The internet will tell you that compiling a portfolio of high-dividend stocks is one of the keys to growing your passive income and ultimately achieving financial independence. While this idea isn't entirely wrong, it's important to recognize that there are two components that make up the total return on your investments: dividend yield and price growth (also known as "capital gain income" in the tax world).
When choosing an investment strategy, it's best to focus on these two components taken together. Viewing your total portfolio from a total return perspective is both a simple and effective way to get the most out of your investments.
What are dividends?
Dividends are cash distributions paid to shareholders. Distributions typically occur on a monthly, quarterly, or semi-annual basis, regardless of where the company's stock happens to be trading at the time. Investors are attracted to dividends, because they can provide a relatively steady stream of income that can be accessed without selling shares of the underlying investment. Dividends originating from investments held for more than one year also receive favorable tax treatment, potentially far better than income earned from working as an employee.
Dividend yield -- or the stock's dividend payout divided by its share price -- is also a component of return on investment. The unique quality about dividends is that they represent the cash portion of your investment return. Dividends have the effect of increasing cash flow for an individual, which can be useful in meeting short-term obligations such as personal debt or emergencies. While dividends are a critical part of the total return equation, they should not be viewed in isolation when evaluating an investment.
What are capital gains?
When the IRS uses the term "realized capital gain," it simply refers to the difference between the price at which you sold your investment over the price at which you bought it. For example, if you were to buy one share of stock for $50 and sell it for $100 after holding it for more than one year, you would be said to have a $50 long-term capital gain. Fortunately, long-term capital gains are also taxed at a favorable rate as compared to ordinary income.
Importantly, capital gains represent the second component of total return. The reality is that capital gains can matter at least as much as dividend income, and you also have far greater control over their recognition. A stock can rise exponentially over a period of years, but until you take action to sell shares of that investment, you incur no capital gain -- until shares are sold, your capital gains are simply "unrealized."
What is total return?
Total return investing refers to examining both the dividend yield and the capital gain components when evaluating an investment. Given that both components have the potential for advantageous tax treatment, both can have significantly positive effects on your overall investment results.
Still, there's a popular focus on high dividend-paying stocks, and for good reason: Dividend stocks produce passive income in the form of tangible cash that can be paid directly to a bank account. In other words, dividend stocks will pay you "as you sleep." However, stocks in volatile sectors -- such as energy, for instance -- may advertise high cash payouts but fail to experience any meaningful (or even negative) price growth. You might invest in a high dividend stock paying 5% per quarter, but the stock itself can lose 10% or 20% in a matter of days. Your total return, in that example, would be negative.
A portfolio relying too heavily on dividend payout risks the possibility that a company may cut or eliminate its dividend and ignores the possibility for capital losses. A portfolio with both capital gains and dividend income stands the best chance of performing well over long periods of time, as the character and timing of income is well-diversified. Dividend-paying stocks in sectors like consumer staples and utilities tend to also have more stable price growth over time, so the chance of generating dividend income as well as capital gains is increased.
Focus on all sources of return
Investors who focus solely on dividend income are leaving a critical component of their total portfolio return on the sideline. It's vitally important to total return investing to include an analysis of capital gain income, which is not only eligible for beneficial tax treatment but can also have an even greater effect on total return should a company cut or eliminate its dividend for any length of time. In addition to creating a diversified portfolio from geographical and sector standpoints, investors should pay attention to the quality and character of their portfolio income when it comes to maximizing their total return.