When the stock market is rising steadily, growth stocks are the place to invest your money. Growth stocks are often new companies; they can be exciting businesses with tremendous future growth potential that drives their stock prices higher and higher. But in volatile or declining markets, they can be tough stocks to weather the storm in as they struggle to gain a foothold in their industry.
Why Dividend Stocks Protect You
When markets look shaky investors generally follow one of two courses: sell stock positions in favor of interest bearing securities, and/or shift their stock positions to higher ground within the market itself. That higher ground is often found in dividend paying stocks. For at least six reasons dividend paying stocks are the place to be when markets are looking volatile.
Dividend paying stocks don’t relying completely on capital gains
All stocks rely on capital gains to one degree or another. It’s the whole reason we buy stocks rather than putting all of our money into no-risk, interest paying securities such as Treasury bills and certificates of deposit. “Growth stocks”—stocks that are pure plays on higher prices in the future—rely on capital gains entirely. Because of this, they also tend to fall hard and fast during periods of market volatility or decline. After all, the very reason for their popularity—higher stock prices—is now in doubt. Dividend paying stocks rely on capital gains as well, but not nearly to the same degree. Yes, you invest in dividend paying stocks in the hope of higher prices in the future, but part of your overall return will be comprised of the dividend yield on the stock in addition to price growth. Since dividend paying stocks are less reliant on rising prices, they tend to fall less during volatile or falling market conditions. Dividends can also be the force that drives capital gains. A company with a long history not only of paying dividends but also of increasing them creates a compelling reason for a higher stock price in the future.
Dividends can put a “floor” on a stock price
As long as the underlying company is strong and likely to continue paying dividends, those dividends can put a floor under the price of its stock, keeping it from falling as far as pure growth stocks might. Stocks compete with bonds for investor attention. A critical determining factor between the two is yield, so if the price of a stock falls to the point where its dividend yield becomes higher than what can be had on interest bearing securities it will become more attractive than bonds and other fixed income assets. Money, therefore, will move into the dividend paying stock, which also holds the potential for capital gains.
Companies paying dividends tend to be more established
Dividend paying stocks tend to be issued by companies that have been around for a long time, are leaders in their industries and have strong cash flows. These are the very companies investors will look to during times of market volatility. Their status as established businesses, in addition to the cash flow from dividends they provide, make them safer plays than younger, fast-growing companies that pay no dividends.
Dividends can give you staying power during market volatility
If your entire reason for holding a stock is the prospect of selling it at a higher price in the future, your interest in owning it could disappear during a long term market decline. Falling prices, after all, are the exact opposite result you’re going for, and the lower the price goes the less likely recovery and gain will be. However, if your stock pays a dividend you may be earning a return comparable to or even better than what you can get on fixed income investments. For this reason you will be in a position to wait out a drop in the stock price, safe in the knowledge that you’re getting a solid return on your investment even as the price of the underlying stock gyrates.
The company may be solid—even if the stock market isn’t
A “take no prisoners” attitude often sweeps a falling stock market—good stocks go down with the bad. The market can take a dive on international news, unpopular political developments, interest rate changes or even on the declining outlook on a few popular bell weather stocks. But the fortunes of all companies don’t suddenly decline with a change in market sentiment. Some strong companies will prosper despite the development of factors that negatively impact the stock markets in general. How do you tell the strong companies that are positioned to resist the downward trend from the weaker ones that will go down with the markets? The payment of dividends is hint. If a company has a track record of paying dividends, and even more so if the pattern has been for consistently higher payouts over the years, it’s an indication of a solid company. The company is strong enough that it’s been able to increase sales, maintain profitability and share its gains with it’s stockholders through the payment of dividends. Not only can you ride out a declining market better with solid, dividend paying stocks, but they’re also excellent stocks to buy during a decline because…
When markets fall the herd seeks yield
Next to being in cash or cash equivalents, dividend paying stocks are probably the best place to be during a major market slide. There are two reasons for this:
- Stocks with healthy dividend payouts tend to fall in price less than pure growth stocks, and
- Market psychology shifts from growth to yield, making stocks with healthy dividend yields prime targets for early recovery.
Whether the market is falling or it has hit bottom and investors are looking for relatively safe bargains, dividend paying stocks are superior equity positions to take during times of market volatility.
Photo by jon jordan via Flickr