Are Dividends Important?

The term “dividend” refers to the payout of a company’s or fund’s earnings to its investors. Dividends aren’t guaranteed like bank interest or bond coupons. However, there are businesses and investment vehicles that may profitably pay dividends on a steady basis and even grow their dividend payments over time. This is primarily because of the nature of the business they run or the assets they possess.

Many companies in the real estate, consumer goods, and pharmaceutical industries are dividend aristocrats, even though they are considered “old economy” corporations. These businesses are typically long-standing and successful, with strong economies of scale, well-known brands and names, established rivals, reliable income streams, and secure profit margins. They have reached their full potential and are known as cash cows. In most cases, these businesses don’t require a higher level of retained earnings on the balance sheet because doing so would reduce their returns-on-assets performance.

While traditional businesses often reinvest their profits back into their operations, “new economy” companies, such as those in technology-driven sectors with “disruptive” business models, often keep all of their cash reserves for expansion. Most of the time, these are fast-growing businesses.

Warren Buffett’s Berkshire Hathaway is a strong counterexample to the aforementioned possibilities. 

Some investors may be well-served by receiving dividend payments on a monthly basis, but the vast majority would be better off just reinvesting the dividends to take full advantage of compound interest. If the latter group of investors needs some quick cash, they can earn their own “dividends” by selling a portion of their interests.

You shouldn’t count on dividends as your sole source of retirement income because they are not guaranteed. Dividends are a bonus that can be used to pay for things like a vacation or a new piece of technology. Investing it again will help it grow and protect it from inflation.