Dividend stocks have some appeal for a lot of investors. Companies paying a dividend are usually mature and produce strong enough earnings to cover their payout. A long history of paying a dividend can give investors confidence that a company is going to keep paying that dividend for a long time.
But dividend-paying stocks aren't a perfect investment option for everyone and they may not be the right fit for your portfolio. Here are three reasons you may want to avoid them.
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1. Dividend stocks offer less control over taxes
The tax code is very generous for dividend-paying stocks. Qualified dividends are taxed at the long-term capital gains tax rate, which is typically 15% for most investors.
However, you don't have any control over whether to take a dividend or not like you would if you were merely taking a long-term capital gain in a stock. You get paid the dividend on a regular schedule determined by management, and you don't get to decide how much the dividend is.
The good news is that you typically know how much the dividend will be ahead of time, so you can do some tax planning around that. But if you want complete control over your taxes every year, dividend stocks aren't for you.
2. Dividend stocks generally offer less growth potential
Dividend stocks are usually mature companies with consistent earnings. There's limited room for growth at such companies. In fact, when a company commits to returning excess cash to shareholders through a dividend, it's sending the signal that it can't invest all of its earnings to grow the company efficiently.
Conversely, growth stocks pump all of the cash generated back into growing the business. In many cases, growth stocks are unprofitable and use debt and equity to fund the business while growing the potential for future profits.
Unlike dividend payers, there's no pressure on growth stocks to produce steady profits or cash flow. That gives management more leeway to invest in opportunities that may cost a lot upfront but could generate significant profits over the long term.
While reinvesting dividends back into the stock or in another stock can help improve the returns of dividend-paying stocks, growth stocks can produce even better returns for smart investors over the long term. That said, the sword cuts both ways; growth stocks are also more likely to see their price drop much more than dividend payers when they don't meet expectations or the entire stock market undergoes a correction.
3. Dividends are not guaranteed
Dividends are generally considered a strong commitment to return excess cash to shareholders. When a company announces a dividend, it typically does so with the intent to pay that dividend for years to come, perhaps even increasing it on a regular basis.
But sometimes a dividend cut is unavoidable. And when it happens, it can be devastating for investors. Not only are the annual payments lower than originally anticipated, a dividend cut or suspension can send the stock price cratering. Without the regular payments, investors will look elsewhere for income.
Management knows the impact such a decision will have on shareholders, and it generally does whatever it can to avoid cutting the dividend. That, however, can lead management to make decisions based on the dividend instead of what's in the best long-term interest of the company. As noted above, companies without a dividend are able to invest in the best decisions for a company's long-term earnings potential.
Consider more than the dividend
There are plenty of great stocks that can produce market-beating returns and also pay a dividend. But investors need to consider much more than something like a dividend yield when making investment decisions. After all, they're investing in a company and the management team running it. It's not just a financial instrument paying a yield. To that end, look for a company with strong management and competitive advantages, and you'll find plenty of great companies -- both dividend payers and not.
