Buy a stock and your reward (you hope) is an increase in the stock price as the company grows and appeals to more investors.
But some companies offer another incentive: They pay a dividend, or a portion of profits, to shareholders on top of any appreciation in the stock price. And in the last few years, these types of stocks--and the funds that buy them--have attracted many investors.
Unlike interest paid by bonds, a dividend is not a fixed rate, meaning companies can increase or reduce a dividend. But it can help pad total return, the sum of the dividend and any change in the stock's price.
For example, the Standard & Poor's 500, an index of major U.S. stocks, increased 24 percent over the last five years. The S&P 500 total return index, however, which takes into account reinvested dividends, rose 35 percent, according to data from Thomson Financial.
Translating that into dollars, a $10,000 investment would have grown to about $13,500 with dividends, versus $12,400 otherwise.
Companies that pay dividends tend to be well established and have a steady record of profits. They're often categorized as value stocks, not growth stocks, which are businesses trying to expand rapidly and therefore are reinvesting most of their cash.
That's one reason dividend-paying stocks--and the funds that buy them--have been popular recently. After the dot-com bubble burst earlier this decade shareholders became wary of upstart businesses.
"Investors were burned, and companies that pay dividends tend to be more defensive in adverse climates," said Brian Rogers, manager of the T. Rowe Price Equity Income Fund, which invests in dividend-paying stocks.
At the same time, a federal law passed in 2003 capped the tax rate on dividends at 15 percent, down from as high as 38.6 percent previously.
As a result, dividends became more appealing to shareholders.
"They started to demand it," said Phil Davidson, co-manager of the American Century Equity Income Fund. "They didn't want cash wasted on capital spending."
More demand led more companies to start paying out dividends.
So does that mean you should focus on buying dividend-paying investments? Not necessarily.
-- Balancing risk with return
Stocks that pay dividends tend to be less volatile.
Growth stocks, while more risky, can benefit from major upswings. And as a young investor, with enough time to overcome market setbacks, you could receive a higher return by being more aggressive.
"Dividend-paying investments are probably less appropriate for young investors, except for conservative young investors," said T. Rowe Price's Rogers.
Just keep in mind that the market will not always favor dividend-paying stocks, despite their recent popularity. In fact, there is growing buzz among fund managers about growth stocks.
"It's just the growth-value cycle that has gone on for years and years," Rogers said.
-- Expenses can eat into dividends
On top of weighing risk versus return, you also have to pay attention to fund expenses, which can reduce a dividend's benefit, according to John Coumarianos, a mutual fund analyst at Morningstar Inc.
The Fidelity Spartan 500 Index Fund, for example, has a yield of 1.54 percent, according to Morningstar.
The yield is the dividend paid out over the last 12 months, divided by the stock's price. The Fidelity Equity-Income Fund came in just shy at 1.51 percent. The difference could be explained in part by the funds' expenses: The Index fund charges only 0.10 percent, while you'll pay 0.67 percent for Equity-Income.
-- You may have dividend stocks already
Finally, you don't have to invest in a fund that solely picks dividend-paying stocks. An index fund that tracks the S&P 500, such as the Fidelity Spartan 500 Index Fund, will hold a mix of growth stocks and dividend-paying stocks--which may be just the blend you need.
E-mail Carolyn Bigda at firstname.lastname@example.org.