The Importance of Dividends on Investments

When we talk about investing, stock price appreciation usually steals the spotlight, while dividends quietly sit in the background. This is partly because not all companies pay dividends, and at first glance, dividend payouts might seem too small to matter. $1 or $2 does not really make much of a difference, right?

But that is far from the truth.

The importance of dividends cannot be understated. Dividends are actual earnings. They are cash straight in your pocket that can strengthen your finances and bring you closer to your goals. And when you zoom out, these small payments can add up to a significant part of your overall returns.

If you have ever wondered why dividends are important to investors, let’s break it down and explore their role in building wealth.

What are dividends, and why are they given out by companies?

Dividends are a way for companies to share their profits with their shareholders. They are a portion of the company’s earnings and are distributed based on the number of shares you own. For example, if you own five shares of a company and it declares a dividend of $1 per share, you will receive $5 as dividend payments. These payments are over and above any gains you make from the stock’s price rising.

Let’s say you bought the stock at $2 per share, and later it trades at $4. The $2 increase per share is your capital appreciation, while the $1 dividend per share is your cash payout. Together, they make up your total return on investment. While dividends are usually paid in cash, companies can also pay them in the form of additional shares. These stock dividends increase the number of shares you own without you having to spend more money on buying stocks.

However, not all companies pay dividends. Young companies may choose to reinvest their profits back into the business. These can then be used to fuel expansion. This can benefit you later if the company performs well and its stock price appreciates. It will ultimately allow you to earn a profit when you sell your shares. On the other hand, well-established and mature companies tend to distribute a portion of their earnings as dividends. This will offer you an immediate benefit in the form of a dividend.

Why are dividends important?

1. They may give you instant gratification.

When you think of investing in stocks, the first thing that probably comes to mind is price appreciation. You buy a stock, wait for it to go up in value, and eventually sell it for a profit. That is the dream, right? But stocks do not just keep going up in a straight line. Prices rise, fall, and sometimes stay stagnant for years. But dividends can give you income while you wait.

Stock investing is a long-term play. Your shares might double or even triple in value, but it could take years before that happens. Dividends, on the other hand, give you something right now. They are a reward while you wait for the big payoff from price growth. Even if your stock’s price is not moving much, the dividend payments are still being credited to your bank account.

Over time, they will add up and, in some cases, they can even cover a good part of what you initially invested. This can be a tremendous psychological boost because you feel like you are actually getting something back, even if the market is being slow.

Also, even though unfortunate, there is always a chance that a stock never appreciates the way you hoped. The company could struggle, the market could stay down longer than expected, or your financial needs may crop up before your investment gets a chance to deliver. If that happens, dividends can help soften the blow. At the very least, you are still getting paid something for holding that stock. And if you reinvest those dividends by buying more shares, you could get the chance to earn even more in the future. Over the long term, reinvested dividends can be a considerable part of your total return.

But there are some things you need to consider. Just because dividends sound great does not mean you should only buy high-yield stocks. A stock with an unusually high dividend yield might actually be a red flag. It could mean the company is struggling, and the market expects them to cut that dividend soon. Your focus should always be on total return, which is the combination of dividends plus price appreciation. A stock that pays a modest dividend but grows steadily might leave you far better off in 10 years than a stock that just gives you a big payout but does not grow at all.

2. They help you analyze a stock’s potential

Another reason why dividends are important to investors is that they can actually tell you a lot about a company and help you make smarter investment decisions. You can gauge a stock’s value by looking at dividend models. These models can be used to estimate a stock’s fair value based on the dividends it pays and how much those dividends are expected to grow. If the calculated value is higher than the current price, the stock might be undervalued. In this case, you can consider buying this stock at a discount.

Dividends can also help you determine the right time to buy a stock. When a company announces a dividend, it must first declare its amount and the ex-dividend date. If you want to be entitled to the payout, you must buy the stock before this date. The ex-dividend date is usually set one business day before the date of record, which is when the company checks its shareholder list to determine who gets paid. Interestingly, the stock price typically drops by about the same amount as the dividend on the ex-dividend date. That is because new shareholders who buy after that date are not entitled to the upcoming payment.

Dividend announcements can also drive stock prices higher in the short term. When a company declares a dividend, it signals financial stability. This can attract buyers and push the price up, sometimes by roughly the same amount as the dividend. Some investors buy stocks right before the ex-dividend date to qualify for the dividend, then sell the stock shortly after to earn a profit.

However, this can be risky. Prices can fluctuate unpredictably after the ex-dividend date, and frequent trading may also create tax consequences and other short-term charges. Therefore, while helpful, you need considerable experience to carry out a strategy like this, along with the guidance of a financial advisor.

3. They can help you lower investment risk

Dividend stocks are often recommended for retirement portfolios. They have a reputation for being more stable and less risky compared to pure growth stocks. But have you ever wondered why that is?

The most significant advantage of dividend-paying stocks is that they provide you with a regular stream of income. This steady cash flow can be a lifesaver when selling your shares may not be the best option. If you hold dividend-paying stocks, you still receive your dividend checks regardless of what is happening with the stock price, as long as the company does not cut its dividend. This income can cover some of your day-to-day expenses and reduce the need to sell at the wrong time. That is why many retirees prefer dividend stocks.

Another way dividend stocks lower risk is through liquidity. You might not always be in a position to sell your stocks. Dividends give you cash in hand. Of course, dividend-paying stocks are not entirely risk-free. Companies can cut or suspend dividends during difficult times. That is why it is important to conduct thorough research and select established companies with a track record of paying dividends.

4. Qualified dividends can help you save tax

Do you know that some dividends can help you save on taxes? These are called qualified dividends. They are regular dividends in terms of how they are paid to you, but they are taxed differently. Instead of being taxed as ordinary income, qualified dividends are taxed at long-term capital gains rates, which are usually lower.

Not all dividends are considered qualified. To meet the Internal Revenue Service (IRS) definition, a dividend has to check a few boxes. Let’s discuss these:

• Holding period matters: You must hold the shares for at least 61 days during the 121-day period. This period begins 60 days before the ex-dividend date. If you buy the stock too close to the dividend date and sell it right after, the dividend will not qualify. So, be mindful of the time of purchase.
• No hedging allowed: The shares can’t be part of a hedging transaction like short sales, puts, or calls. If they are, you will not qualify for the capital gains tax rates.
• It has to be a qualifying corporation: Most U.S. corporations qualify, as do certain foreign corporations, but some distributions may not count. Make sure you speak to your financial advisor about this.

If the dividend meets these rules, it becomes qualified, and you get to enjoy the tax advantage.

Qualified dividends are reported to you on IRS Form 1099-DIV, so you will know which ones qualify at tax time. The tax rate you will pay depends on your income. For the 2025 tax year, the rates are:

• 0% tax rate if your taxable income is less than $48,350 for single filers or $96,700 if you are married filing jointly.
• 15% tax rate if your income is between $48,351 and $533,400 for single filers or $96,701 and $600,050 if you are married filing jointly.
• 20% tax rate if your income is above $533,401 for single filers or $600,051 if you are married filing jointly.

If you were receiving ordinary dividends instead, you would pay tax at your regular income tax rate, which could be much higher. But if you rely on dividends for income, qualifying for these lower tax rates can make a big difference to your overall profits and income.

5. They give you a reliable source of income

When everything else in your investment portfolio feels unpredictable, dividends can bring a sense of stability. Real estate might go through cycles, stocks can swing wildly, and even bonds may offer lower yields in certain economic environments. Dividends, on the other hand, provide a level of consistency. This makes them a good choice for investors who prefer predictability, especially those who are risk-averse.

In fact, one of the best things about dividends is their versatility. They can work for conservative investors who simply want a steady stream of income, and they can also be reinvested for those focused on long-term growth. If you are just starting out, you can use dividends to buy more shares and let compounding do its magic. If you are already living off your investments, such as in retirement, the same dividends can help fund your monthly expenses.

That said, not all dividend stocks are the same, nor are they all equally lucrative. Some companies have a strong track record of paying and even increasing dividends every year. Others may lack the financial stability to sustain those payouts. So, hiring a financial advisor to research the right options for you is a must. You can also research yourself, but a financial advisor’s work can be much more thorough.

Summing up the importance of dividends to shareholders

Dividends play a potent role in building wealth, but they do so rather quietly. They add to your income, provide financial stability, and can even bring some tax advantages (at least some of them do), all while reducing the overall risk in your portfolio. For many investors, they can also be a useful tool for evaluating stocks. Companies that consistently pay and grow dividends are often financially sound and committed to rewarding shareholders. That said, picking the right dividend stocks takes research and a bit of expertise.

If you have not factored dividends into your investment strategy yet, now is a good time to start. Talk to a financial advisor about how they fit into your goals. Consider what it is that you are looking for. Do you want to create a steady income stream, reinvest your dividends for long-term growth, or add a low-risk, regular payout in retirement?

A financial advisor can guide you toward reliable dividend-paying companies. You can also use our free advisor match tool to get matched with 2 to 3 seasoned financial advisors who can advise you suitably.