While dividends can't be ignored as part of a total return strategy (dividends plus capital gains), there is a lot of confusion surrounding the supposed efficiency of a portfolio comprising only dividend-paying stocks. Let's explore what's actually happening when you receive a dividend -- and whether it really matters if you receive one at all.
What's a dividend?
A dividend is nothing more than a return of capital in the form of cash. You won't need to actively sell any shares to receive a dividend -- instead, you'll receive a cash deposit to your settlement fund once a quarter. Psychologically, this feels great: You received money and didn't have to sell any shares. It feels like your money is paying you.
What's often not discussed is that you'll also see a reduction in the share price of the company that paid the dividend; the company is, in effect, paying you a portion of its value as opposed to investing it in other projects. When the stock begins to trade at this lower price, it is said to be trading "ex-dividend," or "without" the value of the dividend.
The point is this: at the very moment the dividend is paid, you're no better off than before the dividend happened.
Say for example you own 10 shares of a stock trading at $100 per share. Your position totals $1,000. The company then declares a $1 dividend, and you're paid $10 ($1 dividend * 10 shares). You now own the same 10 shares of stock trading at $99 and have $10 cash for a total position value of $1,000. Recall that the share price falls to $99 because the stock is now trading "ex-dividend", but your total position value is still $1,000 due to the $10 cash dividend you received.
Also imagine you own 10 shares of stock in a company that doesn't pay a dividend. While you won't receive any cash payment, your position will stay flat at $1,000 because there's no price adjustment -- there's no dividend.
Over time, the prices of both stocks will fluctuate, but the total performance of either position is not going to be determined solely by the fact that one pays a dividend and the other doesn't.
The tax bite
When a dividend is paid, you'll be taxed on the entire amount of the dividend. If you receive a $100 dividend, you'll be taxed on all $100, although you may be taxed at a lower rate if you've held the underlying stock position for more than a year.
In the opposite scenario, imagine again you hold a stock that doesn't pay a dividend. To create a "dividend effect," you could sell $100 worth of stock. In this case, however, you won't be taxed on the entire $100 -- only the proportional share that represents capital gain. Here, capital gains are shown to be more tax-efficient than dividends when held in a taxable account.
Dividends, from one angle, are a form of passive income. On the other hand, in a taxable account, they'll increase your tax bill every time they're paid -- usually more than a capital gain of equal magnitude would.
What should you do instead?
This is all to say that dividends are an important piece of your total return, but you shouldn't base your stock picks on dividend yield alone. Doing so excludes a large swath of companies that don't pay dividends but derive a tremendous amount of value from price appreciation. A strategy based on dividend yield would leave out many of the big tech companies that have powered returns throughout the past decade.
Also remember that it's impossible to predict financial markets. With that in mind, one sound strategy is to focus on the long run by investing in passively held index funds. This way, you won't be leaving out any market segment, and you'll have the odds on your side going forward. You also won't have to spend any time in the way of actively managing your portfolio or trying to figure out what happens next.
Broadly speaking, we're very poor predictorswhen it comes to company-specific returns. It's a good idea to focus on what you can control -- specifically, your asset allocation and the amount of money you invest -- and let long-term market returns do the work.