What dividend stocks can offer

INVESTORS TEND TO FOLLOW the ups and downs of the stock market closely, watching — and hoping —for price gains. But many overlook another potential source of returns: the dividends that many companies can pay their shareholders.

Investors should always look at both price gains and dividend income when considering their total return, says Kirsten Cabacungan, an investment strategist in the Chief Investment Office for Merrill and Bank of America Private Bank. There are a couple of reasons that make dividend-paying stocks particularly useful. First, the income they provide can help investors meet liquidity needs. And second, dividend-focused investing has historically demonstrated the ability to help to lower volatility and buffer losses during market drawdowns.

Below, Cabacungan offers more insights into the role that dividend-paying stocks could play in your portfolio.

What exactly are dividends — and what kinds of companies offer them?

Dividends represent a payment by a company, typically made on a quarterly basis, to its shareholders from income generated by the business. “Generally, it’s larger, more mature companies that return capital to their shareholders in the form of dividends,” Cabacungan says. Smaller and growing companies tend to reinvest earnings back into their business. Dividends aren’t guaranteed, however. For instance, some dividend-paying companies temporarily lowered or suspended dividends in response to earnings losses as a result of the coronavirus pandemic.

Why should I consider adding them to my portfolio?

There are two key roles that dividend-paying investments can play: providing investors with income to help meet immediate cash needs — something that retirees might increasingly look to them for — and offering potential downside defense during market sell-offs. “Companies that have consistently increased their dividends tend to be more stable, higher quality businesses, which historically have weathered downturns and are more likely to have the ability to pay dividends consistently¹,” Cabacungan says. It’s worth noting that investors close to retirement may not be able to experience the return potential of a dividend-paying stock over time.

Are there different kinds of dividend-paying stocks?

Absolutely. Some offer a higher dividend, while others issue smaller dividends that may tend to grow steadily. “One mistake to avoid,” Cabacungan says, “is to buy a company’s stock simply because it issues a high dividend.” If the company has leveraged excessive debt to fund the dividend, it could come at the expense of future profitability and hurt growth prospects. Or a company may seem to offer a high dividend yield simply because it recently experienced a price decline. “Always take into account prospects for both growth and income and how they align with your particular needs and goals,” Cabacungan notes.

What types of dividend stocks should I consider for my situation?

If your goal is creating an income stream, you might simply look for stocks with above-average dividend yields over a longer period, says Cabacungan. But if you’re a growth-oriented investor who isn’t looking for immediate income, consider investing in stocks that have a track record of increasing their dividends as cash flows and profits increase.

How do I get started?

Beyond individual stocks, there are numerous exchange-traded funds, index funds and mutual funds to explore. Some emphasize dividend yield; others focus on dividend growth or offer a mix of both. Still others focus on global stocks, which can provide further diversification. Many international equity indexes potentially offer higher dividend yields than U.S. indexes. “Work with your advisor to tailor your strategy to your individual needs, considering your short- and long-term goals and time horizon, as well as your risk tolerance and liquidity needs,” Cabacungan says.