Dividend-paying stocks have their upside, no question: In times of market volatility, receiving a steady income stream can be psychologically comforting in the short run.
However, there are some long-term considerations around holding dividend-paying stocks that may have you thinking twice about including them in your portfolio. Here, we'll discuss three reasons you may want to avoid holding a portfolio of dividend-paying stocks.
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1. Total return is what really matters
A stock's total return comprises two important pieces: price appreciation and dividend yield. Price appreciation refers to a stock's upward movement over time, while dividend yield refers to a company's cash payouts to shareholders.
As an investor, it's a good idea to focus on your portfolio's total return as opposed to its dividend yield alone: By focusing only on dividend yield, you miss out on the long-term stock performance in companies that don't pay dividends (like many of the larger tech names).
This is all to say that a focus on dividend-paying stocks leaves out a wide swath of the broader market, such as companies that rely more heavily (or entirely) on price appreciation for performance, like Netflix or Alphabet. And it also creates a less-diversified portfolio that focuses too heavily on one angle of the available investment universe.
2. Dividends generate taxable income
Since you won't be able to hold single stocks in most 401(k) plans, you'll either need to hold them in an IRA or a taxable brokerage account. If you choose the brokerage account, you'll be taxed on any dividends you receive over the course of a given year. Depending on the underlying stock and how long you've held it, you might be taxed federally at long-term capital gains rates (anywhere from 0% to 20%) or at ordinary income rates (between 10% and 37%).
You also have no control as to when a dividend is paid, or if it's paid at all. There is just no way to tell in advance -- which is why maintaining a diversified portfolio containing both dividend payers and nondividend payers is as important right now as ever.
3. Individual stocks carry additional risk
Individual stocks carry idiosyncratic risk, or unsystematic risk, which is the risk specific to an underlying company's particular business or industry. The conventional way to remove unsystematic risk is to invest in well-diversified, low-cost, broad-market index funds that contain companies in many different industries with varying risk threats.
With that said, to buy dividend-paying stocks is to buy individual stocks, which can inadvertently increase your portfolio's total risk profile. Given the volatility we've seen in recent weeks, buying any single company to rely on their dividend payment is a more tenuous proposition than it once was. Reminding yourself to diversify, or to keep your eggs in many different baskets, should remain a foundational concept for your long-term investment plan.
Proceed with caution
Dividend-paying stocks are enticing to most small investors for their promised income stream. However, it's key to know the strings attached when you only focus on cash flow. A better strategy may be to bring your focus back to total return investing and to remaining diversified, no matter the market backdrop. Dividends will increase your tax bill every year, whether you reinvest them or take them in cash.
When markets hit turbulence, the most effective thing you can do is to reframe your attention toward the long term. This means holding companies that offer both price appreciation and dividend yield, giving consideration to your portfolio's tax efficiency, and remaining globally diversified. Those who stay the course with that prescription are likely to benefit -- handsomely -- in the future.
