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A dividend is a token reward paid to the shareholders for their investment in a company’s equity, and it usually originates from the company’s net profits. While the major portion of the profits is kept within the company as retained earnings, which represent the money to be used for the company’s ongoing and future business activities, the remainder can be allocated to the shareholders as a dividend. However, at times, companies may still make dividend payments even when they don’t make suitable profits. They may do so to maintain their established track record of making regular dividend payments.
The board of directors can choose to issue dividends over various time frames and with different payout rates. Dividends can be paid at a scheduled frequency, like monthly, quarterly or annually. For example, Walmart Inc. and Unilever make regular quarterly dividend payments. Additionally, companies can also issue non-recurring special dividends either individually or in addition to a scheduled dividend. Backed by strong business performance and an improved financial outlook.
Companies pay dividends for a variety of reasons. These reasons can have different implications and interpretations for investors.
Warren Buffett and Albert Einstein once noted that the most powerful force in the universe was the principle of compounding. In investing, this manifests itself through something called compound interest.
In simple terms, compound interest means that you begin to earn interest income on your interest income, resulting in your money growing at an ever-accelerating rate.
In other words, if you have $500 and earn 10% in interest, you have $550. Then, if you earn 10% of interest on that, you end up with $605. And so on and so forth until you have a very hefty sum of money.
It is the reason for the success of every person on the Forbes 400 list, and anyone can take advantage of the benefits through a disciplined investing program. Benjamin Franklin was famous explaining to people that it was the best way he knew how to get rich.
Three things will influence the rate at which your money compounds. These are:
The concept of compound interest is the foundation of the time value of money, which states that the value of money changes to a person depending upon when it is received. Earning $100 today is preferable to earning $100 several years from now. After all, if you have it in your hand immediately, you can invest it to generate dividends and interest income. After that, you can spend it on things you want, you can pay down your debt to lower your interest expense, or you can give it to charity. By postponing the receipt of the $100, you are losing something economists call opportunity cost.
The best way to understand these concepts is to put them into a compound interest table that shows you just how substantially your wealth can be helped, or hindered, by small changes over time.
For instance, a 20-year-old that invests $10,000 today and parks it in Treasury bills, earning 4% on average for the next 50 years, will find himself with $71,067 if the purchases were made through a tax free account such as a Roth IRA. Had he invested in stocks and real estate, earning a 12% average rate of return over the same time, he would have ended up with $2,890,022. Adding higher returning asset classes would result in more than 40 times more money thanks to the power of compound interest.
One glance at the compound interest chart and you may want to do whatever it takes to earn the higher rate of return—in this case, 16%. That can be dangerous. Unless you know what you’re doing, no matter how successful you are along the way, you always want to avoid the possibility of losing all your savings. In finance, 20%, 40%, 60% returns in the first years are great, but if there is a -80%, -90%, or -100% in there anywhere, it’s game over because you will have lost your capital. Without capital, you can’t make investments that will later grow.
Benjamin Graham, known as the Father of Value Investing, was aware of this risk when he said that more money had been lost reaching for a little extra return or yield than has been lost to speculating. He warned that it is one of the greatest temptations new investors face when building a portfolio.