How Does Dividends Work: Passive Income or High-Yield Trap?

Why Should Anyone Care About Dividends?

Dividends, as you may know, are often perceived as an attractive source of passive income for all those who want to invest. And honestly, this can be understood. They are defined as a share of the profits of a company that are redistributed to its shareholders. It is a form of remuneration for their investment (a small gift of fidelity in a way).

Historically, dividends have contributed about 30-40% of the total return on S&P 500 shares over the past 90 years. In an economic context where financial security is quite important, the usefulness of dividends in investment strategies is growing every day. In 2022, the total amount of dividends paid by companies listed in the United States reached about $565 billion (yes, you read it well).

If you are still unconvinced, the following chart shows the cumulative returns of the S&P 500 that can be obtained by reinvesting the dividends in relation to a situation where they are not reinvested. If it doesn't convince you, I don't know what will do it at all.

Many companies adopt a growing dividend policy to increase their payments each year, which can be seen as an indicator of financial strength, but it must be borne in mind that not all dividends are equal. Some may be unsustainable and very likely to be cut in times of economic hardship.

What is a Dividend?

A dividend can simply be defined as a distribution of a portion of a business's profits to its shareholders (i.e., you). It's a direct compensation, usually in the form of cash payments or new shares (it's always a pleasure to receive new shares, isn't it?).

According to one study, the dividends paid by listed companies around the world in 2022 have reached about $1560 billion! This shows how important it is to know how dividends work in your investment strategy.

Dividends are also seen as a positive signal on a company's financial health. When a company regularly pays dividends, one can clearly say: "It is a good sign of stability and growth." For example, well-established companies, such as Procter & Gamble or Johnson & Johnson, have a long history of dividend payments.

But we still need to know that not all types of shares pay dividends. Some companies, mainly those in high growth, prefer to reinvest their profits. This is intended to finance some projects (such as expansion projects) instead of distributing dividends. Prefer investing in growth actions can also be interesting, so it's a personal choice you'll have to make.

Why are Dividends Attractive?

Dividends have several notable benefits. Here I will sum up clearly what makes them so attractive:

• Regular passive income: Dividends offer constant income. If you are looking to generate passive income, this can be particularly attractive. According to a study by S&P Dow Jones Indexes compared to U.S. shares, dividends have accounted for about 31% of total return since 1926. In times of volatility, such as during the VOCID-19 pandemic, companies that pay dividends have often resisted better.

• Reinvestment of dividends: Many people choose to reinvest their dividends instead of cashing them. This is a (very) known strategy. It can lead to a significant capitalization effect, as I showed you in the figure at the top of this article. By reinvesting, you buy more shares, thus increasing your shares in the company. Need an example? A study by Fidelity International shows that by reinvesting dividends in an index such as FTSE All‐Share, a monthly investment of $127 over 30 years can almost double in value. That's about $91,000 without reinvestment, and $182,000 with it, isn't it interesting?

• Investment security: Companies paying dividends regularly are often perceived as more financially stable. I know that can reassure people in general (and I too). Companies like Procter & Gamble and Johnson & Johnson, which have increased their dividends for decades, are often considered safe values.

The 3 Types of Dividends

In general, there are three types of dividends:

• Cash Dividends: This is the most common type, where money is paid directly to shareholders. In 2023, the average return on S&P 500 dividends was approximately 1.6%. This means that a share that is valued at $100 will pay you a dividend of $1.6 directly.

• Dividends in free shares: You prefer to receive shares rather than money? Then this type of action is made for you. You get extra shares, and all of this at no additional cost! For example, if a corporation declares a 10% dividend, you will receive 1 additional share for all 10 shares you own.

• Special Dividends: We see a little less often, these are non-recurring payments, often made when the company has made exceptional profits. In 2021, some technology companies paid special dividends ranging from 2 to 5 per cent, as a result of high profits during the pandemic. As with every thing with the scholarship, it shows us that all circumstances can have an influence.

Key Dates of Dividends

So far, we've seen a lot of things. I'd like to talk to you about the different key steps in the process:

1. Declaration: When a company decides to pay a dividend, it publishes an official announcement. This statement includes important items such as the amount per share but also the date of payment.
2. Ex-dividend date: This date is a decisive moment for investors. It is the last day to own shares in order to be eligible for the dividend (i.e., to receive the dividend). If you purchase after this date, you will not receive the payment, even if you have the shares on the payment date. For example, if a dividend is announced on May 15 for a detachment on May 20, the ex-dividend date will generally be set one day before May 19.
3. Payment: Dividends are paid to shareholders on the scheduled date, usually by bank transfer or cheque.

Companies themselves choose to distribute dividends according to their net profits. A firm that generates solid profits will necessarily be more likely to do so on a regular basis. These payments may be quarterly, semi-annual or annual, depending on the company's policy (small precision which is important).

Traps to Avoid in Relation to Dividends

Okay, all this is great, but... when you plan to invest in dividend shares, there's gotta be pegs. For example, a high yield may seem irresistible, but it may not always be a good idea:

• High return search: You want to invest in high dividend shares, but how do you know if it's wise or not? These shares, often referred to as "attractive dividend shares", may hide some problems, such as reporting financial difficulties. In 2021, some companies in the energy and banking sectors posted returns of more than 10%, but they also suffered decreases in profits. It is therefore quite important to carry out a thorough analysis of the financial situation of the company before making any decision.

• Understand distribution ratio: This is a very useful indicator that measures the percentage of profits allocated to dividends. A ratio above 100% simply indicates that the company distributes more than it earns (no need to tell you that it is not a good thing).

• Know the industry: Various sectors offer various returns on dividends, not necessarily equal. Technology companies, for example, often reinvest their profits rather than distribute regular dividends. On the other hand, essential consumer goods are often more stable. Learn about trends in each sector before deciding where to invest.

Ultimately, being aware of these pitfalls and doing thorough research accounts for 90% of the job. I still give you some common mistakes in the next section (to avoid reproducing them of course).

Common Errors of Beginner Investors

It must be recognized that beginner investors (including me) often make mistakes that can harm their portfolio, and that can easily be avoided.

• Neglect portfolio diversification: One of the most frequent mistakes is to concentrate too many investments in a single sector, especially in those that pay dividends. For example, in 2022, a diversified portfolio including shares, bonds, etc. recorded a decrease of about -14%, compared to -17% for a classic portfolio 60/40, according to Morningstar. By diversifying (by necessarily just related to dividends), you mitigate the risks associated with fluctuations in each sector.

• Living to a dividend without assessing the company's health: I know it's tempting to focus only on dividends, but it's crucial to analyze the company's financial health. You can mostly use the distribution ratio for that. A ratio above 60% can mean risks to maintain these dividends.

• Open the tax impact of dividends on net return: Dividends are (in general) subject to tax, which can reduce your return. In the United States, the tax rate on dividends can be as high as 20%, which is not negligible. In addition, you can look at options to invest in tax-friendly accounts, such as an IRA or a 401(k), where dividends grow free of tax until you retire (all depends on where you live, and it quickly becomes technical, so you have to do some research by yourself).

How to Invest Effectively in Dividends?

Here are a few approaches to keeping abreast of, if you want to maximize your dividend investments:

• Choose companies with a strong dividend payment history: Look for those that regularly increase their dividends. For example, the "Dividend Aristocrats" are these S&P 500 companies with at least 25 consecutive years of increasing dividends.

• Analysing return, distribution ratio and dividend evolution: Examine the distribution ratio, which shows how much of the profits are paid, is a useful tool. A ratio of less than 60% is generally considered a sign of robustness.

• Use ETFs and dividend funds: If you want to diversify your portfolio, but you don't know how to do it effectively, then Exchange-traded funds (ETFs) and mutual dividend funds are excellent choices. For example, the Vanguard Dividend Appreciation ETF (VIG) offers exposure to companies with a good history of dividend growth.

My Final Words

As I said throughout this article, dividends have a dual role: as a (1) source of passive income and (2) indicator of a company's health. A company that regularly pays increasing dividends often shows that it generates stable profits (which is reassuring to the investor).

But first of all, you need to evaluate factors such as the distribution ratio. A ratio greater than 60% could indicate financial instability.