Most people are familiar with the idea of earning interest on money in a savings account. However, fewer people know that some investments also generate cash payments simply for owning them.
These payments are called dividends. And they are one of the ways that investors can earn a return in the stock market.
When a publicly traded company earns a profit, it generally has two options on what it can do with that money: it can either reinvest that money back into the company for future growth, or it can distribute a portion of those profits to its shareholders. These distributions are the dividends.
Most companies pay their dividends on a pre-determined quarterly or annual basis, though they can also be distributed monthly, biannually, or on a completely ad hoc basis. It is entirely up to the company. The amount that one receives during these payments depends on how many shares an investor owns and the size of the company’s dividend payment.
Because dividends are paid in cash (direct deposits to the investment account), investors often view them as a source of passive income. Some retirees rely on dividend-paying investments to help cover their living expenses while young investors typically choose to reinvest those dividends back into the market, which can help accelerate long-term growth through compounding.
However, dividends are not guaranteed. A company’s board of directors can increase, decrease or eliminate dividends altogether at any time. When companies are in times of financial stress, it is common for them to reduce dividends in order to reserve cash and strengthen their balance sheets.
It is also important to note that high dividends do not automatically make an investment attractive. In some cases, unusually high dividends can be a sign that big investors in the company are concerned about the company’s future. As with all investment decisions, it is important to look at the entire picture before making a decision.
While dividends can provide investors with a valuable source of income, they shouldn’t be viewed as the end-all and be-all in making any investment decision. But for young investors, their ability to be reinvested to capitalize on compounding does serve as an easy step towards building long term wealth.