paying stocks of great businesses with growing profits may be a great approach for you to help build your base of retirement income.
It combines the benefits of regular, tax-advantaged income, a growing income stream, and the potential for capital growth that also exceeds inflation.
However, you have to be willing to ride out the ups and downs of stock prices. And, right now, we may be at an up, with markets nears all-time highs. While dividend-paying stocks have the buffer of the dividend, volatility is still a fact of life when you own shares.
For many people, that’s a reasonable price to pay.
The securities or sectors mentioned herein are not suitable for all types of investors. Please consult your investment advisor to verify whether the securities or sectors suit your investor profile, as well as to obtain complete information, including the main risk factors, regarding those securities or sectors.
* * *
Dollars and Sense is meant as an introduction to this topic and should not in any way be construed as a replacement for personalized professional advice.
Please consult legal, tax and investment experts for advice on your unique situation.
David Christianson, BA, CFP, R.F.P., TEP, CIMis a financial planner and advisor with Christianson Wealth Advisors, a Vice President with National Bank Financial Wealth Management, and author of the book Managing the Bull, A No-Nonsense Guide to Personal Finance.