Amid a declining stock market and talk of a potential recession in 2023, investors' attention has shifted to prioritizing safety and maximizing cash flow. Dividend-paying stocks can act as reliable passive income generators but are by no means perfect investments; it's especially important to understand what you sign up for when you buy a portfolio of dividend-heavy shares.
Let's review three downsides to your everyday dividend payers.
1. You leave out many growth stocks
Famous growth stocks like Meta Platforms, Amazon, and Netflix have soared over the past decade but pay no dividend whatsoever. Dividend-paying stocks often happen to be more established value stocks, or companies that trade at discounts relative to their underlying fundamentals.
Over the past 10 years, big growth names have substantially outpaced the Vanguard Value Index (VTV 0.30%), as demonstrated by the chart below. If you focus only on a company's dividend, you might miss out on other companies experiencing spectacular price appreciation.
Even after major price corrections in 2022, some of the large growth names are still significantly ahead of the composite value index over the past 10 years. Focusing only on dividends is a way to miss out on these outsized gains.
2. You have limited control over timing
If a stock appreciates in price, you have control as to when you sell (or realize your gains). This can help with cash flow planning as well as ongoing tax management. With dividend stocks, you have no control as to when you'll receive your dividend.
If you're a long-term investor and have other sources of cash flow, waiting to receive your dividend isn't a particularly big deal. But if you're someone who relies on dividends to meet unexpected expenses, you might have to sell shares early if the dividend doesn't arrive soon enough.
Either way, consider diversifying your portfolio with both growth and value stocks to cover yourself in any future scenario. Better yet, consider buying the entire market with a low-cost, well-diversified S&P 500 index fund. These funds tend to experience price appreciation over long periods and even pay a modest dividend.
3. You might pay more total tax than you want
Every time you're paid a dividend on a stock that you hold in a regular taxable account (again, at the discretion of the company paying it), you rack up income. Additional income means additional tax liability.
Admittedly, many stocks qualify for a lower qualified dividend tax rate. Nevertheless, that's still money out of your pocket. By contrast, with non-dividend-paying growth stocks, you decide when to realize capital gains and losses. If, for instance, you want to defer realized stock gains to the next taxable year, you can simply wait to sell appreciated shares beyond the end of the current year. You don't have that control when it comes to dividend payments.
Be a big-picture investor
Broadly, you tend to do better as an investor when your portfolio is properly diversified. This means including stocks of all different sorts: dividend payers and growth stocks, as well as shares from different business sectors. Often the easiest way to do this is to buy a few broad-market index funds and call it a day.
Focusing only on one type of investment is likely to leave you with suboptimal results on the whole, even if it does leave you better off in any one realm (like cash flow). Given the turbulence we've seen this year, recommitting to a balanced, diversified portfolio is a reasonable goal for most investors as we approach the end of the year.