Dividend stocks are probably an important piece of your investment portfolio, but they might not be the best asset for your goals. Every different type of security has features that make them great tools for specific purposes, but no single investment is perfect for every circumstance. Consider these characteristics of dividend stocks that can make other assets more suitable for certain roles in an investment plan.
1. Slow growth
Dividend stocks are popular because they can provide balanced returns from both price appreciation and cash distributions to shareholders. That balance is attractive to many investors, but it also means that dividend stocks aren't optimized for high growth.
Businesses usually need to deploy cash to achieve high growth rates. To push sales higher, they need to make key hires, develop product enhancements, and maintain a rising marketing budget. As a result, high-growth companies typically don't have excess cash to distribute to shareholders as dividends. Instead, they reinvest cash flows for expansion.
Dividend stocks aren't optimal for growth investors. If you're looking for big returns, you're better off focusing on early-stage tech stocks that have more room to expand.
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2. Investment risk
As far as equities go, dividend stocks are relatively low risk. They tend to be established, stable businesses with predictable cash flows. They're usually industry leaders with diversified operations. This can be contrasted with unprofitable disruptors who are fighting an uphill battle to displace incumbents.
That said, dividend stocks are still considered volatile assets. Their prices fluctuate on the open market. If a company's financial results are poor, the stock price can suffer. Even if a company is performing well, a bear market can drive the stock price down.
Investors with a short time horizon need to manage volatility carefully. They might not have enough time to recover from unexpected losses or difficult market conditions. To combat volatility, these investors usually increase their allocation to bonds, cash, and other lower-risk assets while reducing the weight of equities in their portfolio.
Of course, dividend stocks can be a healthy addition to a balanced portfolio, along with bonds and cash. However, it's important to make sure that your stock allocation aligns with your investment goals.
3. Lower yields than some fixed-income investments
Dividend stocks are a great source of investment income, but income investors can usually find higher yields elsewhere. Dividend yields and bond yields fluctuate with capital market conditions throughout the economic cycle, so these relationships aren't always set in stone. They're subject to change. Nonetheless, it's fairly common for relatively low-risk corporate bonds to generate more investment income than dividends.
VYM Dividend Yield data by YCharts
Stocks tend to appreciate over time, so long-term investors are willing to accept lower yields than they require on bonds. Again, this doesn't invalidate dividend stocks for income investors. However, a diversified portfolio of investment-grade corporate bonds could provide more income for anyone prioritizing investment cash flows.
4. Lack of tax efficiency
Dividend income isn't always the most tax-efficient form of investment return. When you own a stock that goes up in value, you have control over when you'll pay long-term capital gains taxes on your profits. Capital gains taxes are only assessed when gains are realized, after a position is closed by selling an asset for cash.
By contrast, dividends on stocks held in regular taxable accounts get taxed in the year that they're paid. This is true even if you choose to reinvest your dividend payment into additional shares of stock.
Moreover, not all payouts meet the requirements of qualified dividends, and those that don't incur tax at higher ordinary income tax rates rather than the lower rate of 0% to 20%, which also apply to long-term capital gains. There's also no difference in taxation for returns in a 401(k) or traditional IRA. In those retirement accounts, all distributions are treated as ordinary income, while returns accumulate on a tax-deferred basis. Returns and qualified distributions from a Roth IRA are tax-free.
Households with high income need to consider their personal circumstances and the status of dividends. It's important to consider tax liability when forecasting net returns.
