Logic is at the heart of any good investing strategy, yet for many investors logic is thrown out the window and emotions take over. Greed, fear, overconfidence and built-in cognitive biases are just some of the pitfalls that keep investors from making rational decisions.

Invest for Cash Flow, not just Capital Gains, with Dividend Paying Stocks

For example, most investors chase hot stocks without knowing anything about their fundamentals. But even when investors take the time to look at the fundamentals, many miss a powerful advantage that’s usually staring them right in the face.

What is this advantage? Dividends.

Most investors invest solely for capital gains, hoping to make money when a stock’s price increases. Smart investors invest for both capital gains and dividends. That’s because dividends provide a steady cash flow stream that can be used to purchase additional shares, build positions in other assets or simply used for other purposes, such as retiring debt.

Dividends can also see you through rough patches when markets fall and panic reigns supreme. They can provide money to purchase inexpensive shares when prices fall and other investors don’t have cash available because they invest solely for capital gains.

In fact, a large portion of the markets’ returns come from dividends. From 1975 to 2009, global stocks provided an inflation-adjusted annual return of 6.9%. Of that, 2.9% came from dividends while 4% came from capital gains.

In addition, dividend paying stocks generally outperform the market because such companies need to be profitable in order to continue paying out dividends. To see this in action, if we look at the S&P 500 from 1980 to the beginning of 2010, the annualized, non-inflation-adjusted, return would have been about 11.2%.

However if we chose the top 30% of S&P 500 stocks with the highest dividend yields, the result would have been an amazing 24% annualized, non-inflation-adjusted, return.

But there is a limit to this thinking. Stocks with ultra-high dividend yields tend to severely underperform (because these stocks’ prices are usually in free fall, for a variety of reasons – none of them generally good, and so make bad candidates for your portfolio).

Therefore it’s important to not only look at the dividend yield but also at a stock’s fundamentals and moat strength. Bad stocks with prices that are rapidly falling will eventually have to cut, or eliminate, their dividends.

However if you can find strong companies with solid moats that also provide a relatively high dividend yield, then these are the types of stocks on which you should concentrate because not only will these companies have the best chance of continuing their strong performance, and thus provide you with decent capital gains returns, but they will also deliver a healthy dose of cash flow during the years you hold them.

And if you’re able to purchase these companies at a discount to their intrinsic value, you’ll have a better chance of making more on the capital gains side and the dividend yield will be higher.

But that’s not all. Investing in dividend paying stocks is also appealing because good companies have a tendency to raise their dividends over time which puts more money into your pocket and is a sign the company is healthy (because only healthy companies can afford to continually raise their dividends over long periods of time). Plus, stocks with increasing dividends have historically outperformed their static dividend paying brethren by about 2% annually.

A good rule of thumb is to look for companies that have increased their dividend at least 3 times in the past 5 years.

And if that weren’t enough, dividend paying stocks tend to fall less than their non-dividend-paying counterparts during market corrections.

In his book, What Works on Wall Street, James O’Shaughnessy looked at high-yielding dividend stocks from 1951 to the end of 2003. Large cap stocks plunged a terrifying 46.6% during the worst market correction over that period while the 50 large cap stocks with the highest dividend yields fell by just 29% during that same market correction.

He also discovered these stocks displayed less volatility.

Given these benefits, it’s incredible more people don’t concentrate more on dividend paying stocks. If you’d like to improve your portfolio’s return and lower its volatility, take a look at what investing in dividend paying stocks can do for you.

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