Investors love dividends, and for good reason. Getting paid to hold a profitable stock is always an added bonus, and dividends receive preferential tax treatment too, being capped at a 23.8% rate. However, dividend yields are greatly misunderstood by many. Many investors think of dividend yields as a return on invested dollars, thus a higher yield implies a better investment. In some ways we are programmed to look for recurring cash inflows as a means for survival, making this lesson a little hard to digest. But a good understanding of how to think of dividends can help deliver better investment results while meeting your income goals.
Let's start with the basics - why do investments or assets earn an income? For a risk-free treasury bond, the income is a compensation for parting with current liquidity. You are parting with a hundred dollars today to receive back the hundred at a future date. If that future date is a year from now then you earn an income of two dollars for the year; if it's ten years away then you can earn almost three dollars each year. Thus, the longer the commitment, the higher the income. Now what if there were risks involved and you didn't know if you would get your $100 back at the end of the first year or $95? You would certainly demand a higher income as compensation for not just parting with your money today but also for accepting the risk of a five-dollar loss on your capital. Junk bonds do just by that paying an income of six dollars per hundred.