Sunday, November 2, 2008

How Is A Dividend Different To Interest?

by Aussie 0 comments

When you put your money into a savings account at the bank, it is on the understanding that you will earn some interest on that deposit. It's your reward for letting bank use your money for a while. Alternatively, you could say it's the cost a bank incurs when borrowing your money. Dividends are a little bit like interest but with a number of subtle yet important differences.

A dividend is a payment a company makes to its owners (stock holders) out of any profits it makes in a given period. Dividends are normally paid either quarterly or half-yearly.

While the interest you receive on your deposit in a savings account is typically agreed up front (ie. the interest rate is advertised), the amount a company pays out in dividends is a little more fluid. The payout may fluctuate from year to year. If the company is successful, the the amount will normally go up each year. However, when profits falls, so does the dividend - and if things get really bad, there may be no payment at all.

Another thing to consider about dividends is the chance of capital appreciation (or capital loss). In order to receive a dividend, you must first buy stock in a given company. You may consider this to be the equivalent of making a deposit in a bank savings account. However, when it comes time to take your money back out again, there can be a big difference between a bank and a shareholding.

With a bank account, you would expect to receive back the same amount of money as you deposited, plus your interest (not withstanding the present economic climate). But with a stock market investment, you need to sell your shares to get your money back. And for this, you will be at the mercy of the markets. Stock prices may have gone up - but as we have seen over the past year, they can also go down.

Now it's is not all down and gloom with dividends. History tells us that provided you invest in good quality stocks for the long term, then your dividends, along with some capital growth, will exceed the interest you could get in the bank. Just be aware that a much longer time horizon is needed. Most investment professionals recommend 5 years or more.

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