Why You Need Dividends

Through the power of compounding, dividends provide amazing returns for investors, usually regardless of stock price movements.

For many novice investors, there is a perception that you will only make money when the price of a stock rises. They however forget that while capital appreciation is great, if you are an investor in a business you are also entitled to a share of the profits. This share of the profit is known as dividends.

Perhaps we should put it another way.

When you think of the stock market, you may think of traders barking out instructions on the trading floor or desk jockeys banging a keyboard or mouse as they try and make profits from miniscule intra-day movements in shares. Yet ironically, more sustainable wealth is created in the long run by investors who seek out quality companies which focus on returning profits to investors.

Legendary investor Warren Buffett once commented, "We believe that according the name ‘investors’ to institutions that trade actively is like calling someone who repeatedly engages in one-night stands a ‘romantic.'"

Perhaps to illustrate this point we need to take two highly recognizable companies in the form of beverage group Coca-Cola (KO) and industrial conglomerate General Electric (GE). Both stocks have pretty standard dividend yields of 3% for Coca-Cola (KO) and 2.6% for GE (GE), but are recognised as market leaders in their fields with global brands and strong cash-flows.

If you had bought 100 shares in Coca-Cola (KO) on 31 December 1996 it would have cost you $5,263. In the middle of August 2010, the share trades around $55 and your investment before dividends is worth $5,500, which sounds relatively unspectacular. However if you take into account the dividends earned from the start of the period to the end of the 2009 financial year, your 100 shares would have scored an extra $1,276. That represents a roughly 25% return on your initial investment.

GE (GE) shareholders would have done even better. 100 shares purchased on 31 December 1996 would have cost you $10,160. The company had a 2 for 1 stock split in 1997 and a 3-1 split in 2000, meaning your holding now totals 600 shares valued at $9,000. However over the period you would have earned roughly $7,700 in dividends representing a return of over 65%.

If investors bear in mind that there are stocks yielding between 4% and 6% and consider the power of compounding as illustrated above, a significant chunk of return can be generated by high dividend yielding stocks.

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