Dividend stocks have plenty of great qualities, but they aren't the best investment for every purpose. Different assets are optimized for different roles. When investors put together a financial plan, it's important to make sure that you aren't using dividend stocks when something else is better suited for a specific purpose.
1. Some non-dividend-paying stocks provide higher growth
If your priority is high growth, then dividend stocks aren't always the best tool to get you there. Companies usually require predictable cash flows before they start distributing capital directly to investors. High-growth businesses generally retain their cash so they can invest in new hires, product development, and marketing. For this reason, dividend stocks tend to be mature businesses that offer stability, but they generally have limited growth prospects.
That relationship is illustrated by the total return charts of the Vanguard High-Dividend Yield ETF (VYM -0.80%) and the Vanguard Dividend Appreciation ETF (VIG -0.95%). These are two popular ETFs that hold a variety of dividend stocks. One is managed to optimize yield, while the other aims at more price appreciation. Over the past 10 years, both dividend funds trailed the S&P 500, and they were nearly doubled by the NASDAQ.
Dividend stocks still provide returns with price appreciation. They can play a role in any stock portfolio, especially for investors with short time horizons. That's one of the reasons that they're so popular among younger retirees. However, there are other stocks out there with higher growth potential. Young professionals who are saving for retirement might want to focus elsewhere.
2. Some other income-producing assets have lower risk
Dividend stocks usually aren't risky as far as stocks go. They tend to be some of the most stable and reliable equity investments. However, income investors might consider better alternatives for low-risk returns.
Bonds are the most popular security for low-volatility returns. There are certainly risky bonds with volatile prices on the secondary market. However, investment-grade corporate bonds and debt issued by creditworthy government agencies tend to carry a lower risk of investment loss along with reduced volatility relative to stocks.
Certificates of deposit (CDs), money market deposit accounts, and savings accounts are even further along that spectrum. These are some of the lowest-risk asset classes in existence, especially if they're FDIC-insured. Investors should never count on these cash-like assets to perform like securities. Their interest rates barely exceed inflation in most years, if at all. They'll never match the long-term performance of dividend stocks, but they're not volatile.
None of these investments are necessarily superior to dividend stocks -- they just perform differently. Bonds and cash instruments might be better suited to certain roles in your portfolio if your goal is to minimize risk.
3. Some other assets can be more tax-efficient
Many people rely on accountants to minimize their taxable income each year, but holding too many dividend stocks could have the opposite effect. Dividend taxation is a complicated topic, so there's no blanket approach that applies to every investment plan. It's important to understand how returns from various assets fit into your overall tax situation, and shareholder distributions deserve serious attention.
Investors need to be mindful when it comes to dividend stocks held outside of their retirement accounts. Any returns in a qualified account such as a 401(k) or traditional IRA are taxed as income upon withdrawal, whereas Roth IRA distributions are tax-free. Things get more complicated for dividends received in a regular brokerage account. Shareholder distributions that don't meet qualified dividend status are often taxed as ordinary income. Income tax rates on ordinary dividends that don't get preferred qualified dividend treatment are often higher than long-term capital gains tax rates. If the government is taking a larger-than-necessary cut of returns, portfolio performance suffers.
That issue doesn't apply to everyone -- it all depends on financial circumstances and your state of residence. It's still something that investors should consider when building a financial plan. Dividend stocks aren't the most efficient tool sometimes. Investors might want to consider assets such as municipal bonds in these cases.