With interest rates rising, I have begun to see articles suggesting that the appeal of dividend investing is waning. While higher interest rates may give income seekers a broader range of investment options, here are four reasons that I believe dividend investing remains a smart strategy.
Dividend Yields Remain Attractive
The dividend yield (annual dividend payment per share divided by the share price per share) on many high-quality stocks is still higher than can be earned on alternative investments such as CD's. For example, as of July 2, 2013, the 30 stocks that make up the Dow Jones Industrial Average had an average yield of 2.7%, including yields, at the high end, of 5.1% for AT&T, 4.1% for Verizon, and 3.8% for Intel. In contrast, a one-year CD yields about 1% or less (based on an internet search for the best certificate of deposit (CD) rates).
Tax Free Income
For many investors, the tax treatment of dividends today can't be beat. For those in the 15% or lower tax brackets, there are no federal taxes due on qualified dividends, whereas interest income typically is taxed at the recipient's ordinary tax rate.
Potential for Dividend Increases
With many companies, investors have the potential for dividend increases and, therefore, growing yields on their initial investment. For example, suppose an investor purchases a stock with a 3% dividend yield in year one and suppose the dividend increases by 5% annually in years two through five. In the fifth year, the investor's dividend income would be almost 22% higher than it was in year one and, if the share price simply stayed the same, the dividend yield on the initial investment would have risen to 3.6%.
Potential for Capital Appreciation
In the example above, the assumption is that the stock's share price is the same after five years. However, the potential for capital appreciation is one of the primary reasons investors purchase stocks. If, in the example above, the share price and the dividend both appreciated by 5% annually in years two through five, then the 22% increase in dividend income would be supplemented by 22% of capital appreciation. Put another way, if the stock was purchased for $50 per share and sold at the end of year five (after having increased 5% annually in years two, three, four and five) for $60.78, the investor would have collected $10.78 in capital gains and $8.29 in dividends, or an average of $3.81 per year for five years. This translates to a yield of 7.6% annually on the initial $50 investment.
A word of caution is, of course, always in order when it comes to stock investing. Needless to say, investing in stocks is risky and the flip side to the potential for capital appreciation is the potential for capital loss.
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