Retirement portfolios make money for you a number of ways. Of course, they hold stocks, which can rise in value and be sold at a profit.
They also hold bonds, which are loans by an investor to governments or corporations. The loan is repaid with interest, resulting in a gain in the form of interest paid.
The gap between the repaid loan and the extra money you earn as interest can be calculated as “yield,” a predictable return expressed as a percentage.
But what is “dividend yield” in a retirement portfolio?
Dividend yield is a form of periodic cash income earned from stock holdings. It’s calculated slightly differently, since stock ownership is not a loan, but it can be easily compared to bond income and is relatively predictable.
If you own a share in a corporation, you are an owner, just the same as the founder, the board and the employees who work there and collect stock in their pay packets.
Being an owner, however small your investment, often means that you are entitled to a portion of the company’s earnings — the dividend.
Every three months the board meets to release new earnings results, reporting on whether the company made or lost money.
Many companies take profits and reinvest them. Or, they can give a portion of that cash to shareholders.
Growth companies, for instance, often choose to use profits to expand, buy out competitors or to finance research and development. That’s usually a good thing for investors, if the opportunities are real.
Other companies issue occasional dividends as money piles up, especially if no clear new investments are at hand. Better you should take your money to invest elsewhere.
Still others are stocks known as “dividend payers.” They pride themselves on disbursing extra cash every quarter, often raising the dividend each year and never missing a payout for years and years.
If you decide to own a dividend payer, you can figure out what your yield will be by dividing the dividend amount paid over one year by the current share price.
For example, if a share costs you $50 and the total annual dividend payment is $2, then the dividend yield is 2/50 = 0.04, or 4%.
If you know the stock pays 4% at $50 a share, then as the price of the stock falls the dividend yield will go up, assuming the dividend payment amount in dollars remains unchanged.
For instance, let’s say the share price drops to $40 but the dividend is still $2. At the new price, 2/40 = 0.05, or 5%. The dividend yield is higher on any shares bought at the lower price.
Considering that the long-term bond yield is relatively low, at around 2.6%, a stock that pays 5% can be an attractive proposition. As long as the dividend remains steady, the risk of loss is low.
Dividend stocks are very attractive when their prices drop, if the dividends are reliable. It is far more common for a dividend to be cut than for a bond to default, however. Companies also can go out of business, of course.
Nevertheless, dividend yield is an important indicator of value for many investors, particularly those seeking to avoid the risks of pure long-term bond investing. Held in a diversified portfolio, dividend stocks are an important tool for retirement investment growth.