Welcome to our new guide series exploring the various types of financial instruments that you can invest in! If you haven't checked out our beginner and intermediate guides to investing, feel free to do so below!
As a beginner, it can be overwhelming to hear about so many products that are available for us to invest in. As such, we will be going through each financial instrument in greater detail so that you have a better understanding of each one.
In this guide to financial instruments, we will go through the following:
- REITs and real estate
- Options and puts
- ...And more!
If you're looking to start investing and want a more comprehensive overview of the various products as well as which is suitable for you, do give this guide a read!
Chapters in this guide:
Part 1 - All About Dividends
Part 2 - All About Stocks & Shares
In this first part, we will be exploring dividends. When you invest, there are two primary ways to get returns - capital gains and dividends.
Capital gain is the raw increase in value since your purchase of the financial instrument, and constitutes the extra value you get when you decide to sell.
Dividends, on the other hand, is a consistent, separate payout that the financial instrument may offer investors when they are in possession of the financial instrument.
Sure, dividends aren't exactly a financial instrument, but they are important for investors to know about, since many investments pay out dividends. This will be pretty long, so grab a drink and let's dive right into it.
What are dividends?
A dividend is simply the distribution of a portion of the company's earnings. When you buy a company's share, you are technically an owner of a small portion of the company. As such, you are also entitled to a part of the company's profits.
When a company makes a profit, its board of directors can choose to do three things with the extra earnings:
- Distribute the profit to shareholders
- Keep the profit as retained earnings for reinvestment back into the company
- A combination of the above two
If the company chooses to do either option 1 or 3, then as a shareholder of the company, you'll receive a portion of the profit in the form of dividends.
Why would you want dividends?
Before we dive into the intricacies of dividends, it is first important to understand why we might want dividends.
You can think of dividends as a regular payout throughout the year. They serve as a supplementary income source, giving you a somewhat stable return alongside capital gains.
Primarily, dividends help us to hedge against uncertainty. As mentioned earlier, there are two main ways to make returns - capital gains and dividends.
With capital gains, we have to sell our holdings to get the profit. However, we are uncertain about the future and how our investments may perform. Even though our research may lead us to conclude that the company we (partly) own is profitable, reality often differs from expectations, especially in the short term.
As such, dividends serve as a way to get your returns now instead of in the future. By receiving regular payouts, you lower uncertainty through upfront returns.
An added benefit is that you don't have to sell your holdings to get your returns. This gives you additional liquidity (via dividend payouts) while still retaining your assets. If they perform well, you can even hold them for life, resulting in a recurring income stream.
Therefore, if you want steady cash flow with low risks while still getting decent returns, consider adding dividend paying instruments as part of your portfolio.
Who pays dividends?
Not all companies distribute dividends to its shareholders. For example, companies may choose to keep all their profits as retained earnings.
This can be for a multitude of reasons, the chief of which is simply that the company wishes to reinvest their profits back into the company, seeking stronger growth instead. This still serves to attract investors looking for capital gains rather than dividend payouts.
Therefore, just because a company doesn't pay dividends doesn't mean that they are not worth investing in!
For example, Berkshire Hathaway, owned by Warren Buffet, famously doesn't pay dividends because they believe that can make better use of the money to reinvest in stocks and grow the company even further.
Even for companies that do pay dividends, dividends are not a guaranteed thing. You can think of it as an extra incentive for investors. In reality, dividends are subject to a company's declaration. They can reduce the dividend or cut it at anytime (although of course, investors don't like that).
Having said that, companies are often reluctant to cut dividends even when they are not doing well as it sends a signal to investors that they are not doing well, possibly causing investors to pull out.
Generally, companies have different dividend paying policies that they will try to uphold.
Stable dividend policy
These are companies that try to pay out a stable dividend every time. This means that barring financial failure, these companies will try to pay out dividends according to a declared schedule.
The actual amount may vary depending on the company's profits, but most companies tend to try and maintain the previous year's amount to inspire confidence in investors.
Some investments, like real estate investment trusts (REITs), are required by law to pay out around 90% of their rental income as dividends.
Companies may even increase the dividends paid out over time to attract more investors, and will try to maintain this dividend payout even if they are short in cash (e.g. by borrowing money or dipping into their past reserves).
Of course, if they have to resort to that, the company may be financially unstable and requires further scrutiny to see whether it is good debt (the company thinks they can make more money by borrowing money) or bad debt (the company borrows money because they don't have a choice).
Residual dividend policy
This policy entirely depends on how much money the company has left over after funding their capital expenditures. The remaining amount is then paid out as dividends to shareholders, meaning that it is not stable and may fluctuate.
This results in special dividends which are additional dividends (on top of scheduled dividends) paid out in a good, especially profitable year.
How are dividends paid?
While dividends mainly come in the form of cash payouts, they can be distributed in a variety of other ways as well. For example, you may receive dividends in the form of extra shares in the company, or even vouchers for the company's services.
Cash dividends are perhaps the most common form of dividend payouts to a shareholder. This is usually declared as a certain cash amount (e.g. 0.3 dollars) per share that you own.
There are two main ways that cash dividends are credited to you - either by cheque, which is mailed to you for depositing, or directly through electronic transfer to your associated bank account.
Your bank account can either be the one that you use to trade or another that is not used to trade. All you have to do is to indicate your preferences as to which account you would like your dividends to be deposited into.
It is recommended to set up electronic transfer if possible unless you have a specific reason to use cheques. You'll get the cash faster as opposed to waiting for your cheque to come in the mail, and it's way more convenient.
Sometimes, dividends may come in the form of stocks, whereby the company will declare new stocks to be given out to shareholders. For example, they could give you one new share for every five shares owned.
In other words, the number of shares that you own in the company increases when you earn stock dividends.
Note that when a company gives out stock dividends, the overall value of the company does not rise. If the company was originally worth 10 million, the total enterprise value will stay constant at 10 million, but the number of shares outstanding increases due to the stock dividend.
This causes the share price for each share to fall since the same value has to be divided among more shares. At first glance, this may seem to be detrimental to shareholders, but this is not the case.
Firstly, depending on your country, you may be taxed for cash dividends, but not on stock dividends. This is because a stock will only fall under capital gains tax when you choose to sell it. You usually don't get taxed for holding stocks.
Secondly, as the company merely has to give out new shares (which are effectively created by the company), no actual money is given out. As such, all the excess profits are retained earnings of the company, which can be reinvested to grow the company.
Don't underestimate this - if you had bought Microsoft share back in 1986 at 0.32 dollars per share, each share of yours would have seen a 58000% increase in value by 2020 as the company grows.
When stock dividends are given out, investors have the freedom of choice. You can choose to keep the extra shares and wait for the value to rise if the company manages to grow using their retained earnings.
Alternatively, you can choose to sell those extra shares given to you through the stock dividend. In effect, this will be the same as converting a share dividend into a cash dividend.
As such, share dividends are usually preferable to cash dividends for two reasons - it's not taxed, and it gives you a choice - to keep or to sell. If you sell, it's effectively a cash dividend, but if you keep the shares, you get more shares of that company without having to pay brokerage trading fees for it.
With cash dividends, although you can reinvest your dividends to buy shares (known as dividend reinvestment) which effectively achieves the same as getting a stock dividend, you will incur additional trading fees.
That said, stock dividends are not always better. When stock prices are depressed, such as in a recession, cash dividends might be the better option to receive instead, giving you the liquidity to buy more attractive investments without having to sell your shares at low prices.
Sometimes, a company may want to pay dividends even if they don't have enough cash to do so. This may be due to the fact that investors expect dividends, and their share price may tumble if the dividends are cancelled.
In such a case, a company can declare scrip dividends, which are essentially a promise to pay shareholders their dividend at a stipulated date in the future. The company may declare additional interest payments to the shareholder for this delay.
The other less common dividend types may also be paid out in various ways, such as through property or vouchers for services.
Whatever form the dividends come in, the dividends will have the same value (using their market value) as declared by the company.
How often are dividends paid?
How often dividends are paid differs from company to company. There is no fixed frequency and companies are not obliged to pay dividends every year.
As mentioned before however, many companies will follow a stable dividend policy, and pay out their dividends at standard schedules every year. This allows investors to have expectations on their dividend returns, making the investment more attractive.
Usually, companies may pay dividends yearly, biannually, quarterly, or monthly. Of all these, dividends are most commonly paid out quarterly (4 times a year).
When companies do exceptionally well in a certain year, the board of directors may decide to declare an additional dividend payout to its shareholders as a little reward or incentive. These are special dividend payouts, or one-time dividends which are non-recurring and usually of a larger amount than usual.
Important dividend dates
Since dividends are not paid out on any fixed date, we have to pay attention to the statements released by the company in order to qualify for the dividend payouts.
For example, let's say the dividend is declared on 5th May. If you sell your shares on 5th May, who is entitled to the dividend? The person that bought the shares, or you? Knowing the important dates for dividends is important in order to ensure that you receive your dividend!
This is the date that the board of directors declare a dividend payout. On this date, the company will announce the dividend amount, as well as the other key dates that this dividend payout will be under.
This is simply a heads up for investors that dividends have been declared and that you'll get a dividend payout some time in the future if you own the stock.
This is probably the most important date for investors to know. Simply put, if you buy the stock on or after this date, you will not be eligible to receive this time's dividend payout.
Therefore, if you want dividends, you'll have to buy a day before this date, or hold off on selling the stock until this date. Even if you sell on this date, you will still receive the dividend.
When this date arrives, the stock will be considered as trading without a dividend, since anyone that buys this stock on this date will not receive the declared dividend.
As such, the stock will lose value equal in amount to the dividends declared, meaning that the stock price will fall by the dividend amount per share on this date.
As we approach the next dividend payout, the stock price will slowly go back up in value, until the share price includes the next dividend payout amount.
The record date is usually one day after the ex-dividend date, and is the date where the company decides who to pay dividends to.
The record date is determined by the company paying the dividends. On this date, all shareholders as recorded by the company in their books will be entitled to the declared dividend, and all those not on the company books will not receive the dividend.
This is different from the ex-dividend date because the record date is recorded by the company, while the ex-dividend date is recorded by the brokerage.
Usually, brokerage trades are settled in T+2 days (2 days after the trade is conducted). This means that the company's books are updated 2 days after you make a trade on the exchange.
Let's say a company decides to pay a dividend, with an ex-date of 5th May and a record date of 6th May.
If you had bought a stock via the exchange on the ex-dividend date (5th May), the company's books will only be updated 2 days after that (7th May). Therefore, on the record date (6th May), your name will not be in the company's books and you will not receive the dividend.
In effect, this is the same as not being able to receive the dividend because you bought only on the ex-dividend date itself.
Conversely, if you had bought before the ex-dividend date (let's say 4th May), then the company's book will be updated on 6th May, which is the company's declared record date. On that date, your name will be on the company's books, making you entitled to the dividend.
Simply put, you need to own the stock before the ex-dividend date to have dividends, because in this way, the company's book will be updated in time to have your name on there on the record date, making them list you as a shareholder.
This date is announced on the declaration date, and is the date when the company actually pays out the dividends. If you have set up electronic transfer, you should receive the funds directly into your account on this date.
If you have dividends mailed to you via cheque, it may take a few more days for the cheque to arrive by mail.
What is a good dividend yield?
Now that we have a preliminary understanding of dividends as well as when and how they are paid, let's look at returns.
When we talk about returns coming from dividends, we talk about dividend yield - the annual amount of dividends received expressed as a percentage of the current share price. In other words, it is the percentage return you get per share.
Dividend yield = Annual dividend amount / Share price
It is important to check how many times a company declares dividend payouts in a year, because this affects how much dividend yield you can expect.
For example, let's say a company share price is $10 per share. If the company pays $0.2 per share quarterly, then the dividend yield in a year would be 8%, but if the company pays $0.2 per share biannually, then the dividend yield would be 4%. Make sure to calculate the proper dividend yield that you expect to get!
So what is a good dividend yield to have? Truthfully, a good dividend yield depends on the underlying company and how it makes its money.
Companies that earn a stable income year after year, without much fluctuations even during economic downturns tend to pay higher dividends because predictable earnings allow these companies to continue paying dividends.
However, growth in these companies are also likely to be meagre as a consequence since most of their profits are handed out to shareholders.
For example, telecoms are more likely to pay higher dividends since phones, are pretty much a necessity even in times of economic downturns. You would not end your phone plan simply because the economy isn't doing well.
For companies that rely on handing out dividends to attract investors, you can expect a ballpark figure of 4-6% to be a decent dividend yield (as of 2020).
Conversely, sectors that are strongly affected by the economy are more likely to pay lower dividends since their earnings are unpredictable and they need to retain more of their earnings to tide them over in times of economic downturn.
Besides that, sectors that require significant amounts of innovation are more likely to pay lower or even no dividends so that they can reinvest retained earnings for research and development.
For example, in the technology sector, companies are often reinvesting large amounts of their retained earnings in order to beat their competitors to produce the next "big thing".
Hence, their shareholders get either very little or no dividends. Having said that, growth due to research and development can be significant - so investors that go for these investments are looking to make capital gains instead.
Stocks in the S&P500 average around 1.5% in dividend yield (as of 2020).
High dividend yields may not be a good thing
Whichever type of investment you choose, you should never buy a dividend stock solely based on its high dividend yields.
The higher the dividend yield promised, the harder it is for the company to maintain.
Remember, the dividend is simply the result of the company's directors deciding that handing profits out to shareholders has a greater upside than reinvesting it into the company.
This could be to attract more investors to invest in the company, which could provide more funds than retaining the earnings for the company to grow.
As such, the main point of dividends is, in the end, to make the company more money. If the dividend yield becomes so high that the company ends up losing money instead, then it's not going to be sustainable.
An important thing to remember is that dividends come from a company's earnings. If a company is having trouble making money, then their dividend payout will simply be unsustainable.
Dividends comes with an expectation - that the dividend yield will hold and is sustainable. If the dividend payout is removed, the share price will drop significantly as investors lose confidence in their investment.
Do not be baited by high dividend yields, and then lose a lot of money when dividends get reduced or cut because the company cannot sustain them. Instead, look at the company's financials and earnings, and determine if the dividend yield promised by the company is sustainable.
A good ratio to look out for in this case is the payout ratio of the company. If the payout ratio is low (below 1), then the company still has enough cash to cover their dividend payouts, making their dividends sustainable.
Of course, this is not the only metric to look out for. For example, even if the payout ratio is low, if the company's earnings are steadily dropping year over year, then it's only a matter of time before the dividends become unsustainable.
Check out our intermediate guide to investing to learn how to analyze a company's financial stability!
Should I reinvest my dividends?
When investing, you may come across stocks that are labelled as accumulating and distributing. Distributing stocks are basically normal dividend paying stocks that distribute the dividend payouts to you as they come in.
Meanwhile, accumulating stocks will automatically reinvest the dividend payout back into the same stock for you as it gets paid.
The incentive for investors with accumulating stocks is that you get to buy back in automatically without having to pay trading commissions on it. Of course, this comes with a drawback - you are locked into that particular stock.
On the other hand, if you wish to have cash flow and the freedom of choice, choose distributing dividends. You will get the cash payout, and you can put that into any other investment you choose.
Naturally, the drawback here is that you will incur trading fees on your trades. Additionally, since each dividend payout may be small, you might have to wait a while to collect enough dividends for reinvestment. This often results in cash sitting on the sidelines, suffering from inflation.
Importantly, note that dividend taxes apply on both options, meaning that your dividends get taxed, then reinvested if it's an accumulating stock, and your dividends are also taxed before being paid out to you if it's a distributing stock.
Honestly, there is no better option - it's completely up to you as to which one you want to choose.
Whichever you pick, we usually want to reinvest our dividends (automatically or not) since we want our money to work for us through compounding. The more time the money stays in the market, the longer it has to grow.
Should you buy dividend stocks?
After learning quite a bit about dividends, how they are paid out, and what they are for, should you add them to your portfolio?
In general, dividend stocks are less risky than growth stocks since you get cash flow every so often, which allows you to move your returns from an uncertain future to a more certain present.
This allows you to use dividend stocks to supplement your income. Instead of getting one lump sum at the end when you sell your shares, you get a consistent payment so you can enjoy your life as it is right now rather than have the money much later in life.
As such, it can be tempting for some to build up a dividend heavy portfolio. Do note however, that dividends are not without risks. Since dividends are not guaranteed, even companies that have been consistently paying out dividends for 25 years can stop doing so at anytime.
When evaluating dividend paying investments, make sure to first look at the financial stability of the company before the dividend yield itself.
Do remember that dividends can be taxed. Depending on which country you're from, if you buy a US-domiciled dividend stock, your dividends will be subjected to a 30% withholding tax. As such, if you plan to make dividends a supplementary income source, be sure to find out how to reduce taxes on them.
It's your choice whether to invest in dividends or look for capital gains in investments instead.
Generally, our advice is to focus less on dividend stocks when you have little capital. Instead, use this time to invest in growth stocks that are more risky but also tend to give higher returns.
Imagine you have a thousand dollars to invest with. If you put them into dividend paying investments at an average 4-5% dividend yield, that's only around $40 extra a year.
This is not a lot of extra income - and relatively insignificant once you have more capital to invest.
Conversely, if you invest that into a growth stock, it might be more risky, but you also stand a higher chance at getting better returns on your money. That $1000 could become $2000 if the stock grows - something relatively rarer with dividend investments.
This is because investments that pay high dividends give out more of their earnings instead of retaining it for research and development. Hence, they have relatively low and stable growth - meaning that the returns are expected and will not change.
If you are willing to take a chance on growth investments however, then you have a shot at getting higher returns with your low capital. Of course, pick wisely and not randomly! Investing is not a gambling process.
Note that growth investments include those that pay little to no dividends, since these also reinvest the majority of their profits back into the company.
Basically, when you have low capital, returns on dividends, while stable, is also low.
When the capital you have to invest goes up however, you will also be adverse to risk since you stand to lose much more. As such, dividends can make more sense to give you returns with a relatively lower risk level.
For a well diversified portfolio, perhaps a combination of growth and dividend investments would serve you well - growth to bet for higher returns, and dividends to protect against your liabilities while giving a stable and expected return.
All in all, dividends have an important role to play no matter what your investing strategy is. The debate between growth vs value is forever ongoing with no concrete conclusion.
The best way to look at it is to see the overall value of the investment instead. If the underlying company is good in your book, and has a product that will perform well in the next 10 years or more, then you can be somewhat confident in betting in the company - dividends or not.
Dividends help to hedge against risk due to the earlier and constant payout of returns over time, but it is not risk free.
Dividends can, and have been cut. Even dividend aristocrats, investments that have been growing their dividends for over 25 years or more, can be cut if finances get bad.
Look at the company's financial prospects first, then its dividend. You'll be safer that way. In the next part, we'll look at stocks, shares and equities!
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