Many people are fans of dividend-paying stocks for a variety of reasons, most notably that when you own dividend payers, you'll receive a passive income stream without having to sell any shares of your underlying investment.
While there are merits to holding stocks that pay dividends, there are four major reasons you should think twice before making dividend payers the core of your investment strategy. Here, we'll explore those four reasons and offer some basic guidance on how to invest instead.
1. Dividends are taxed as they're received
Assuming you're using a regular taxable account rather than a tax-deferred retirement account, every dividend you earn will be taxed as its received -- whether you take the dividends in cash or reinvest them. Further, you have no control over when or if you receive a dividend; the company declares it, and you receive it shortly thereafter.
This is all to say that dividends will drive up your taxable income, perhaps unnecessarily. If you hold your investments for long enough, you'll begin to be paid qualified dividends, which are taxed at a favorable rate. Nonetheless, holding dividend-paying stocks will drive up your adjusted gross income (AGI) and, depending on how much you get paid, may even push you into a higher tax bracket.
If you hold dividend-paying stocks in a tax-advantaged retirement account, you'll avoid immediate taxation but may not end up with optimal after-tax results in the long run.
2. You could miss out on high-growth stocks
Most of the big-name stocks that pay high dividends are otherwise known as value stocks, and they typically have strong, stable earnings that enable consistent cash payouts. By focusing too heavily on companies that pay dividends, you may not have enough money left over to invest in high-growth stocks.
If you were to buy companies solely based on the fact that they pay a dividend and excluded those without one, you'd be missing the spectacular growth from stocks like Tesla (NASDAQ:TSLA), Square (NYSE:SQ), Meta Platforms (NASDAQ:FB), and Amazon.com (NASDAQ:AMZN) -- just to name a few!
Remember that if you hold a stock for the long run and it appreciates in price, you'll have the opportunity to generate some serious long-term capital gains.
First, long-term capital gains are taxed at a favorable rate, and you control when to lock them in -- not the company. And second, while it may be purely passive income in the same way dividend income is, capital gain income is income nonetheless -- and should be treated as such.
3. Your focus strays from a total return objective
Sound investing -- and indirectly, sound financial planning -- arises from a total return objective within your investment portfolio. Total return is simply the sum of dividends and capital gains; ideally, it's best to have a portfolio that generates both. A strong combination of dividends and capital gains, coming from many companies of different underlying character and structure, is really the best way to develop the core of your portfolio.
There are times when dividend-paying stocks fall out of favor and growth stocks soar. There are also times when the reverse happens. It makes sense to hold both types of stocks at the lowest possible cost so you'll be able to win regardless of what the market does in the near future. From this angle, a portfolio too heavily tilted toward dividend payers misses out on the price appreciation component of total return.
4. Common stock dividends aren't guaranteed
In the world of preferred stocks, you'll receive a fixed dividend; this is the very essence of owning preferred stock. You sign up for a hybrid security that has both stock and bond characteristics, and you receive a fixed dividend at predetermined intervals.
With common stock, on the other hand, companies have the ability to cut or even eliminate dividends at any given moment. To give one of many examples, General Electric (NYSE:GE) had been heralded as a stable dividend payer for many years. In 2018, the company found itself under a mounting debt load that forced a dividend cut to $0.01 per share. Unfortunately, this came alongside a steep fall in the company's share price.
It's unlikely that all of your dividend-paying stocks will stop paying dividends at the same time, but it is possible that one or more of your stocks experiences some financial distress and you're hit with a reduction in the dividend. This is another reason it's so vital to have a widely diversified portfolio that won't be adversely affected if one company goes south.
Diversify with dividends and growth
On one hand, passive income generated by dividend-paying stocks can be a nice wealth engine for the initiated. On the other hand, it's still advisable to put together a globally diversified portfolio comprising both value and growth stocks. This gives you the best chance of success in the long run, without being overly reliant on any one type of income source.