Written by David Shabotinsky

“Compound interest is the eighth wonder of the world. He who understands it earns it … he who doesn’t … pays it.”– Albert Einstein

What Are Dividends?

Dividends, essentially are a payout to the shareholders from a firm’s profits. A company has two intrinsic choices to decide what to do with its earnings: pay a dividend or retain that money and use it for further business development and possibly greater future earnings (Retained Earnings on a balance sheet). In the past decade, with major market crashes, dividend stocks have become more attractive to investors looking to maximize their returns on equity investments.

(Source: www.weretiredearly.com)

There are essentially two types of investors interested in ‘dividend stocks’. The first type are more risk tolerant investors, i.e. those in their twenties, seeking opportunities for a higher compound growth on their investments. These investors are able to reinvest their dividends in the form of mores shares that will hopefully continue to appreciate in value due to the believed intrinsic value of the firm’s stock price. The second type, are those around the retirement age who are more risk averse, because they need to be able have a higher range of liquidity of their assets. The second group of individuals can use the dividend payments as a way to slowly receive cash from the stock, today. Many investors often incorrectly believe that since dividend stocks offer a payout to shareholders, they are either risk-free or a ‘safe’ equity investment. The fallacy in this logic though is that all equity investments are a riskier asset class than other underlying assets such as bond or CDs.

Benefits and Drawbacks of Dividend Stocks

A huge benefit is that you are sharing in the company’s profits by receiving payments from the firm’s balance sheet. Additionally, you are able to earn a greater compound interest on your equity investment. The reason is because you can use that dividend to purchase further shares in the firm, and earn a greater upside on the investment in the stock itself (without including the dividend). The more often you receive that dividend and reinvest it, the greater your rate of return will be. Therefore, if one invests in a firm that is known to pay a steady dividend, eventually the investor will be earning a greater dividend due to one’s position in the company increasing, by the logic of compounding using the reinvested capital.