In this article we’ll explain why dividends are an investor’s best friend.
We’ll start by going over what is the definition of dividends, how dividends works, why dividends are important and how safe dividends really are. We’ll then dive into the details of why companies issue dividends, how much dividends is enough, and wow are dividends taxed? Let’s get started!
What is a dividend?
Dividends are a stock investor’s best friends.
In short, a dividend is money paid out to you when you own a stock. Here’s how it works: You buy a stock, you wait, and you receive money. Pretty great right?
Dividends come from a company’s profits. When a company has extra cash sitting around at the end of the year, it has three options:
(i) The company can keep the cash and use it to hire more staff, buy better equipment, or pay for advertisements. This is called reinvesting profits;
(ii) The company can use the cash to buy other companies. This is called an acquisition;
(iii) The company can use the cash to pay-out shareholders. This is called a dividend.
Why are dividends important?
Over the long term, dividends will represent the bulk of your investment gains.
You see, dividends are a sure thing. It is money that is deposited directly in your bank account.
In contrast, an increase in stock price can be wiped-out in a stock market crash. Sometimes companies make bad deals and end-up paying too much in a take-over. At other times, a CEO may make a series of bad decisions which will leave the company burning through cash instead of giving it back to shareholders.
Who pays the price for a CEO’s failure? The shareholders (you!)
Dividends are one of the only sure ways to count your investment gains. Everything else can be taken away from you.
The best part? In general, companies raise their dividend every year, so you’ll get richer every single year!
Why do companies issue dividends?
Not every company issues dividends. Some companies believe they can use the profits well and choose to reinvest it in the business.
Companies issue dividends for one sole reason: to reward their shareholders.
When a company pays a dividend, shareholders benefit both directly and indirectly:
(i) Directly because shareholders receive money straight to their bank account and;
(ii) Indirectly because a generous dividend may attract more investors. This will create a higher demand for the stock. As more people will want to buy the stock that pays high dividend, the price of the stock should increase, and shareholders will reap the benefits of a higher share price (also referred to as capital gain)
How safe are dividends?
The safety and consistency of the dividend is largely a result of the quality of the company that pays it out.
Not every dividend is created equal. Some come from safe, established, well-managed companies that will continue paying a dividend for years. Others come from risky companies with large amount of debts, declining profits, and a failing business model.
It may now get a bit technical but here goes: the safety of the dividend is correlated with the company’s pay-out ratio. The pay-out ratio is the percentage of profits paid out to shareholders in the form of dividends.
As a general rule, a company with a low pay-out ratio (e.g. Apple with its 20% payout ratio) is more likely to continue paying its dividend over the long term. That is because, the company is only paying out 20% of its profits and keeping the rest. In this case, even if the company has a bad year and its profits and cut in half, it will still have enough to pay a dividend.
In contrast, companies that have high pay-out ratios (e.g. oil companies) do not have a large financial cushion to soften any financial loss. This is what happened in 2020 when the price of oil plummeted and renowned oil companies like British Petroleum or Royal Dutch Shell had to drastically cut their dividends in order to avoid bankruptcy.
How much dividend is enough?
This is where investor profiles come into play. There are two main strategies out there:
(i) high-yield dividend strategy – This is where an investor picks stocks mainly for their high dividends. The hope is that these high dividends will provide sufficient passive income to live on. This strategy entails high risk and doesn’t perform well over the long term.
(ii) dividend-growth strategy – This is where an investor picks stocks for their ability to grow their dividends over the long term. In general, these stocks (e.g. Unilever, Johnson & Johnson) pay much lower dividends than others, but consistently raises their dividend every year. These companies are often referred to as Dividend Aristocrats.
There is no good answer to how much dividend is enough but one thing is certain: buying stocks just for their high dividend is a losing strategy.
The dividend trap
It may be tempting to buy a stock that pays a high dividend but doing so seldom pays-off. This is because of the dividend trap.
Companies know that investors like dividends, and so its only natural that they try to increase their dividends to attract investors. However some companies, especially those that are failing, are trying to exploit this.
Failing companies often try to offer a high dividend (e.g. 8-10%) in a desperate effort to attract investors. These companies know that a 10% dividend may lure amateur investors but this is a trap:
You see, if a company is offering an 8% dividend, it probably doesn’t have much money left to grow its business. These companies would have a very high payout ratio that simply isn’t sustainable in the event of a crisis. (in short, they’re paying out each cent of profit).
In short: Stay away from high-yield dividends.
Think of it this way: if this stock was such a good deal, why isn’t everyone buying it? If people did buy the stock, its share price would increase and, consequently, its dividend yield would decrease.
There is no free lunch in investing, and dividends are no different.
How are dividends taxed?
This will depend on which country you’re living in.
At the time of writing, you can expect dividends to be taxed at 20% in the USA or Japan, 25% in Germany, 30% in France. This obviously drags down performance over the long term.
However there are two ways this mitigate this drain:
(i) Choosing to be taxed on income – Sometimes the income tax rate is lower than the tax rate on dividends, and some countries allow you to choose how you wish you file dividend income. If you’re looking to retire off your dividend income, it may make sense to research your country’s tax rate further.
(ii) Investing through an ETF – ETFs are great, they’re highly versatile and super easy to use. Most ETFs or index funds will give you the ability to choose whether you want dividends to be distributed to you, or automatically reinvested. The latter is preferable and here’s why: Each time you receive a dividend, you pay tax, sometimes even without knowing it (e.g. foreign dividends may be withheld by the host country automatically). However, if you choose an ETF or index fund which reinvests your dividends automatically, you won’t have to pay tax as you aren’t directly receiving it.
Make no mistake: you’ll still end up paying tax when you sell part of your ETF or index fund, but until then you can enjoy your dividends reinvested at pre-tax levels!
Beware of foreign dividends
International diversification is great and highly encouraged for all investors. However there is one thing to bear in mind if you’re buying a foreign stock for its dividend: foreign taxes.
You see, governments don’t quite like it when foreigners snatch up local dividends but don’t pay local taxes. To address this, most countries have created dividend withholding taxes.
This means that a foreign government will withhold a percentage of your dividend before it even reaches your wallet. This can drastically reduce future earnings. For example: were you expected a nice and stable 4% dividend from a French healthcare stock? Well this dividend may dwindle down to 2.8% after tax.
What’s worse is that the dividend is withheld automatically with no option to opt out. The only thing you could do is to file a tax return at the end of the year and hope that your home country has a double taxation agreement with the country of your foreign stock. If so, you may be eligible for a tax break in your home country. If not, you may have to pay tax in your home country too. That’s double the tax!
The next time you feel like investing in Addidas (Germany), Louis Vuitton (France), or Sony (Japan), don’t forget to come back to our table below to check how much dividend withholding tax you may have to pay.
Dividend withholding tax per country
Country | Withholding tax |
UK | 0 % |
USA | 15 % |
Spain | 19 % |
Japan | 20.42 % |
Germany | 26.37 % |
France | 28 % |
Australia | 30 % |
Disclaimer: This table is updated on a best-effort basis but, with laws and international tax treaties changing all the time, it is possible that this table is out-of-date at the time of reading. Make sure to always do your research before investing!
Should I own dividend stocks?
This depends on your profile!
Some investors appreciate the added peace of mind of receiving a periodical dividend straight into your bank account. This makes for easy passive income that can complement your existing income. A stable dividend can also help you sleep better at night during stock market crash as you know your dividend is real and tangible.
Some make an entire strategy out of it by focusing only on dividend aristocrats. The hope is that reinvesting the dividends will help grow their total investments and that, one day, they will be able to live-off solely from dividends.
Others avoid dividends all together. This is typically done by growth investors who favor smaller companies that pay little to no dividend and instead reinvests their profits straight into the business for higher growth. Growth companies tend to rise quickly but also crash pretty hard.
As for myself, the vast majority of my portfolio is held through index funds that automatically reinvests dividends. While I do not physically see a dividend deposited in my account every month, I sleep well knowing that they are still there, simply automatically reinvested. This helps lower both taxes and transaction cost, both of which can drag on performance over the long term.
Summary
Dividends are an investor’s best friends. They ensure the returns on your investment is real and tangible. Some like dividends just for the added peace of mind of receiving a periodical dividend straight to your bank account. This makes for easy passive income.
Over the long term, dividends are going to be one of the biggest factor in your stock market performance however there’s a few things to keep in mind:
1. Beware of high-yield dividends;
2. Dividends are never guaranteed;
3. Dividends aren’t optimal as you’re paying tax each time you receive them.
For optimal long-term performance, consider owning stocks through an index funds that automatically reinvest dividends. You can learn how through our mini-guide on how to get started with index funds.