Why dividends matter

If I could sum up my investment philosophy with one word that captures what I consider to be the most important ingredient in a successful wealth-building strategy, that word would be … dividends. I love dividends. I do not buy stocks that don't pay dividends. If my wife would have let me, I would have named our first-born child Dividends. Okay, maybe not, but you get the idea.

What is it that I adore about dividends? Well, for starters, dividends pay you a regular stream of cash. And because dividends are taxed at more favourable rates than interest income, more of that cash stays where it belongs - in your pocket. If you make $80,000 a year and live in Ontario, for example, you'll pay just 12.9-per-cent tax on eligible dividends, compared with 39 per cent on interest.

This low tax rate is made possible by the dividend tax credit, which is one of your best friends as an investor. For an explanation of how the dividend tax credit works, check out this column. For a look at dividend tax rates in different provinces and at different income levels, visit taxtips.ca.

Low tax rates aren't the only reason I like dividends. When a company pays a dividend, it's a sign of financial health. When a company raises its dividend, as many banks, insurers, pipelines, cable and telecom providers have done over the years, it's an expression of confidence about the future. That's why, when choosing dividend stocks, I stick to those with a history of increasing their dividends.

Apart from paying you more cash every year, dividend growth stocks also outperform the market. According to a 2006 study by RBC Dominion Securities, stocks with rising dividends returned an average of 17.2 per cent over the preceding 10 years, compared with 8.6 per cent for the S&P/TSX composite index and just 1.3 per cent for non-dividend payers.

Here's an article I wrote on building a portfolio of Canadian dividend growth stocks.

True, some companies cut their dividends this year, but when the economy recovers, dividend growth should resume. Even as the financial industry reels from the aftershocks of the credit crisis, many other companies are still raising their payouts. The list of dividend growers includes BCE, Rogers Communications, Enbridge, Fortis and many others.

Here's another reason dividends are important: They can mean the difference between so-so returns and fabulous profits in the stock market. According to a study by Barclays Capital, $100 (U.S.) invested in U.S. stocks in 1925 would have grown to $6,443 by 2008, assuming dividends were not reinvested. But if dividends had been reinvested in more shares, that $100 would have grown to $193,687.

This is the magic of compounding at work, and it reveals the awesome power that those seemingly small quarterly cheques have over time. You ignore dividends at your financial peril.

So now that I've convinced you about the importance of dividends, you're probably wondering how to invest in dividend stocks. If you're not comfortable building a portfolio of individual companies, there are plenty of dividend mutual funds to choose from. Only problem is, you'll pay a hefty fee for the privilege of having a manager in charge. Even so, it can be money well spent.

Consider the BMO Dividend Fund, which has a management expense ratio (MER) of 1.7 per cent. Even with those fees weighing it down, the fund still managed to post a 10-year annualized return of 8.9 per cent through Aug. 31, handily beating the 6.7-per-cent return of the S&P/TSX total return index.

Investors can also choose from a growing number of dividend exchange-traded funds, or ETFs, which provide diversification but have lower fees than mutual funds. One example is the iShares CDN Dividend Index Fund, which has an MER of 0.5 per cent and invests in banks, telecoms, insurers, pipelines, power producers and other solid dividend payers.(It's worth noting that financials account for more than two-thirds of the fund, which may be on the high side for some investors.)

There's also the Claymore S&P/TSX Canadian Dividend ETF, which has a higher management fee of 0.6 per cent but offers more diversification by virtue of its exposure to income trusts and real estate investment trusts. Claymore also allows investors to reinvest their dividends in more units without incurring additional brokerage fees, so you can make the most of compounding.

Dividends will not make you rich overnight. But if you focus on companies that raise their dividends, and if you spend those rising dividends on more shares, you'll be on a long-term path to wealth.