To understand the differences in volatility commonly seen in the stock market, we first need to take a clear look at exactly what a dividend-paying stock is and is not. Public companies and their boards typically start issuing regular dividend payments to common shareholders once their companies have reached a significant size and level of stability. Often, young, fast-growing companies prefer not to pay dividends, opting instead to reinvest their retained earnings into business operations, compounding their growth and thus the book value of the company's shares over time.
How Volatility Is Affected by Dividends
Once a company decides to start paying a specified amount of money to shareholders in the form of regular cash dividends, its stock usually trades with a little less price volatility in the market.
There are a couple of key reasons for this, the first being that the regular dividend payments received by the company's shareholders represent consistent cash flows received from their investment in the stock.
For example, suppose you were considering investing in two hypothetical widget companies, ABC Corp. and XYZ Inc. Let's say that ABC pays out a regular, quarterly dividend of $0.10 per share, while XYZ never pays out dividends. Both stocks trade at $10 per share. Suppose that whichever stock you choose to invest in, you don't really have a great idea what the share price will be in one year's time. ABC could be trading at $5 and XYZ at $20 or vice versa — you just don't know. However, one thing you do know is that if you invest in ABC Corp., you'll very likely receive $0.40 in cash dividends over the year for each $10 share you purchase today. The same cannot be said about XYZ Inc. Therefore, this makes ABC a little safer.
Secondly, companies know that the stock market reacts very poorly to stocks that reduce their dividend payments. Thus, once a company begins paying a regular dividend amount, it will generally do everything it reasonably can to continue paying that dividend. This gives investors high confidence that the dividend payments will continue indefinitely at the same amount or greater. As a result, the shares of dividend-paying stocks tend to be viewed as quasi-bond instruments. These entities pay a regular cash flow that is backed by the entire financial strength of the company, but they also allow investors to participate in any share price gains the stock may enjoy.
The Bottom Line
Given both of these factors, the market tends to be less likely to drive down the share prices of stocks that pay high dividends than those of companies that pay no dividends. This means that stocks that pay sizable, regular dividends usually trade in the market with less volatility than stocks that don't pay dividends. Of course, this is not a hard and fast rule, but on average it holds true.
According to Merrill Lynch, over the 10-year period that ended Dec. 31, 2015, the S&P 500 Dividend Aristocrats — those stocks within the S&P 500 Index that have increased their dividends each year for the past 25 years — produced annualized returns of 10.25% vs. 7.31% for the S&P 500 overall, with less volatility (13.99% vs. 15.06%, respectively).