What Is a Dividend? | Finances | MD&D #24

Evidence based insights into physician compensation, RVUs, contracts, healthcare economics, and personal finances. For residents, fellows, and early-career attendings.

Life and Finances, in Medicine.

If you're learning about investing, you've probably come across terms like dividends, dividend stocks, or a company raising its dividend. Like me when I first started, you may wonder what a dividend is, and why it matters.

When you own a share of a company's stock, you own a tiny piece of that company. When the company makes a profit, it has several choices. It can reinvest the money in the business, buy back some of its own shares, or return some of that money directly to shareholders. A dividend is that direct payment to shareholders. Dividends are usually paid in cash and deposited into your investment account, often quarterly.

A Little History

Dividends have been around for centuries. The Dutch East India Company, in the 17^th century was one of the earliest major companies to pay dividends to shareholders. Some of these were even paid in goods, like spices. For much of investing history, dividends were an important reason people owned stocks. Investors could buy shares, hold them, and collect income over time. They treated it like owning a rental home.

But there is an important concept that is easy to miss. A Dividend Isn't “Free Money”. Suppose you own a stock worth $50 and the company pays a $1 dividend. Assuming no change in the stock market or the company’s value, the stock price will adjust downward by roughly $1. You now have approximately: $49 worth of stock + $1 in cash.

Your total wealth is still about $50 before taxes. The company hasn't magically created an additional dollar for you. It transferred part of the company's value from the business into your pocket.

This helps explain dividend irrelevance theory, the idea is that a company's value depends on its ability to generate profits and invest its money productively. Not simply on whether it distributes those profits as dividends. What should matter to you as an investor is the total return,  meaning the change in the value of your investment plus any dividends you receive.

 Homemade Dividends

Now, you don't necessarily need dividends to generate immediate cash income from your portfolio. You can create what is sometimes called a homemade dividend, by selling a small portion of your investment yourself. Suppose you own stock that pays no dividend, but has increased in value. If you need $2,000, you can sell enough shares to generate that amount. You may owe capital gains taxes on the return generated by those $2,000 (the profit regenerated from the difference between what you paid and the current value). Not on the entire investment. For example, if you sell $2,000 of shares and you originally paid $1,500 your taxable capital gain would be $500.

This gives you several advantages. You control how much money you take out and when you take it. You don’t have to receive dividends from the company when you don’t want them or need them. And you don't have to build your portfolio around high-dividend stocks simply because you want cash income.

There are disadvantages too. During a market decline, the price of your stock may drop, and you may need to sell more shares to generate the same amount of cash. Furthermore, your number of shares in the company gradually decreases.

Whether you invest on dividend producing company or create your own homemade dividend, neither method creates free money.

Dividends aren't bad. Many excellent companies pay them. A dividend is simply one way a company returns money to shareholders. What ultimately builds wealth is total return: how much your investment grows plus the dividends you receive. Understanding that distinction early will make it much easier for you to create your portfolio.

✓ Understanding dividends protects you from a common investing mistake. Many new investors are drawn to "dividend stocks" or "dividend funds" because a cash payment feels tangible and safe. That payout isn't an extra return, but part of the return you've already earned.
✓ It reframes what "passive income" really means. As a resident, essentially all your income comes from your labor. Learning that you can eventually produce your own cash flow from a portfolio, on your own schedule, regardless if the investments pay dividends, can be very useful.
✓ It helps you set up a smarter, more flexible portfolio. Once you have a portfolio, you'll constantly see "dividend yield" listed as if it were automatically a sign of quality. Knowing that total return is what ultimately matters will serve you well when making investment decisions.

“Do you know the only thing that gives me pleasure?

It's to see my dividends coming in.”

Attributed to John D. Rockefeller

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Life and Finances, in Medicine.