When the stock market is volatile, many investors consider whether or not to invest their money in bonds or dividend-paying stocks. Quite simply, when a company or government wants to borrow money from investors for longer than a year, it issues a bond. A company issues stock when it wants to raise money by sharing ownership among investors. Both may be sound strategies, depending upon your investment goals.
The Safety of Bonds
Fixed income investments, commonly referred to as bonds, provide you with a steady and dependable income stream that's sometimes tax-free. For example, if you purchase a bond that pays 3 percent per year, you'll get a check in the mail every year for 3 percent of your total investment. Fixed income investments have a well-earned reputation for safety because top-rated bonds rarely default. Keep in mind that some bonds, called "junk" bonds, are much riskier but often pay higher premiums. Each company or government that issues a bond has a credit rating that indicates the level of risk it presents to the investor. Higher premiums usually indicate higher risk.
While many investors -- those approaching or already in retirement, for example -- prefer bonds because it's an (almost) worry-free investment, there is a significant risk that long term bond holders won't earn enough to outpace inflation. Inflation is the measure of how much goods and services cost, and rising inflation means that your dollar this year may not go as far as it went last year (deflation means the opposite). Rising inflation means that your annual return on a bond won't go as far as it did the year before.
Your best chance to beat the inflation problem is owning a dividend-paying stock. Dividends are paid from profits to stockholders, usually on a quarterly basis, to encourage future ownership. Investors like it because it provides a hedge against their initial investment -- meaning you don't have to hope that the stock rises in value to see a return. Investors who receive dividends may elect to reinvest their dividend payments or take the dividend in cash. In these ways, you have the option to increase your stake or earn a regular source of income, while not putting in more than your original investment.
Dividends aren't perfect, however. In tough times, a company may eliminate the dividend, which eliminates your income stream; this is unusual, but not unheard-of. If the dividend stock you own is in a non-tax-sheltered account, then you'll have to pay income taxes on the dividend earnings. Also, there is no guarantee that a company that's paying a dividend is acting wisely; dividends are usually a way for companies to share profits when there's nothing better to do with the money, according to the personal finance blog FreeFromBroke.com. If the company doesn't earn enough in profits to warrant paying a dividend, then it may be putting its future -- and your money -- at risk.
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