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Before you ‘chase dividends,’ here’s what to know

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With increased fears of a possible recession, investors looking for regular income may turn to stocks paying quarterly dividends, that are a part of company profits sent back to investors.

Historically, dividends have significantly contributed to an asset’s total return, sometimes providing a lift during economic downturns.

From 1973 to 2021, corporations paying dividends earned a 9.6% total annual return, on average, beating 8.2% from the S&P 500 Index, and eclipsing the 4.79% yield from non-dividend payers, in response to a 2022 Hartford Funds study.

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Dividends have investors’ attention: Dividend funds have added $43 billion in 2022 as of late June, in response to SPDR Americas research.

Still, investors have to scrutinize their picks before adding dividend payers into their portfolios.

“People sometimes chase dividends, and so they don’t understand the risks,” said certified financial planner Scott Bishop, executive director of wealth solutions at Avidian Wealth Solutions in Houston.

Here’s what to know.

Why dividends are attractive in tough economic times

“Dividend-paying corporations are typically going to have higher levels of free money flow,” said Dave Sekera, chief U.S. market strategist at Morningstar. They usually could also be valued more modestly, he said.

“Each of those have definitely been attractive for investors this 12 months as we see the economy softening, rates of interest rising and inflation still running hot,” Sekera said.

Dividend payers are inclined to be large, mature corporations, producing services and products still needed during a recession, explained Kashif Ahmed, a CFP and president at American Private Wealth in Bedford, Massachusetts.  

“No person needs a Rolex day-after-day, but all of us need toilet paper,” he said.

Some corporations, generally known as the “dividend aristocrats,” have a history of accelerating dividends annually, even during previous recessions. And plenty of corporations are slow to chop dividends, providing some investors with reliable money flow.

Be critical when chasing high dividend yields

While the next dividend payout could also be appealing during a flat or down market, it is important to evaluate what you are buying before adding recent assets to your portfolio. As Bishop identified, there could be risks.

There are two parts to an organization’s dividend yield: the annual dividend per share and the present share price, Bishop explained. If the dividend yield is way above similar corporations, the stock price can have dropped for various reasons.

People sometimes chase dividends, and so they don’t understand the risks.

Scott Bishop

Executive director of wealth solutions of Avidian Wealth Solutions

“You should not just have a look at dividend yield,” Bishop said, explaining why it’s essential to grasp the financials of the corporate.

And for those unwilling to research each company, dividend-paying funds may offer more diversification than individual stocks.

Keep dividend payers in tax-friendly accounts

Whether you receive income from stocks or bonds, you will have to be strategic with what type of account you employ to carry those assets, Ahmed explained, especially in the event you’re an investor in the next tax bracket.

Generally, it’s higher to maintain income-producing assets, similar to dividend-paying stocks, mutual funds with annual payouts or bond coupons, in tax-friendly accounts, like a 401(k) or individual retirement account, he said. Otherwise, you could owe yearly taxes on capital gains.

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