Do you like investment income? Most people do, even if their plan is to invest that income in other assets like growth stocks. That's why it's not unusual to find dividend-paying stocks even in a growth investor's portfolio. Quality dividend stocks can keep cranking out their payments in turbulent times, providing funding for new picks while the market's down.
Before you start adding dividend-paying stocks to your portfolio simply on principle, though, you may want to rethink the idea. While doing so has its merits, there are reasons you may still want to avoid dividend-paying stocks as well.
1. They might create a potential tax liability right now
Regardless of your plans for any dividend payments, know that they may create unwanted taxable income for the tax year in which they're received.
There are exceptions to this possibility, of course. Any dividend-paying stock held within a tax-deferred account (like an IRA, 401k, etc.) makes that dividend payment into that account rather than directly to you. As such, it's not a taxable event -- you don't pay taxes on these accounts until you withdraw funds from them.
Any dividend stocks held outside of a tax-deferred account, though -- like an ordinary brokerage account or in a company-offered DRIP plan -- generate taxable income as those dividends are paid. So-called qualified dividends are taxed like capital gains and at usually affordable capital gain rates. Ordinary dividends, on the other hand, are taxed like income. If you're an above-average earner, these dividend payments will be taxed at above-average federal income tax rates, taking a big bite out of their benefit.
2. Dividend stocks could produce lower overall returns
It's an age-old debate: Do growth stocks outperform value stocks, or does the slow-and-steady nature of value stocks ultimately win out in the end? It matters to dividend-minded investors mostly because dividend-paying stocks also tend to be value stocks.
There is no ironclad answer. Prior to the tech boom of the late '90s and the dot-com bust of the early 2000s, value stocks typically outperformed growth names in the long run. Since then, despite their extreme volatility, growth stocks have led the way even when factoring in reinvested dividends. If the market environment created since then is the new norm -- one marked by sky-high valuations and wild growth rates stemming from new technologies -- growth stocks could continue to outperform value stocks well into the future.
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That doesn't mean dividend-paying value stocks aren't worth owning. They'll still offer predictability and stability, after all, which for many investors is more important than maximizing gains.
If you're at a point where you're weighing growth against value, though, just be sure you've defined what you're trying to achieve and that you know how each of your stocks is truly likely to help you reach that goal. For now, anyway, growth stocks are producing more net investment gains.
3. Temptations to stop reinvesting dividends are stoked
Finally, while many investors buy a dividend-paying stock with every intention of reinvesting those dividends in more shares of the same equity, not every investor sticks with that plan. For a variety of reasons, sometimes an investor will stop reinvesting dividends in the stock that's paying them. They may even stop investing those payments in any form of equity and just begin accumulating idle cash instead. In some cases, these investors might even simply start spending these cash payments when they're received.
There's nothing inherently wrong with this. It's their money -- they can do what they want with it. And if fear of continuing to pour money into what looks like a weakening market is the motivation, that's certainly understandable.
Such a decision is ultimately a long-term mistake, though. By the time you realize it's a mistake, there's little that can be done to fix it.
Data from Standard & Poor's tells part of the story. The market research outfit indicates that since 1926, 32% of the S&P 500's total return has been produced by dividends, while the other 68% comes from capital appreciation. That's significant in and of itself. But it's also understated in that it doesn't consider the impact of reinvesting those dividend payments in more shares of the index. Numbers crunched by mutual fund company Hartford say that over the course of the past 50 years, reinvested dividends account for 84% of the S&P 500's net return during that stretch.
The moral of the story is that you must have enough discipline to reinvest dividend payments even when you don't absolutely have to do so. Not everyone has that much discipline.
