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.
Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Sam Swenson, CFA, CPA has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Alphabet and Netflix. The Motley Fool has a disclosure policy.
I'm a financial expert with a deep understanding of investment strategies and market dynamics. I've spent years analyzing various investment vehicles, from stocks to diversified portfolios. My knowledge extends to tax implications, risk management, and the intricacies of different asset classes.
Now, let's delve into the concepts discussed in the article about dividend-paying stocks:
1. Total Return is Crucial:
- Total return is a comprehensive measure that combines price appreciation and dividend yield.
- Emphasizes the importance of looking beyond just dividend yield for a well-rounded portfolio.
- Highlights that solely focusing on dividend-paying stocks may lead to missing out on the performance of non-dividend-paying companies, especially in sectors like technology.
2. Taxable Income from Dividends:
- Discusses the tax implications of holding dividend-paying stocks, particularly in taxable brokerage accounts.
- Points out that dividends generate taxable income and the tax rates can vary (long-term capital gains rates or ordinary income rates).
- Stresses the lack of control over when dividends are paid and advocates for a diversified portfolio to manage tax efficiency.
3. Individual Stock Risks:
- Addresses the idiosyncratic risk associated with individual stocks, emphasizing the importance of diversification.
- Suggests that investing in well-diversified, low-cost index funds can mitigate unsystematic risk.
- Warns against relying solely on individual dividend-paying stocks, given the increased risk profile, especially in times of market volatility.
Conclusion and Caution:
- Advises caution in relying solely on dividend-paying stocks for income, pointing out potential downsides.
- Recommends a focus on total return investing and maintaining a diversified portfolio.
- Discusses the tax implications of dividends and suggests considering both price appreciation and dividend yield.
- Highlights the value of long-term investment plans and staying globally diversified, especially during market turbulence.
In summary, the article provides a nuanced perspective on the drawbacks of concentrating on dividend-paying stocks, urging investors to consider total return, tax implications, and the risks associated with individual stocks in building a well-rounded investment portfolio.
