It's easy to see why dividend stocks might appeal to investors. After all, who wouldn't want the chance to sit back, do nothing, and enjoy a steady stream of payments?
But while dividend stocks can serve as a nice means of passive income, they're not automatically a great investment. Here's why it pays to be careful with dividend stocks -- or perhaps steer clear of them altogether.
1. They may not align with your investing strategy
Companies that pay dividends to stockholders make the decision to share their profits rather than invest more money back in the business. And that's not necessarily a great thing. By giving out that money instead of reinvesting it, dividend-paying companies might stunt their own growth. And that might lead to slower share price appreciation.
If your investing strategy centers on filling your portfolio with growth stocks, then dividend stocks may not fit in. And there's no sense in straying from your strategy if it's been serving you well thus far.
2. They can increase your tax bill
If you hold dividend stocks in a tax-advantaged retirement plan like a 401(k) or IRA, then the dividend income you receive on an ongoing basis won't be taxable on a yearly basis. But if you hold dividend stocks in a brokerage account, then those payments could result in a higher tax bill for you.
Granted, dividends (at least qualified ones) are taxed at a more favorable rate than ordinary income, so the impact there may not be as severe. But at the end of the day, taxes are taxes, and if you don't want to pay the IRS more on an annual basis, then you may want to pass on dividend stocks.
3. They can lead you to make poor investment choices
It's easy to caught up in the allure of a generous dividend. But that could drive you to put your money into companies that aren't actually solid businesses.
It's a big misconception that companies that pay large dividends can afford to do so, and so clearly, they're doing well. That's like saying that the guy in your neighborhood who drives a $90,000 sports car must be loaded because he can swing those vehicle payments. In reality, that guy might be drowning in debt or have $0 in savings, and all his fancy car is doing is masking that reality.
The same can hold true in the context of dividend stocks. Companies that pay big dividends aren't necessarily doing well financially. And if you don't make that distinction, you could end up really unhappy with the stocks you invest in.
Be careful with dividend stocks
Dividend stocks could be a great investment -- one that helps you achieve your financial goals. But fixating on dividend stocks could also backfire on you. And it's important to be aware of that fact before you go chasing dividends, all the while passing up the opportunity to put your money into quality businesses that are more likely to reward you in the long run.