What Are Dividends?

Even after years of studying and working in finance, the mention of dividends still reminds me of the little mustachioed man from the Parker Brothers Monopoly game—"Bank pays you dividends of $50!" As I recall, the little man is joyfully tossing his money in the air while kicking back at a desk with a rotary phone. It was always a little underwhelming, of course. Fifty bucks is a nice, but it doesn't count for much, even in Monopoly. It's not like landing on Free Parking, is it? And that's pretty much how we feel about actual dividends. But they do matter, and it's worth understanding why.

Most of us invest in stock these days in the hopes that the price of the shares will go up while we own them. I buy shares in Apricot, Inc. stock for $20 a share today because I believe that I can sell them each for $30 or $40 in a few years time. Simple.

But even while I am watching the share prices jump around in the market, the company I invested in is actually busy trying to, well, run a company. If Apricot, Inc. is doing this right, it is creating new products, expanding in new states or countries, keeping current on its debts and hopefully, making a profit. Notice that while all of this great, profit-generating activity can have an impact on the company's share prices, it can also be completely ignored by the people buying and selling stocks. After all, the shareholders will be completely happy if the share prices go up for any reason, even if the company itself is actually losing money. This, by the way, is the story behind a lot of the big social media and app companies today (I'm looking at you, Twitter).

All of this means that your average CEO is trying to run a company for the long-term while also making shareholders happy in the short-term. One of the tools at her disposal to appease shareholders is dividends. When a company has a profitable year, it can put the money back into the business, or it can declare a dividend. The dividend will go to all of the people who own a certain class of the stock. And the company can pay this dividend out in cash (which you can reinvest or use to update your rotary phone) or in partial shares, called a "stock dividend." If the company chooses stock or "scrip" dividends, then you as the shareholder will get an additional fraction of a share for every share you currently own. For instance, if you have 10 shares of Apricot, Inc., stock and Apricot announces a dividend of .05, you will get a new .05 of a share for each share you currently own, which brings your 10 shares up to 10.5 shares.

As you can imagine, people don't tend to get very excited about their new partial shares, but this is where reinvestment comes in. Many companies issue dividends every year, and these little bits of shares can accumulate fast. This doesn't help you at all if the share prices don't go up, or if company doesn't fare particularly well in the long-term. But then, you don't lose anything from the dividends in that case. But if you have chosen well, and your share prices really are going up over time, you won't just make money on the shares you originally bought—you'll be making money on shares you didn't have to buy.

And that, my friends, is why the little man with the round face and mustache is feeling so good about his dividend.

Should I keep putting money in this investment? Dollar-Cost Averaging and Time

I got a great question yesterday about the difference between saving and investing. Everyone knows that we are supposed to regularly save money. Most of us who follow a set savings plan have our banks set aside a little bit monthly or from each paycheck just to make sure this is happening. But putting money aside in a savings account is not the same as regularly investing it in a stock, bond or fund. We all know the difference matters. So here are a few things to think about when you are trying to decide where, exactly, the money goes.

Dollar-cost averaging.

This is the auto-pilot of investing, which makes it one of my favorite techniques to recommend to new investors. The old "buy low, sell high" investment advice suggests that you should be analyzing the market every time you buy more units of your favorite stock, bonds or fund—not so realistic if you are putting money aside monthly and don't plan to give up your job for day trading.

Fortunately, dollar cost averaging studies show that you actually do well over time by choosing your fund and buying into it at a regular interval, regardless of the price that day. Some months, you will pay more as the price goes up. Other months, though, you will hit those bargain moments when the price is temporarily down. And in between, you usually take advantage of the general growth in the market.

If you could predict the future, you could always get the lower prices, but since none of us (even the experts) are really good at those short-term predictions, statistics show you are better off to not even try. With this in mind, use the settings in your investment account to automatically invest your monthly savings in a good fund. And don't forget the automatic dividend reinvestment setting, too. We love studies that tell us to do less work.

Volatility and your investment account.

Let's say that you already have money in the investment account and want to keep adding but know that the college tuition bill or house down payment will be coming your way in a few years. This is when you start thinking about volatility.

Volatility is the measure of how often and how dramatically the value of a particular investment tends to change. A mutual fund with high volatility will drop and soar in price regularly. We don't have a crystal ball, but we know that the value of bonds tends not to move very fast while company stocks tend to be volatile. For this reason, financial planners recommend that you start putting more of your money in bonds as you get closer to the time when you need it. After all, you don't want one of those price drops to hit just when the tuition bill comes due.

If you don't have a financial planner to help you figure this out, try creating your own simple version of one—pair a cheap, blended stock fund with a government bond fund. As you get closer to when you need your money, put more into the bond fund. (For more on how to choose a fund, check out this earlier post). Or, you could use a "Target Date Fund."  Target date fund managers assign each fund a target year when the investor expects to start drawing out money. The fund manager gradually shifts the investments as it gets closer to that year. Target date funds and blended funds are only a rough approximation of your needs, but they can be a cheap and viable way to manage things yourself.

Bank Accounts verses Investment Accounts

Almost all of the investment advice you will see on the internet assumes you are going to leave that money in your investment account for a long period of time—preferably 10 years or more. Why? Because we are betting that the economy and its markets will continue to grow bigger over time. The majority of investment professionals have developed their strategies to take advantage of just that fact. On the other hand, we are all pretty much positive that the market's growth is not going to be smooth and easy. In other words, we expect a few dips and crashes along the way. That's where your time problem comes in. If you need that money out in 2 years, you may get hit with the crash but not had time to benefit from the growth. It's a good way to lose some of your hard-earned money.

There are cases in which you are better off to use an investment account than a bank account even if you only plan to put the money in something very safe. College savings accounts and retirement accounts offer tax advantages over regular bank accounts. But if you aren't looking for the tax deferral and you are just putting the money away for a few years, don't overlook your bank. I find that local banks and credit unions often offer you better interest rates on savings accounts and CD's (Certificates of Deposit), so you can squeeze just a little bit more out of that savings.

Follow the plan

The single most important factor in determining you success as an investor is making a plan and sticking to it. Choose your strategy and your investment allocation first. And then let all of those auto-deposit and auto-invest features work for you. I firmly believe that paying for a financial plan at this stage is a bargain for just about anyone. But if you are willing to put in some time and do a little research, you can do this yourself. Ready to start? Begin with this How To Start Investing: Basics for Doing It Yourself.

It isn't really about the investments

September is always a busy month for financial advisors. Everyone has returned from those last vacations of the summer, kids are back in school and there is a general sense that it's time to get back to work. At this point in the year, we usually get a lot of interest from people who have steeled themselves to face the investment questions they have been putting off: should I own these bonds? Is this a good stock still? What about this mutual fund? Should I have bought this annuity? And over and over again, I find myself explaining that it isn't really about the investments. By which I mean that I can't answer any of your questions about whether an investment is "good" until you've answered some questions about what you are trying to do with it. And that's the really stuff part about buying, selling and managing investments. There are some truly crummy investments out there, but for the most part any given investment is "good" for somebody. It's just a question of whether that someone is you.

Let me give you an example. We invest most of our clients' money in a long list of stocks or index funds that are designed to move with different portions of the economy. A so-called U.S. "mid cap" index fund should reflect how well the stocks of our large (but not enormous) publicly traded companies are doing as a group. We like this type of index fund strategy because, historically, it has allowed investors to take advantage of the growth in U.S. markets over time (and it's relatively cheap to do!). But that growth in "mid cap" companies over time might require a long period of time—years, in fact. What if you might need that money three years from now? What if your investments are in a 401k that doesn't have a "mid cap" fund? Or, what if you know you are only going to look at your investments every couple of years? What if your job hinges on the health of these same "mid cap" companies? In all of these cases, I might recommend that you avoid one of my favorite investments. They can be just as bad for your strategy as they are great for someone else's.

I write this blog so that you can better understand the often intimidating world of investments and consumer finance. You need to financial understand the tools that are out there if you are going to make the most of what you have and what you earn. Never lose track, though, of the fact that these are tools. And just as the best drill in the world is a lousy tool for fixing your tv set, the best investment in the world could be exactly what your financial strategy doesn't need.