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.

What the Heck is an ETF? More on Understanding Funds

When I first started this blog several months ago, I added a snappy little glossary definition of ETF's, figuring that I would not be able to get many of you excited about them as a topic. But the other night I got a question from a reader about these increasingly popular investment vehicles, so I have decided it's time to give you the fully story (or at least the slightly-longer-but-not-too-tedious story)—

Let's start with my original glossary definition:

An investment fund that tracks a list of stocks, bonds, commodities or other investments. Investors own shares of the fund, rather than directly owning the investments within it. Unlike mutual funds, ETF's trade like a stock such that the price changes throughout the day.

The best known ETF's are index funds and are popular for their low costs.

If you really want to wrap your head around ETF's, you need to understand how funds in general work. A fund is a like a shared pot for which the fund manager buys a selection of investments. Those investments are usually stocks or bonds, but there are other investments they can choose from as well. Once the fund manager has created that "pot", she will buy and sell investments according to whatever strategy she has laid out at the beginning—think of that strategy as the fund's "recipe." The recipe can be pretty precise: "I'll only buy stock from companies that make things out of timber." It can be broader: "I'll look for the most undervalued stocks in the U.S. market." Or it can be blended: "I'll always keep 70% U.S. stocks and 30% U.S. bonds."

Regardless of the fund manager's strategy, all of the money for these purchases comes from people like you who buy shares in the fund. And this raises the question of how you buy "into" the fund...and how you get your money out. This is where the type of fund you buy—ETF or mutual fund—makes a difference. If you want to purchase or sell one share of a mutual fund, you will always find the price of a share from the fund's Net Asset Value (NAV for short). That number is a simple calculation of how much the fund's current investments are worth, and it's only calculated once a day—at the end of the trading day. Simple!

An Exchange Traded Fund (or ETF) doesn't make things so easy. Just as stock prices slide up and down over the course of a trading day as people bid and sell them, an ETF price slides around constantly depending on how much traders in the market are willing to pay for a share in it at that moment. If everyone is betting that the fund manager is doing well, the price of a share in the ETF will go up (and vice versa).

Should you buy ETF's?

As you can see from my glossary entry, ETF's have been a particularly popular form of "pot" for a fund manager wanting to create an index fund, where the "recipe" is to have a little bit of everything on a given list (say, all companies on the S&P 500, or all U.S. oil companies). With index funds, a computer does most of the work calculating buys and sells, and the fund manager generally can charge you, the fund owner, a little less as a result. Lower fund management fees is always a good thing.

And there is one other thing you should know about ETF's vs. Mutual Funds—the taxes are different. If you own a share of a mutual fund, you and the rest of the fund's owners will share the fund's tax bill at the end of the year. These are called contribution taxes, and they come from the capital gains taxes created when the manager sells an investment in the fund for more than she paid for it. As with any investment, you will also pay a capital gains tax on your shares when and if you sell them for more than you originally paid.

On the hand, the IRS treats ETF's like a big, funny looking stock. As with the mutual fund (and other investments) you pay capital gains taxes when you sell your shares. But the IRS ignores the fact that the ETF has all of that other buying and selling going on inside it, which means no contribution taxes for you. A lot of investors and fund managers choose ETF's over mutual funds for this tax efficiency.

Have more questions about ETF's or other investments? Post something to me in the comments box below!

What The Heck Happened To The Stock Market?

Most of you probably did not notice the drop in your retirement accounts at the end of last week. CNN was still covering the story of the American guys on the French train, and frankly, there in nothing more pointless than staring at your 401k balance every day. This morning, however, CNN and the rest of the media are off to a roaring start on the topic of stock markets. While we were sleeping, China's market gave in to the fears of a crash... and crashed. Which led the European markets to fall into a bit of a frenzy during the wee hours of our morning. Which caused our own market traders and press to fall into a tizzy over their morning coffee. And there you are; a news story to rival failed terrorist attacks. So, is this the crash we've been dreading?

Probably not. Don't get me wrong, this is going to hurt in China, where we have suspected for months that the amount of money (much of it borrowed) in Chinese stocks is excessive. And the amount that middle-class Chinese investors lose here could well cause problems for some companies that depend on those Chinese consumers. But very few people outside China are invested in this market. In fact, it was only in October of last fall that China began to give out licenses allowing foreign investors to buy directly into their markets. And that move itself was a sign of China's new direction.

The Chinese economy has grown by leaps and bounds for years now. Economists like to measure the size of a nation's economy by calculating Gross Domestic Product (GDP). Roughly speaking for our purposes, GDP takes one year of information and adds together how much a nation's consumers spent, how much the government spent, how much businesses invested and how much was exported minus how much was imported in that year. To figure out whether a country's economy is going forward or backward, we compare that number to how much the economy produced the year before

In its best years, China's GDP has grown by as much as 14.2% from one year to the next. And China has had no difficulty getting its GDP to grow about 7% to 8% a year since 2012. That number seems to be steadily dropping, though, which means that while China's economy is still getting bigger and richer every year, it may only be by 6% instead of 7%.

You might be thinking that this doesn't sound like such a bad problem to have. And you'd be right. Consider this—for 2014, the annual growth rate of the U.S. was 2.3%, the U.K. was at 2.6%, and Germany was at 1.6%. Among the "highest performing" countries in terms of growth rate were South Sudan (36.2%), Sierra Leone (13.8%) and Papua New Guinea (8.4%). The fact is that 2% of a lot is still bigger than 36% of next to nothing.

So why is China in panic mode? What all the figures are telling us is that China is no longer (and hasn't been for a while now) an "emerging market" or a "developing country." It is a significant player in the global economy with a well-developed work force, a solid middle class, and a stock market capable of handling enormous investments in Chinese firms. The nation now has to iron out its plans for this new role. And the rest of us are going to have to adjust to those plans, as well. That doesn't mean the transition will be easy, but it does mean that China's stock market problems are not likely to cause a global melt down this year.

And if you are feeling anxious about that 401k balance this morning, take another look at last month's post, What To Do When The Stock Market Drops.

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Curious about GDP? Read more at Investopedia's GDP entry, or check out the GDP growth rates of all the world's economies at Trading Economics.