Investors love dividend stocks for their ability to provide a source of passive income. But like any other investment vehicle, it’s important to understand the pros and cons of dividend stocks before adding them to your portfolio.
Let’s take a deeper look at dividend stocks and how they might impact your investment strategy.
What Are Dividend Stocks?
Dividend stocks refer to companies that pay their shareholders a portion of their profits. These payments are known as “dividends,” and are used to reward investors for remaining loyal to the company. There are many pros and cons to dividends, but for some investors, they provide an extra influx of cash. One 35-year-old investor now uses his $250,000 as his sole source of income.
How Do Dividend Stocks Work?
After a company earns a profit, it may distribute a portion of these earnings back to its shareholders. This payment may come after the company makes additional investment in their own business (known as residual dividends), or by paying a set annual rate to eligible shareholders (stable dividends).
Dividend payments may come in the form of cash, but they also may come in the form of additional shares of stock. The purpose of the dividend is to provide shareholders something of a “bonus” for investing in the company, a strategy that helps to attract new investors as well as retain loyal ones.
What Companies Pay Dividends?
Not every company pays dividends. As a general rule, larger corporations are in a better financial position to provide dividends. Additionally, companies that operate in the following sectors tend to distribute dividends more readily than other companies:
- Banks and finance
- Real estate investment trusts (REITs)
- Healthcare and pharmaceuticals
- Oil and gas
But every company is different, which is why it’s important to carefully research each company before buying stock. Some companies offer dividends, but residual dividends may not be paid on a regular basis.
The Pros of Dividend Stocks
There are many pros and cons of dividends. On the one hand, dividend stocks offer shareholders a number of benefits, including:
They Provide Passive Income
Perhaps the greatest advantage of dividend stocks is that they reward investors with cold, hard cash. In this sense, dividends function a bit like the interest you receive on a savings account. Not only do you possess the value of your stock shares, but you receive regular payments as a reward for your investment.
As you weigh the pros and cons of dividend investing, you’ll want to consider whether you’re interested in this immediate, passive income, or whether you’re more set on long-term gains.
Dividends Tend to Increase
Generally speaking, companies that offer dividends rarely lower the amount they pay their shareholders. Most companies prefer to increase the amount that they pay their shareholders, which means that the passive income you receive from dividend investing offers a fair degree of stability over time.
Dividends Tend to Be More Stable
Investing in a small startup might offer high growth potential, but this move also carries considerable risk. Companies that pay dividends tend to be large, well-established corporations. These companies are less vulnerable to the massive fluctuations and upheavals of a volatile stock market.
This means that not only will your dividend payments themselves remain secure, but the company you’ve invested in is also unlikely to have its share price plummet, which can make dividend stocks a stabilizing presence in a diversified portfolio.
Dividend Stocks Let You Compound Your Earnings
Some companies offer shareholders the option of using their dividend payments to purchase additional stock. This is known as a Dividend Reinvestment Program, or “DRIP.” DRIPs allow you to purchase additional stock, usually at a discount.
For investors, this provides the opportunity to double down on your earnings. Say you use the dividend you earn one year to purchase additional stock. This means that the dividend payment you receive the following year will be even greater, and you won’t have invested an additional dime of your own money.
Dividends Offer Greater Tax Efficiency
Dividends can potentially offer greater tax efficiency, at least compared to ordinary income or other investment vehicles such as bonds. In fact, if you’re an individual investor whose tax bracket doesn’t exceed 35%, dividend payments are only taxed at a rate of 15%.
The Cons of Dividend Stocks
When evaluating the pros and cons of dividend investing, the advantages seem to tip the scales in favor of dividend stocks. But there are several disadvantages to dividend stocks that potential investors should consider carefully before diving in.
Less Potential for Growth
Companies that pay dividends tend to be large corporations that have been around for years. As we noted, that makes for greater stability, but it also means there’s less potential for growth. In other words, you might be making some passive income from dividend payments, but you won’t see the same kind of return on your investment as you would if you’d invested in a high-growth startup.
Dividend Payments are Low
As much as we love the idea of collecting passive income through dividend investing, the truth is that dividend payments are relatively low, especially compared to the actual share price of many top-performing stocks. In fact, dividend yields for 2021 reached historic lows, which has made many second guess this investment strategy.
Plus, this assumes that dividends are paid in the form of cash. Some companies simply offer their shareholders additional stock, which is an important factor to consider when weighing the pros and cons of dividend investing.
Lower Diversity of Investment
Above, we listed some of the companies that offer dividends. These sectors represent a relatively narrow slice of the market as a whole, which means that dividend stocks won’t provide a clear path toward portfolio diversity. That’s not to say it’s impossible to build a diversified portfolio of dividend stocks, just that you’ll have to be more strategic in your selection process.
Dividend Payments Are Not Guaranteed
While it’s true that dividend payments tend to increase, there’s no reason for that to always be the case. In fact, when a company pays residual dividends, it’s possible that there isn’t sufficient profit to distribute dividends to every shareholder, at least not at a favorable rate. This means that the pros and cons of dividends won’t be the same for every company, which also underscores the importance of thorough research.
Tax Rates on Dividends Are Not Always Favorable
Tax rates on dividends are favorable to those within certain income brackets, but tax laws are notoriously subject to change. Investors can’t rely on dividends to provide a long-term investment strategy, and they may even find that dividend investing becomes less worthwhile as they enter a new income bracket.
Understanding the Pros and Cons of Dividend Stocks: Are They Right for Me?
You’ll need to weigh the pros and cons of dividend stocks very carefully before integrating these assets into your investment strategy. On the one hand, dividend stocks offer passive income and stability, but less chance for growth. This makes dividend investing a good short-term strategy, but not necessarily a long-term investment solution for those who want to maximize their gains.
Some investors prefer to invest in a dividend-paying mutual fund or ETF. These solutions can provide the short-term benefits of a dividend stock, but also assemble a portfolio that provides stable growth in the long term.
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