With heightened fears of a possible recession, investors looking for stable income may turn to stocks that pay quarterly dividends, which are part of corporate profits returned to investors.
Historically, dividends have contributed significantly to an asset’s total return, sometimes providing a boost during economic downturns.
From 1973 to 2021, dividend-paying companies have earned a total annual return of 9.6%, on average, beating the S&P 500 Index’s 8.2% and eclipsing the 4.79% return of non-payers. dividends, according to a 2022 study by Hartford Funds.
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Dividends grab investors’ attention: Dividend funds added $43 billion in 2022 at the end of June, according to research from SPDR Americas.
Still, investors should consider their choices before adding dividend payers to their portfolios.
“People sometimes go after dividends, and they don’t understand the risks,” said certified financial planner Scott Bishop, executive director of wealth management solutions at Avidian Wealth Solutions in Houston.
Here’s what you need to know.
Why dividends are attractive in tough economic times
“Companies that pay dividends will generally have higher levels of free cash flow,” said Dave Sekera, chief U.S. market strategist at Morningstar. And they can be valued more modestly, he said.
“Both have certainly been attractive to investors this year as we see the economy slowing, interest rates rising and inflation still going strong,” Sekera said.
Dividend payers tend to be large, mature companies producing products and services 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 have a history of increasing dividends every year, even in previous recessions, known as “dividend aristocrats.” And many companies are slow to cut their dividends, providing some investors with reliable cash flow.
Be critical when looking for high dividend yields
While a higher dividend payout can be attractive during a flat or bear market, it’s important to assess what you’re buying before adding new assets to your portfolio. As Bishop pointed out, there can be risks.
There are two parts to a company’s dividend yield: the annual dividend per share and the current share price, Bishop explained. If the dividend yield is much higher than similar companies, the stock price may have fallen for various reasons.
“You shouldn’t just look at the dividend yield,” Bishop said, explaining why understanding company finances is critical.
And for those who don’t want to analyze every company, dividend-paying funds can offer greater diversification than individual stocks.
Keep dividend payers in tax-efficient accounts
Whether you receive income from stocks or bonds, you’ll need to be strategic with the type of account you use to hold those assets, Ahmed explained, especially if you’re an investor in a higher tax bracket.
Generally, it’s best to keep income-producing assets, such as dividend-paying stocks, mutual funds with annual payouts, or bond coupons, in tax-efficient accounts, like a 401(k). ) or an individual retirement account, he said. Otherwise, you may owe annual capital gains taxes.