As fears of a possible recession intensify, investors looking for stable income may turn to stocks that pay quarterly dividends, which are part of the company’s profits returned to investors.
Historically, dividends have been a significant contributor to an asset’s overall return, sometimes providing growth during economic downturns.
According to a 2022 report, from 1973 to 2021, companies that paid dividends averaged a total annual return of 9.6%, outperforming 8.2% on the S&P 500 and eclipsing the return of non-dividend companies of 4.79. %. Hartford Funds research.
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Dividends are getting investor attention: As of the end of June, dividend funds have increased by $43 billion in 2022, according to research by SPDR Americas.
However, investors should carefully consider their choices before adding dividend payers to their portfolios.
“Sometimes people chase dividends and don’t understand the risks,” said Scott Bishop, certified financial planner, executive director of wealth solutions at Avidian Wealth Solutions in Houston.
Here’s what you need to know.
Why dividends are attractive in difficult economic times
“Companies that pay dividends typically have higher levels of free cash flow,” said Dave Sequera, Morningstar’s chief market strategist in the US. And they can be valued more modestly, he said.
“Both of those factors have definitely been attractive to investors this year as we see the economy softening, interest rates rising and inflation still rising,” Sequera said.
Dividend payers tend to be large, mature companies that provide products and services that are still needed during a recession, explained Kashif Ahmed, CFP and president of American Private Wealth in Bedford, Massachusetts.
“Nobody needs a Rolex every day, but we all need toilet paper,” he said.
Some companies, known as “dividend aristocrats”, have a history of dividend increases annually, even during previous recessions. And many companies have been slow to cut dividends, providing some investors with a solid cash flow.
Be Critical in the Pursuit of High Dividend Yields
While a higher dividend payout may be attractive during a stable or declining market, it is important to evaluate what you are buying before adding new assets to your portfolio. As Bishop pointed out, there can be risks.
A company’s dividend yield consists of two parts: the annual dividend per share and the current share price, Bishop explained. If the dividend yield is much higher than similar companies, the share price may have dropped due to various reasons.
“You shouldn’t just look at dividend yields,” Bishop said, explaining why it’s important to understand a company’s financial performance.
And for those who don’t want to analyze every company, dividend-paying funds can offer more diversification than individual stocks.
Whether you’re earning income from stocks or bonds, you need to be strategic about which account you use to hold those assets, Ahmed explained, especially if you’re an investor in a higher tax bracket.
As a general rule, it’s best to keep income-producing assets such as dividend-paying stocks. Mutual funds with annual payments or bond coupons in tax-friendly accounts like a 401(k) or an individual retirement account, he says. Otherwise, you may be subject to annual capital gains taxes.