This is a really important concept that’s often misunderstood, even by some self-described “dividend investors”. When you are paid a dividend, from either a stock or a fund (like an ETF, mutual fund, or index fund), it is NOT “free money”!

First a bit of context: a dividend is a cash payment made from an investment to the account that holds the investment. For example, if you own one share of VTI, the Vanguard total stock market ETF, you will have noticed a cash deposit of $0.87 on October 1st. In fact VTI, pays out a dividend like that quarterly, totaling about $3.48 per year per share you own.

Dividends feel GREAT because you’re getting FREE MONEY deposited to your account just for sitting there doing nothing. But are they really free? Not really.

The thing many miss is that when those dividends are paid out, the share price of the stock or fund drops by an equal amount. So as this graphic shows if there’s a stock or ETF that is $100 per share and pays a $5 dividend, the share price will drop to $95 leaving you the same.

Of course, for most normal (smaller) dividends this price drop is easy to overlook amongst the general day to day volatility of the market.

So what’s really going on with a dividend? It’s basically the company saying “hey, we have extra profit that we can’t or don’t want to use to grow the company, so we’re just gonna give it back to you”. That might be a smart move for companies later in their lifecycle whose growth prospects are limited, but are profitable. But investing in JUST these types of companies is certainly cutting out many of the biggest companies of tomorrow.

Warren Buffet’s company, Berkshire Hathaway, has NEVER paid a dividend. He says the reason is that HE is better at re-investing that cash than you are. And if you want a dividend, simply sell 4% of your shares each year. You’ll have 4% lower share value and 4% in cash. Exactly like a dividend works, but you’re in control.

As always, reminding you to build wealth by following the two PFC rules: 1.) Live below your means and 2.) Invest early and often.

-Jeremy