in this post we are going to discuss the 10 biggest Pros and Cons of Dividend Investing and Dividend Stocks.
Dividend investing has become more and more popular among private investors like us. Many of us are constantly on the pursuit of passive income sources and dividend investing is definitely one of them because it allows you to receive a regular income stream from your stock investments. But is it the best strategy for investing in the stock market? Let’s find out together.
If you believe you have any problem picking stocks and don’t really know which company to invest in, be sure to stick to the end because I’m also going to give you a final tip about that. But first, let me define dividends and dividend stocks, to get us started.
What are Dividends?
A dividend is something of value, usually but now always cash, that is given from a company to its shareholders, namely to everybody who owns shares of that company. If you open an account on a trading app and buy some stocks of a company, you officially become a small investor or shareholder in that company. If the company pays dividends, you will also receive them periodically.
Dividend investing is one of many different types of investment strategies and it just means to invest in companies that pay out dividends. Usually, if you use this strategy you should have a long-term, buy-and-hold investment approach. Basically you buy and keep the stock ideally forever. That is because dividends in my opinion only make sense in two cases:
- if you want to reinvest them and make your portfolio grow in the long term
- If you are rich and the dividends you possess can finance your financial freedom.
So what I want to say with this: the average dividend yield on companies listed on the S&P 500 index historically was somewhere between 2% and 5%. So if you imagine that you have 50.000€ invested in dividend stocks, which is already a lot for most people, you will get around 1.000€ to 2.500€ per year, which is not the world. So that’s why I said at the beginning that, except if you are rich, if you invest in dividend stocks it shouldn’t be because you want to see cash flowing every year to spend it on champagne and cars, but more likely because you want to reinvest them and make use of compound interest to make your portfolio grow in the long term. I personally don’t possess a huge amount of dividend stocks, but I do believe that there are certain advantages to dividends that may be more appropriate for certain investors depending on your investing philosophy or your long term strategies.
So let’s now move on to the 10 pros and cons of dividend stocks, starting from the advantages.
5 Advantages Of Stock Dividends
5. Preferential Tax Treatment
Dividends receive a favorable tax treatment compared to the tax rates on your ordinary income. Generally speaking in the USA the tax rate on dividends is usually 15% or 20%, depending on your taxable income and filing status. In Germany, where I live, it’s a flat tax rate of 25% plus solidarity surcharge. So yes, Germany’s tax rate sucks.
Unlike dividends, your personal income from a job is going to be taxed over 40% in some cases. Especially if you also consider the social security tax.
So, the preferential tax treatment of around 15-20% is of course an advantage, but I have to specify 2 more things:
- Even the sale of stocks is subject to a tax rate of 15-20% in the USA, and 25% in Germany. So it’s not just about dividends, it’s about the stock market in general compared to a salary.
- The money you invest in dividend stock was probably derived from your normal job income and therefore was already subjected to the income tax. So in the end it’s like you pay 2 taxes on your dividends.
4. Hedge Against Inflation
Just as all other investments in general, when well done, dividend stocks provide a hedge against inflation. In case you don’t know, inflation is the increase in prices for all the goods and services that we consume, causing our currency like the dollar or euro to lose intrinsic value, and usually, the last 120 years have been dominated by inflation with some rare cases of deflation. Since it is typical for a company to increase its stock dividend regularly, dividend stocks can hedge or offset inflation. Therefore, when prices for goods and services rise due to inflation, so do our dividends, and instead of losing money because we kept it in the bank, we gain more money because we get more dividends.
3. Passive Income Stream with many options
If you own shares of a company that distributes dividends, you get cash paid out to you periodically and it’s there at your disposal. As opposed to the value of your stock portfolio itself, which can be only unlocked if you sell the stocks, the cash you receive as dividend is liquidity and is yours to spend as you please. You can spend it on a new Playstation, you can save it for a rainy day, or you can reinvest it in new stocks.
2. Reduced risk
Companies that pay dividends tend to be more mature and stable than companies that don’t. Startups or risky companies rarely pay dividends, because they blow back all the profits to fuel their growth.
For this reason, you can typically enjoy a reduced risk because dividend stocks tend to be companies with less risk of bankruptcy or to lose value and therefore show less volatility in their share price. This is of course a big advantage during bear markets, where the price of high growth stocks can fall by even more than 50%.
1. Dividend Growth Compounding
As I mentioned before, when you receive your dividends one option that you have is to reinvest them. If you make a plan of reinvesting your dividends you are basically doing a so-called DRIP, Dividend ReInvestment Plan.
In doing this you have a double advantage: The earned dividends that you reinvest are going to add up to your portfolio and increase its value, and if you’ve chosen the right company the stock value will also grow because of the growth of the company.
So you basically have a growth which is fueled by two sources: your reinvestments of dividends and the growth of the company itself.
This is in turn going to increase two things simultaneously: the value of your portfolio and the amount of dividends that you’ll receive in the future, because the dividends are always calculated as a fixed percentage of the value of the company stock you possess.
Okay. These were the 5 advantages of dividend investing. Let’s get to the disadvantages now.
5 Disadvantages Of Dividend Stocks
I personally invest more in growth stocks than dividend stocks, but in reality, the optimum lies in the middle. I think that a stock portfolio should be adequately diversified and this also means possessing shares of some mature companies which pay dividends and some of more risky companies which don’t.
Let’s go now through the main disadvantages of dividend stock investing. Coming in at number 5 we have:
5. Double Taxation
We already discussed the preferential tax treatment that dividends receive compared to normal income from jobs. But when comparing dividend stock with growth stock, there is another side of the medal which you cannot ignore.
Dividends are basically taxed twice. This is called double taxation.
If the company decides to pay out dividends, the earnings of the company are first taxed at the company’s year-end. The second taxation is the personal taxation you are subject to when you receive the dividends, that 15-20% we talked about before. On the other hand, growth companies don’t distribute their earnings in dividends, instead they reinvest them during the same fiscal year into their business growth. This way they can avoid paying taxes on these earnings and you also avoid paying income taxes if you hold onto these stocks instead of selling them.
4. Dividend Policy Changes
Usually you can predict the future dividend payout of a company based on the payouts of the past. But a history of dividend payouts is not a guarantee of dividends payouts in the future. Usually companies that pay dividends pay them and increase them regularly, but can also decide to have better uses for their cash and reduce its dividend, or eliminate it in some cases. The company management can change the dividend policy and this can be very harmful to the dividend investor. Not only as a dividend investor you could suffer a drop in your future portfolio passive income, but often, since these companies are bought mainly by dividend investors who feel now disappointed like you, many could sell and this could cause a big decrease in the dividend stock’s share price.
3. A lame compound interest
The compound interest is the concept for which if you invest in something that grows at a certain percentage per year, the value of what you possess grows slowly at the beginning and then quicker and quicker as the years go by because it grows in an exponential fashion.
This makes investing in the stock market much more useful when you buy and hold the stocks for a long period of time. If you hold onto your stocks, as we said, you don’t pay taxes until you sell them, so you can potentially have your portfolio grow tax free as long as you don’t sell anything and make maximum use of compound interest.
But this is not possible with dividends because dividends are taxed at the source. So whenever you get dividends you are paying taxes on them and their value decreases. As a result, even if you reinvest your dividends right away to increase your portfolio, the value of your portfolio is reduced everytime by the taxes you paid on the dividends.
2. Mature, low-growth companies
Most growth companies, namely companies that focus on a strong, rapid growth, do not give dividends to their shareholders because they prefer reinvesting all their profits into expanding their businesses. On the other hand, big mature companies do not have so many opportunities for expansions and hence they offer a large profit to their shareholders. So when you invest in dividend stocks, in most cases you are investing in low growth companies that may not always offer high returns.
Some investors are okay with the slow growth of their portfolio given by dividends, because it’s safer. But be careful because most of these investors didn’t get rich thanks to dividends, but thanks to other businesses of theirs and use dividend stock investing only to create a passive income source.
1. Buffett doesn’t agree
Warren Buffett is kind of the Buddha of finance so whenever he thinks or says something, everybody listens, and listens carefully. Since shareholders have to pay income tax on dividends, Buffett has never been so fond of using them. A neater trick he prefers is that the company uses some of the excess money to buy back the company’s shares or invest to keep the business growing. Berkshire Hathaway, Buffett’s investing company, never paid dividends and always kept 100% as retained earnings.
If you’re young, chances are you don’t need passive income at this stage and so the payment of dividends simply means that you have to find new places to invest that cash. If instead the company retained the cash and invested it for you, they are making the decision for you and you don’t need to decide where to allocate that money.
Wrap Up: 10 Pros And Cons Of Dividend Stocks
So, let’s wrap up now the benefits and disadvantages of dividend investing:
The benefits of dividend investing are:
- Preferential tax treatment
- Hedge against inflation
- Passive Income Stream with many options
- Reduced risk
- Dividend growth compounding
While the disadvantages of cash dividends are:
- Double Taxation
- Dividend policy changes
- A lame compound interest
- Mature, low-growth companies
- Buffett doesn’t agree
BONUS: ETFs
Finally, as I said at the beginning I’d like to give you a small tip if you are a dividend investor but don’t really know how to analyze companies and are afraid to put money in single companies. In this case you may choose to still invest safely in dividend stocks in an easy way through the use of exchange-traded funds (ETFs).
I’ll talk in detail about ETFs in other videos because they deserve more time and consideration, but basically an ETF is a package you can buy that contains many companies inside it, even hundreds or thousands. So instead of having to choose a single company, that could go good or wrong, you buy an ETF and the average growth of all the companies inside it is most likely to be a positive one.
Conclusions
Alright. That was my list of the top advantages and disadvantages of dividend stock investing. Let me know in the comment section below if you are a fan of dividends or if you prefer to look for growth companies like Amazon or Tesla.
In my humble opinion, the younger you are, the more time you have to find good growing companies to invest in, and you can easily shift from Growth to Dividend later on when you’ve built a generous portfolio. If you think about it, except if you already have something in the range of 300.000$ to a million $, it’s not like you can make a living out of dividends.
You can generate the dividend income later rather than now.
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