Low maintenance and consistent income — that’s the value proposition of dividend investing. As income-generating stocks, dividend stocks are often seen as a safety net for rising inflation and stock market volatility, as well as a way to supplement living expenses in retirement.
With inflation at a multi-decade high and interest rates expected to rise soon, the average S&P 500 dividend-paying stock outperformed non-dividend payers by 6.6 percentage points in January, according to S&P Dow Jones Indices. That’s the biggest monthly advantage for dividend-paying stocks in 17 years.
So with signs of positive growth and the familiar promise of regular income, what’s not to love about dividend-paying stocks? It turns out, there’s more than meets the eye.
Dividend investing can be limiting both in terms of flexibility and in terms of total return potential. Let’s explore the strategies behind dividend investing and how these stocks compare to other investments.
What is dividend investing?
Dividend investing is when an investor buys shares of stock in a corporation that regularly pays out a portion of its earnings to shareholders as dividends. In addition to providing regular income from dividend payments, dividend stocks also provide capital appreciation when their prices increase.
So as a dividend investor, your total return on a stock is calculated by combining the change in its price with any dividends paid as income. For example, if you pay $20 for a stock that increases in value by $5 and issues a $1 dividend, then your total return is $6 — or 30%.
Dividends are most commonly in the form of cash payments, but they can also be paid out in the form of more stock. The majority of corporations pay out dividends to shareholders quarterly.
Put simply, dividends are a way that some companies choose to share part of their earnings with their investors. Profitability will usually determine when and how a dividend changes, though large fluctuations are rare.
Not all stocks pay dividends, but it is relatively easy to find out which ones do. In fact, with some quick online research, you can see if a stock pays dividends as well as some other important metrics for dividend-paying stocks, like:
- Dividend history: when the company has paid dividends in the past
- Dividend yields: dividends paid over the last year divided by the current stock price, and
- Payout ratios: the percentage of the company’s profits paid out as dividends
What type of companies offer dividends?
Most dividend-paying stocks are well-established, blue-chip companies, such as AT&T, Verizon, Exxon Mobil, and Procter & Gamble, to name a few examples. These companies usually have a long history of stable profits and are relatively slow growing.
On the other hand, companies that are experiencing exponential growth and expansion typically won’t pay dividends. Instead, they tend to reinvest their profits into growing the business. These funds may be used to support growth and innovation, acquisitions, or to pay off debt.
One reason a company may choose to pay dividends is to boost confidence in its future profits and financial performance. This sign of strength can attract dividend-seeking investors and create greater demand (and value) for a corporation’s stock.
In some cases, companies hold onto a lot of cash without reinvesting it or issuing dividends. When this happens, stockholders may notice the cash accumulating on the company’s balance sheet and begin pressuring the company to issue dividends.
From the investors’ perspective, if millions of dollars in cash are just sitting in a bank account, it isn’t working for the company to increase its value for shareholders. Thus, the thinking goes, it should be returned to the shareholders either in the form of dividends or stock buybacks so they can redeploy it into other investments with better return potential.
That’s why many slow-growing but profitable companies will pay out dividends. It helps attract investors and signals that the company is on strong financial footing.
Dividend investing vs. other investment strategies
A key difference with dividend stocks compared to other investments is that they provide relatively stable, predictable, and routine income to shareholders. This passive income is attractive to many investors.
The tradeoff is that because as a group they are more mature, dividend paying companies’ profits and share prices are likely to grow more slowly than the overall market over longer periods.
This makes sense from an economic perspective because there’s an inverse relationship between a company’s dividend yield and its stock price. When companies don’t pay dividends to shareholders, they reinvest the profits into the company. Theoretically, these investments lead to greater growth, and that growth helps increase the value of the company’s stock.
So, dividend-paying stocks offer steady income through dividends, whereas stocks that don’t pay dividends often have higher rates of return because of faster growing revenue and profits and, consequently, share prices. While less volatile, dividend stocks do not generally outperform other stocks in terms of total return.
Dividend investing strategies and considerations
More than other investing strategies, dividend investing emphasizes passive income generation over total return or stock value appreciation. With dividend investing, immediate and consistent cash income is the priority.
That said, dividend investing ignores other metrics for total return on your portfolio. For example, when a company pays out a dividend, the amount they pay out represents value that is being carved out and leaving the company.
As a result, it’s not uncommon for a company’s stock price to drop when it pays out dividends. That’s because the total value of the underlying business decreases, and it’s worth less than it was before the dividend was paid.
So functionally, receiving a dividend is no different than selling a little bit of your stock each month or quarter and realizing capital gains. The difference is that dividends are more restrictive. That is, you’re not in control of which stocks in your portfolio you’re receiving cash distributions from.
There are still plenty of investors who are focused on dividend investing, for many of the reasons we’ve already outlined (primarily, steady income and low volatility). Here are some of the common dividend investing strategies.
Dividend Aristocrats strategy
One popular dividend investment strategy focuses on investing in stocks known as the Dividend Aristocrats. These S&P 500 companies have increased their dividends for 25 or more consecutive years.
This strategy is so common among dividend-focused investors that there are exchange-traded funds (ETFs) that specifically track the Dividend Aristocrats. One example is ProShare S&P 500 Dividend Aristocrats (NOBL).
It’s interesting to note that, although the Dividend Aristocrats consistently increase their dividends, these stocks have not historically outperformed the S&P 500 in terms of total return.
Dividend growth strategy
Some dividend investors focus primarily on high dividend growth rates. For these investors, they look at buying stocks that pay low dividends but are growing at a fast pace.
This strategy is usually best for investors with longer outlooks. When dividends are low, the stock won’t pay out much income in the short term. But as they continue to grow, their dividends and stock price will likely grow too.
Diversified dividend portfolio strategy
If you’re set on dividend investing, an important consideration is diversification. That means viewing dividend stocks as one slice of your overall investment portfolio.
Many savvy investors understand this concept. These investors are still attracted to dividend stocks, but they don’t limit themselves by only investing in stocks that pay dividends. This strategy still prioritizes dividend stocks to an extent, but they’re part of a more diversified portfolio.
By diversifying in both dividend stocks and other stocks, you lower the risk of dividend cuts and allow yourself greater flexibility to pursue attractive investments with potentially higher returns.
Warning signs
When evaluating dividend-paying stocks, you want to make sure the dividend appears to be sustainable. In some cases, a corporation’s dividend may look attractive based on the yield, but if you look closer at its financials, you may see profits and stock prices steadily declining even as it continues to pay out dividends.
This is what’s known as a dividend yield trap. When there’s an attractive dividend yield but overall shaky business financials, you should take this as a warning sign that neither the dividend nor the company is sustainable in the long-term.
You want to look for companies with profits that are growing in line with or faster than the dividend. Focusing on a company’s dividend growth is oftentimes more important than the dividend yield.
You will also want to evaluate a company’s payout ratio — that is, the percentage of the company’s net profit that is paid out as a dividend. If a company is paying a high proportion of its profits in dividends, that’s a sign of unsustainability and vulnerability.
Are dividends predictable?
Yes, dividend payouts are largely predictable and rarely volatile. A stock’s dividend history can be viewed and analyzed using a number of free finance websites. According to Investopedia, historical average dividend yields range from 3% to 5%, though they have been closer to 2% in recent years.
Huge jumps or cuts in dividends are uncommon. For example, over the past decade, AT&T’s dividend has never increased by more than $0.01 per quarter. And in many quarters, there were no changes at all. These dividends have remained consistent even as the stock’s price has fluctuated. This is strategic, of course, as companies want to be able to continually attract dividend-seeking investors.
When dividends are cut, it can send a psychological signal to investors that the company’s financial position is unstable. That’s why, in most cases, dividends are only cut or stopped in the face of severe economic and financial situations.
How are dividends taxed?
Dividends are taxable income. However, there are two types of dividends: qualified and non-qualified. Qualified dividends are more favorable from a tax standpoint when they are paid out in a taxable brokerage account, and they are reported separately when you receive your 1099-DIV tax form at the end of the year
Qualified dividends
Qualified dividends in a taxable brokerage account are taxed at the long-term capital gains rate, which is most commonly either 15% or 20% based on your tax bracket. There are two conditions that must be met for a dividend to be designated as qualified:
- The company must be a U.S. corporation, or a foreign corporation that meets certain criteria.
- Investors must meet a holding period requirement, which is intended to discourage day traders from receiving preferential tax treatment. To qualify, an investor must hold their shares for at least 61 continuous days during the period spanning 60 days before to 60 days after the ex-dividend date (the date of record that determines which shareholders are paid the dividend).
It’s important to know that the preferential treatment of qualified dividends only applies in taxable brokerage accounts. Dividends — qualified and non-qualified — in an IRA or other tax-deferred account do not benefit from the preferential tax treatment. They are not taxed when they are paid out, but they are taxed at ordinary income rates when the account holder withdraws them in retirement, just like any other distribution from the account.
Non-qualified dividends
Non-qualified (or ordinary) dividends are taxed as ordinary income using the same tax rate as their marginal tax rate — which could be as high as 37% in 2022.
Some companies’ dividends are not eligible to be considered as qualified. For example, real estate investment trusts (REITs) and tax-exempt companies are always non-qualified. Dividends from hedging — like short sales — are also non-qualified.
There are no meaningful tax advantages to investing in dividend stocks compared to other stocks. In the best case scenario with qualified dividends, you’ll be taxed the same on the dividends as you would be on long-term capital gains.
For non-qualified dividends, you’ll be taxed at the higher ordinary income rate, similar to short-term capital gains or other sources of income.
Is dividend investing worth it?
Ultimately, it comes down to a question of how you want your money — and how you want your money managed.
If you strongly prioritize low maintenance and steady income, then dividend investing as part of a diversified portfolio may be a good idea for you, especially if you’re nearing or already in retirement.
However, if you place more emphasis on your total return, then dividend investing likely isn’t the strategy for you.
One alternative strategy that achieves a similar end result — that is, steady income — without sacrificing total return is to manually (and selectively) sell a portion of the stocks that have performed the best when you rebalance your portfolio, and use those proceeds to fund withdrawals from your portfolio that would have otherwise been covered by dividends.
In this way, you’re still generating steady income, but with more flexibility and no additional tax implications, assuming you’ve held the shares for a year and qualify for long-term capital gains treatment. It will require a more hands-on approach, but it can also improve your returns over time. This is the approach we use at Elwood & Goetz.
Why do people choose to buy dividend-paying stocks?
A lot of factors come into play when people choose their investment philosophy and strategy. In addition to maximizing return, prudent investors must also evaluate their risk tolerance, cash flow needs, and overall comfort and peace of mind.
Here are some of the most common reasons people may choose dividend investing:
- Steady income. Dividends are predictable and largely consistent. This can be especially important to DIY investors who are living on a fixed income. Dividends can act as supplemental income for retirement distributions, pensions, and Social Security.
- Low maintenance. Dividends are paid out automatically, so you don’t really have to do anything to access the payout.
- Lower perceived risk. Because dividends are usually offered by well-established companies, there’s typically a perception of lower risk and lower volatility associated with these investments.
- Generational comfort and familiarity. Let’s face it: psychologically, sometimes we just want to stick with what we know. Blue-chip companies that pay dividends are likely some of the same companies your parents and grandparents invested in. It’s also likely you use products and services from these companies on a daily basis. Subconsciously, a lot of investors have familiarity and affinity both for these companies and for the concept of dividends.
For many of these reasons, dividend investing is historically popular with retirees who view dividends as recurring income to supplement Social Security and pensions.
Conclusion: Should I focus on dividend investing?
Everyone’s financial situation is different. Some DIY investors who rely on their investments for living expenses may find value in the simplicity of having cash automatically paid out into their account and available to withdraw each quarter.
From a purely financial perspective, however, there are no real advantages to dividend-focused investing, especially if you work with a financial planner or investment manager who is actively rebalancing and applying a tax-sensitive distribution strategy.
At Elwood & Goetz, we believe it’s unnecessarily restrictive to focus solely, or even primarily, on companies that voluntarily choose to pay out a portion of their profits to shareholders, as this strategy eliminates a lot of faster-growing companies that could improve the long-term growth of your investments. Plus, while dividends are rarely volatile, they’re a voluntary choice by company management and are never guaranteed. As a result, we generally do not recommend a dividend-only investment strategy to our clients.
When one of our clients approaches retirement or is in retirement and needs to supplement their income with their investments, we functionally do the same thing a dividend-paying stock or fund would do. By strategically selecting and selling positions in their portfolio, we’re able to convert small pieces of their investments into cash distributions for supplemental income.
The difference is that we have a lot more control over where that cash comes from. This can be a huge benefit in the long run as we strategically take more from positions that are outperforming and avoid selling positions that are underperforming. This follows the fundamental “buy low, sell high” rule of investing.
Still not sure which investment strategy is best for you? Working with a financial planning team may be of benefit to you as you map out your retirement plan. If you are interested in learning more about our services and investment philosophy, you can request a no-cost discovery call with our advisory team.
