Focusing only on dividends might be shortchanging your portfolio.
Dividend-paying stocks have their upside, no question: In times of market volatility, receiving a steady income stream can be psychologically comforting in the short run.
However, there are some long-term considerations around holding dividend-paying stocks that may have you thinking twice about including them in your portfolio.Here, we'll discuss three reasons you may want to avoid holding a portfolio of dividend-paying stocks.
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1. Total return is what really matters
A stock's total return comprises two important pieces: price appreciation and dividend yield. Price appreciation refers to a stock's upward movement over time, while dividend yield refers to a company's cash payouts to shareholders.
As an investor, it's a good idea to focus on your portfolio's total return as opposed to its dividend yield alone: By focusing only on dividend yield, you miss out on the long-term stock performance in companies that don't pay dividends (like many of the larger tech names).
This is all to say that a focus on dividend-paying stocks leaves out a wide swath of the broader market, such as companies that rely more heavily (or entirely) on price appreciation for performance, like Netflix or Alphabet. And it also creates a less-diversified portfolio that focuses too heavily on one angle of the available investment universe.
2. Dividends generate taxable income
Since you won't be able to hold single stocks in most 401(k) plans, you'll either need to hold them in an IRA or a taxable brokerage account. If you choose the brokerage account, you'll be taxed on any dividends you receive over the course of a given year. Depending on the underlying stock and how long you've held it, you might be taxed federally at long-term capital gains rates (anywhere from 0% to 20%) or at ordinary income rates (between 10% and 37%).
You also have no control as to when a dividend is paid, or if it's paid at all. There is just no way to tell in advance -- which is why maintaining a diversified portfolio containing both dividend payers and nondividend payers is as important right now as ever.
3. Individual stocks carry additional risk
Individual stocks carry idiosyncratic risk, or unsystematic risk, which is the risk specific to an underlying company's particular business or industry. The conventional way to remove unsystematic risk is to invest in well-diversified, low-cost, broad-market index funds that contain companies in many different industries with varying risk threats.
With that said, to buy dividend-paying stocks is to buy individual stocks, which can inadvertently increase your portfolio's total risk profile. Given the volatility we've seen in recent weeks, buying any single company to rely on their dividend payment is a more tenuous proposition than it once was. Reminding yourself to diversify, or to keep your eggs in many different baskets, should remain a foundational concept for your long-term investment plan.
Proceed with caution
Dividend-paying stocks are enticing to most small investors for their promised income stream. However, it's key to know the strings attached when you only focus on cash flow. A better strategy may be to bring your focus back to total return investing and to remaining diversified, no matter the market backdrop. Dividends will increase your tax bill every year, whether you reinvest them or take them in cash.
When markets hit turbulence, the most effective thing you can do is to reframe your attention toward the long term. This means holding companies that offer both price appreciation and dividend yield, giving consideration to your portfolio's tax efficiency, and remaining globally diversified. Those who stay the course with that prescription are likely to benefit -- handsomely -- in the future.
Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Sam Swenson, CFA, CPA has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Alphabet and Netflix. The Motley Fool has a disclosure policy.
FAQs
Other drawbacks of dividend investing are potential extra tax burdens, especially for investors who live off the income. 3 Once a company starts paying a dividend, investors become accustomed to it and expect it to grow. If that doesn't happen or it is cut, the share price will likely fall.
Why companies should not pay dividends? ›
Highlights. Firms pay no dividends due to cash constraints and investment opportunities. Firms do not pay dividends because of poor profitability and earnings. Firms avoid paying dividends due to the cost of raising external funds.
In what circ*mstance might an investor prefer stocks that do not pay dividends? ›
Thus, investors who buy stocks that do not pay dividends prefer to see these companies reinvest their earnings to fund other projects. They hope these internal investments will yield higher returns via a rising stock price.
Why would a company choose to not pay dividends on their common stock? ›
Companies that don't offer dividends are typically reinvesting revenues into the growth of the company itself, which can eventually lead to greater increases in share price and value for investors.
What are the pros and cons of paying dividends? ›
Sure Dividend
- Pro #1: Insulation From The Stock Market. ...
- Pro #2: Varied Fluctuation. ...
- Pro #3: Dividends Can Provide A Reliable Income Stream. ...
- Con #1: Less Potential For Massive Gains. ...
- Con #2: Disconnect Between Dividends & Business Growth. ...
- Con #3: High Yield Dividend Traps. ...
- Further Reading.
If the stock has a high payout ratio compared to its industry peers and other potential warnings exist such as declining earnings, rapidly growing debt and/or a history of dividend cuts, there's a higher likelihood that the dividend could be in jeopardy.
What is the disadvantage of not paying dividend? ›
Disadvantage: Not paying dividends to its investors might induce some investors to loosen their confidence in the company. Not being able to pay dividends regularly might give investors a wrong or red signal not to invest their money in that particular company.
What are the risks of not paying dividends to shareholders? ›
What happens if I can't afford to pay dividends to directors and shareholders? If a shareholder has invested in the company with a view to receiving regular dividend payouts, failing to receive the anticipated return may result in the sale of their shares.
What are the 5 highest dividend paying stocks? ›
Comparison Results
| Name | Price | Analyst Price Target |
|---|
| IBM International Business Machines | $164.69 | $185.42 (12.59% Upside) |
| CVX Chevron | $160.73 | $185.88 (15.65% Upside) |
| EOG EOG Resources | $131.80 | $147.37 (11.81% Upside) |
| ET Energy Transfer | $15.78 | $18.44 (16.86% Upside) |
5 more rowsDividend investing can be a great investment strategy. Dividend stocks have historically outperformed the S&P 500 with less volatility. That's because dividend stocks provide two sources of return: regular income from dividend payments and capital appreciation of the stock price.
Amazon's business model has long centered on innovating and branching out into different corners of the market, as evidenced by its foray into the grocery and pharmacy business in recent years. As such, it's easy to see why Amazon doesn't choose to pay dividends -- it would rather use its money to grow as a company.
Why do short sellers have to pay the dividend? ›
Your hope is that the stock's price goes down, so you can repurchase and return the borrowed shares for less than you sold them for. However, in the meantime, whoever you borrowed the shares from still technically owns them. And if there's a dividend that is scheduled to be paid out, they're entitled to it.
Why doesn't Netflix pay dividends? ›
This interest-bearing debt makes it much more difficult for Netflix to offer shareholders a dividend. Based on all the above, a dividend may not be the right choice for Netflix, given its investment spending and debt repayment remain much higher priorities for management.
Why doesn't Tesla pay dividends? ›
Tesla has never declared dividends on our common stock. We intend on retaining all future earnings to finance future growth and therefore, do not anticipate paying any cash dividends in the foreseeable future. When was Tesla's initial public offering (IPO)? Tesla's initial public offering was on June 29, 2010.
Can a company pay dividends if it makes a loss? ›
If a company has accumulated losses, it cannot pay dividends even if the group (including its own subsidiaries) is profitable. Intra-group transactions are common within groups of companies.
Is there a downside to dividend investing? ›
They offer relative stability, may pay increasing amounts over time and may provide steady income. But relying too heavily on dividend stocks as a primary investment approach could put you at risk and reduce your long-term investment gains.
Is it risky to invest in dividend stocks? ›
Dividend Stocks are Always Safe
However, just because a company is producing dividends doesn't always make it a safe bet. Management can use the dividend to placate frustrated investors when the stock isn't moving. (In fact, many companies have been known to do this.)
Is it a good idea to buy dividend stocks? ›
Dividend investing can be a great investment strategy. Dividend stocks have historically outperformed the S&P 500 with less volatility. That's because dividend stocks provide two sources of return: regular income from dividend payments and capital appreciation of the stock price.
Do stocks lose value after dividend? ›
With dividends, the stock price typically undergoes a single adjustment by the amount of the dividend. The stock price drops by the amount of the dividend on the ex-dividend date. Remember, the ex-dividend date is the day before the record date.
