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.

Three Terms to Make You Sound Smarter About Investing

No industry does jargon better than finance. You can start with the ETF's, the PFI's and OsMA's and move right on to the "fill-and-kill's" and candles (not the lovely, romantic kind). The implication seems to be that people who work in finance are just too busy to speak English, because you know, the extra 1/10th of a second to spell out that acronym could cost millions. If you want to become an insider in the world of financial acronyms, Investopedia will happily share with you a term of the day (I notice today's term is "topless meeting," which sound pretty juicy). But if you just want a few terms to throw around at cocktail parties, I've made up this helpful quiz (in multiple choice format, of course) to make you feel smarter:

Question One

You are introduced to a guy at a cocktail party who, after bringing up the topic of his stellar investing strategy, explains that he's got great alpha. You:

A. Pretend to receive a text from your "boyfriend" and get away as efficiently as possible;

B. Congratulate him on his spiritual awareness;

C. Ask him what sort of product "Alpha" makes;

D. Congratulate him on beating his benchmarks and lowering his investment risk.

Answer: D. Technically, anyway. Alpha is a favorite term throughout the investment community for saying that the investment strategy you are using is calculated to get the same or better returns than others like it but with less risk. I will leave you to guess how often this claim holds true over time—obviously, Answer "A" also works.

Question Two

A stockbroker offers to get you in on stock in a privately-held company she thinks will become the next Uber. The question most likely to bring her up short is:

A. How much do I need to invest?

B. What kind of liquidity does the stock have?

C. How do you know the stock value will go up?

D. What is Uber?

Answer: B. A stockbroker gets paid a commission every time she sells someone on a stock. If she's any good at her job, she will have ready-made answers to most of your questions: "The minimum investment is $10,000, but I would buy more right now while you can still get a deal—once people know about it, the price will skyrocket"; "the founders  were involved with [insert earlier hot start-up here], so they really know what they're doing"; "we hear they're in talks with [insert well-known corp. here]."

But whether you believe in this new company or not, liquidity is going to be an issue. Liquidity means "how easily and quickly can I get my money out if I want it?" With a privately-held company the answer is almost always "not very." Privately held companies almost always make it very hard to sell your shares, in part because it's just too difficult to figure out what they're worth. Even private funds (like hedge funds) generally require you leave your money in for a certain period (often 10 years). To be able to put your money away and take it out again on demand, go for the publicly traded stuff you see on the stock exchanges.

Question Three

Your broker hears you are about to inherit money and offers to set you up with a margin account. You:

A. Say yes, assuming this is some type of account for inherited money;

B. Say no, assuming that anything called a "margin account" must be marginal, at best;

C. Tell her you'll update your financial plan and see if you want to be that aggressive with your investments;

D. Ask if that comes with an all-you-can-eat buffet

Answer: C. A margin account lets you borrow money from the broker who is selling you the stocks. Say you have $50k in cash and $200k in stocks in your brokerage (stock trading) account. You would normally have up to $50k to buy a new stock unless you wanted to sell some of the other stock. But in a margin account, the broker loans you money to buy more than the $50k worth of stock. This means that if your new stock's price goes up, you can make even more money (!). It also means that if your stock's price goes down, you could lose a whole lot more money. Every margin account comes with a maintenance margin—a ratio between how much your whole account is worth at a given moment and how much you have borrowed. If the value of any of your stocks go down below that level, your Broker will automatically call in their loan, leaving you with a choice of selling off your stocks (often at the worst time) and adding more cash to the account.

All this means that answer D makes sense, as well—if you are just looking for a good way to gamble with your money, the casinos will generally throw in a good buffet for your trouble.