How Will Dividends Affect Long-Term Investment?
Investing money in assets such as stocks that have the potential to increase in value over time is one of the keys to building wealth. Stocks historically have outperformed other investments in the long-term, so practical wisdom states that buying and holding stocks for long periods is among the best ways to build wealth. Some stocks make periodic payments called dividends to shareholders, which can have several effects on long-term investments.
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Dividend Basics
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A dividend is a payment that a corporation gives to its shareholders that depends on company performance. Some companies pay cash dividends, while others pay dividends in the form of additional shares of stock. Dividends typically are offered by large, well-established corporations that have consistent profits. Dividends are ways large companies can attract and retain investors even if they are not growing as fast as small companies.
Cash Dividends that are Not Reinvested
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Most large corporations that pay dividends pay cash dividends. When a corporation issues a cash dividend, it sends all shareholders a certain amount of cash for each share that they hold. For example, Coca-Cola might offer a dividend of 50 cents per share that it pays four times a year. Cash dividends can provide an income stream to investors, but long-term investing is focused on money growth, not short-term income. Receiving cash dividends can be thought of as taking money out of an investment or withdrawing interest from a savings account: it provides some short-run income, but it sacrifices the compounding effect that is the goal of long-term investing.
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Reinvested Dividends
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Instead of actually receiving cash dividends, investors can choose to use dividends to buy more shares of stock or "reinvest." Reinvested dividends become shares of stock that start earning dividends, which leads to a compounding effect similar to interest earned from savings account. Even though large corporations that pay dividends often have lower growth potential than smaller companies, the combination of moderate growth and reinvested dividends can result in more growth over time. Dividends can also allow for wealth creation even when stock prices are stagnant. For instance, if a stock's price remains the same for an entire year, but it pays out dividends that are worth 5 percent of the share price, investors receive a 5 percent return for the year despite the fact that shares didn't actually go up in value.
Considerations
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Buying dividend-paying stocks and reinvesting dividends is a common long-term investment strategy. According to "U.S. News & World Report," dividend-paying stocks have outperformed non-dividend stocks at times and are often less volatile than non-dividend stocks, making them a popular choice among conservative investors. Buying shares of professionally managed investments called mutual funds is a way to gain the advantage of dividends without the risk of purchasing individual stocks.
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