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Retirement Weekly: What value do mutual fund dividends provide?

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Q.: Hi Dan – Thank you for writing Opinion: I just got a huge dividend payout from a mutual fund and my investment value dropped — what’s going on? What value do mutual fund dividends provide? If a dividend is paid out, the value of the mutual fund goes down to cover the dividend. In addition to the mutual fund value going down, we pay taxes on dividends. It doesn’t seem like dividends from mutual funds are a good thing. Any feedback would be appreciated. 

Thanks, Chris

A.: Chris, from the perspective of the total dollar value to you as an investor, dividends and capital gain distributions from mutual funds have no effect because of the ex-dividend dynamic I describe in that article, and you correctly described in your question. A dividend payout in and of itself does not add anything to your bottom line but an investor may see value in owning shares of dividend paying securities, nonetheless.

Like many things, dividends present pros and cons. To declare them good or bad, requires some context and the judgment can change from person to person based on what’s important to them. There is nothing wrong with dividend-paying securities per se. We think everyone with a well-diversified portfolio should own some.

Most U.S. companies do not pay dividends. One reason for that is the tax code makes paying dividends less desirable because a company must use after-tax funds to pay the dividends. If a company is paying a dividend to shareholders, it has less cash for raises, R&D, marketing, or anything else. As a result, generally, newer enterprises and companies focused on higher growth tend to eschew dividends. 

If you look at just the larger, more established companies, dividend payments are more common. Paying dividends is often viewed as a signal that a company is doing well and well established. Most diversified investors want a combination of stock in well-established companies and up and comers.

That said, there are two errors I see made again and again with dividends. One is to think dividends are the same as income from a bond or CD.

As we both mentioned earlier, that is not the case. The principal value of a CD doesn’t change when interest is paid. Same for bonds, though bonds are subject to market fluctuations until maturity. By contrast, per share values of dividend paying stocks can see dramatic declines.

The second error is to think a high dividend yield is the sign of a good stock. Ie, “If a stock with a 2% yield is well-established, then one that pays 8% must be really solid.” Be careful with that line of thinking.

Yield equals the amount of the dividend divided by the price of the stock. The yield can increase by the company paying a higher dividend, but it can also increase via a drop in share price. In many cases, the share price drops because there are doubts about the company’s ability to pay the dividend. When times are tough for a company, it may be decided the cash needed for a dividend would be better deployed elsewhere. For example, according to Dimensional funds, in the first three quarters of 2020, dividends from each dollar invested in U.S. markets decreased by 22% compared with the same period in 2019. As a result, it is usually better to view a high yield as a sign of higher risk.

Overall, just keep in mind that it does not need to be a matter of owning dividend paying stocks or not. A sound portfolio should have a well-diversified array of holdings that includes both dividend paying and non-dividend paying stocks.

If you have a question for Dan, please email him with “MarketWatch Q&A” on the subject line. 

Dan Moisand is a financial planner at Moisand Fitzgerald Tamayo serving clients nationwide from offices in Orlando, Melbourne, and Tampa Florida. His comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some reader questions are edited to aid the presentation of the subject matter.

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