Advantages And Disadvantages Of Stock Dividends Explained
Today’s article is about the pros and cons of dividend stocks. And, the closely related topic: the pros and cons of dividend investing.
On one hand, I only invest in dividend stocks. So, I may be a little biased.
On the other hand, it’s important to examine the opposing point of view. To help you answer these important questions…
Why invest in dividend stocks? Should I invest in dividend stocks? What is the downside to investing in dividend stocks? And when should you definitely not buy dividend stocks?
When we are done, the truth will be on the table. So you can make an informed decision.
About dividend investing and dividend stocks. And, if they are right for you. Let’s go…
Disclosure: At no cost to you, I may get commissions for purchases made through links in this post.
10 Pros And Cons Of Dividend Stocks
Allow me to start with a summary list of the advantages and disadvantages of dividends. It will serve as our guide for the rest of the article.
5 Benefits Of Dividend Stocks
- Passive dividend income stream
- Solid total investment returns
- Dividend reinvestment for compounding returns
- Hedge against inflation
- Preferential tax treatment
5 Disadvantage Of Stock Dividends
- Tax inefficiency
- Investment risk
- Sector concentration
- Dividend policy changes
- Investment research
Related article: How to make dividends every month
Pros And Cons Of Dividend Stocks: 3 Definitions First…
We will dive into each of these pros and cons of dividends shortly.
But first, 3 brief definitions. To get us started. And, make sure we all understand today’s topic about the pros and cons of dividend stocks.
What Is Dividend Investing?
Dividend investing is one of many different types of investment strategies.
First of all, the strategy focuses on building and maintaining a portfolio of dividend stocks. Furthermore, it is typically associated with a long-term, buy-and-hold investment approach.
What Are Dividend Stocks?
Shares of a dividend stock represent partial ownership in a company. Specifically, a company that pays the owners of its stock, dividends.
What Are Dividends?
A dividend is a distribution of economic value to owners of a dividend stock. The issuance of dividends can come in different forms.
The form we are talking about today is the most typical. We are talking about cash dividends.
Dividends are paid for several reasons. Most importantly, to reward investors.
With those definitions taken care of. Let’s move on to the 10 pros and cons of dividend stocks.
5 Advantages Of Stock Dividends
I like investing in stocks for cash dividends. So, I can come up with plenty of benefits of dividend investing.
Today, I’m going to stick with 5 of the most important reasons to invest in dividend-paying stocks.
These points alone indicate dividend investing is worthwhile for anyone looking for an investment strategy.
1. Passive Dividend Income Stream
Dividend stocks pay cash to their shareholders. It’s one way dividend investors make money.
Sometimes dividends are referred to as dividend income, passive income, investment income, or portfolio income.
Whatever you want to call it. Dividends represent cash in an investor’s pocket. Once received, the investor can do with that cash as he or she pleases.
Many investors believe they can count on receiving dividends. Rather than hoping for share price appreciation.
Pros Of Dividend Stocks: Receiving Cash Creates Options
Spend it, save it, or reinvest it. They are the 3 main options. Furthermore, there is less need to sell stock to get cash.
Most importantly, once the investor receives their cash dividend. It can never be taken away.
Finally, research shows that over the long term. About 40% of the stock market’s total return comes from dividends.
This leads us to our next advantage of dividend vs non-dividend stocks…
2. Solid Total Investment Returns
In time, the price per share of a dividend stock will typically rise. This provides the dividend investor with an additional return on investment.
Over and above the cash dividends received. It comes from share price appreciation.
The combination of making cash dividends. And share price appreciation make for an attractive total return on investment potential.
3. Dividend Reinvestment For Compounding Returns
I mentioned that one option for dividends received is reinvestment. Also called dividend reinvestment. Or, DRIP. That stands for dividend reinvestment plan.
By reinvesting dividends regularly. The investor can take advantage of compounding returns.
This means a dividend investing strategy generates cash dividends. Which are then reinvested back into dividend stocks.
To generate more dividends. From the past dividends that have been received.
Compounding dividends is very powerful. For building wealth over the long-term. Some investors call it the dividend snowball effect.
4. Hedge Against Inflation
Dividend stocks provide a hedge against inflation. Inflation is the steady increase in prices for goods and services that we consume.
We haven’t had high inflation over the past 10-20 years. But there is concern it will return because of massive government spending.
Pros Of Dividend Stocks: Dividend Increases
Dividend stocks hedge or offset inflation because of dividend increases. Since it is normal for companies to increase stock dividends regularly.
Thus, when prices for goods and services rise due to inflation. So do our dividends. Often, by an amount more than the inflation rate.
Want another good way to hedge against inflation? Then save on all your online purchases.
We do so by using Rakuten to get cash rebates on everything we buy. You can learn more about Rakuten here.
5. Preferential Tax Treatment
Dividends have historically received favorable tax treatment. As compared to the tax rates on ordinary income.
Tax laws are always changing. And everyone’s tax situation is different.
But to generalize, tax rates on interest income, money made from a job, or business earnings can exceed 40% in some cases. Especially when you include social security tax on earned income.
On the other hand, qualified dividends are taxed at a much lower rate. The exact rate depends on your specific tax situation.
Okay. That concludes our discussion of some reasons to invest in dividend-paying stocks. Next, onto the other side of this argument. The disadvantages of stock dividends…
5 Disadvantages Of Dividend Stocks
Like I said at the beginning, I prefer dividend investing. But, I know there are drawbacks to dividend stocks.
I choose to accept them. Because for me, the pros of dividend stocks, outweigh the cons.
You may form a different opinion. Once you read about the top 5 disadvantages of dividend stocks…
1. Tax Inefficiency
We just discussed the preferential tax treatment that dividends receive. But, there is a different side to the argument. About the tax effectiveness of dividends.
Specifically, when we compare dividend stocks vs growth stocks. We find that dividends are taxed twice. Also called double taxation.
Cons Of Dividend Stocks And Taxes: The First Tax
First, they are taxed when the company paying the dividend earns money. Corporate profits are the source of dividend payments made to you and me.
Cons Of Dividend Stocks And Taxes: The Second Tax
Second, dividends are taxed again when the investor receives their dividends. Because taxes are due on dividend income when it is received.
Taxes On Dividend Stocks Vs Growth Stocks
On the other hand, growth companies take their earnings and reinvest them into their business. Earnings are only taxed at the corporate level.
Business investments are made by companies to generate more profits. In turn, those profits should drive up the price of a growth stock.
Thus, creating capital gains for the investor. Not dividends.
As long as the growth stock investor holds their shares. No further tax is due. Capital gains taxes can be deferred until the shares are sold.
Tax Benefits Of IRAs For Dividend Stocks
Buy and hold dividend stocks in an IRA. Then, much of the additional tax burden of dividend stocks can be reduced.
Or, taxes are entirely avoided. Depending on the type of IRA you open.
Have you been meaning to open an IRA? If yes, get it done. You will be glad you did.
2. Investment Risk
Dividend stocks carry investment risk. Especially when compared to other income-generating investments. Specifically, savings accounts, certificates of deposit, and bonds.
Because stock prices can and will go down. Sometimes by a lot. Creating investment losses even for a dividend stock investor.
On the other hand, savings vehicles and bonds will typically hold their value better. During difficult economic times.
3. Sector Concentration
Dividend stocks are clustered in certain industries and stock market sectors. Thus, dividend investors must pay careful consideration to dividend stock portfolio construction.
This means ensuring adequate diversification. So, all or most of the stocks held, do not reside in the same or similar industries.
Furthermore, by investing only in dividend stocks. An investor may pass on some excellent investments.
Specifically, investments in companies whose stocks do not pay dividends. For example, stocks like Amazon, Tesla, and Facebook.
The stocks of these companies have done very well for their investors. While dividend investors have missed out.
So, growth stock investors may tell you dividends are irrelevant. And sometimes they are right. This shows another of the dividend stocks vs growth stocks tradeoffs.
4. Dividend Policy Changes
Negative dividend policy changes by company management can be very harmful to the dividend investor. They can be another reason not to invest in dividend stocks.
On one hand, some companies have the policy to pay dividends and increase them regularly. And they do so without a hitch.
In contrast, when a dividend-paying company encounters difficult economic times. Or, management decides they have better uses for their cash. Rather than pay dividends.
Then, a company may choose to reduce its dividend. Or, in the worst case, eliminate it.
Not only will the dividend investor suffer a drop in their future portfolio income. But these actions tend to come with big decreases in the dividend stock’s share price.
Thus, dividend reductions and eliminations. Are a “lose-lose” situation for a dividend stock investor.
Thus, dividends are neither free nor guaranteed. They have an opportunity cost. And it is management’s obligation to constantly evaluate other opportunities for using company cash.
5. Investment Research & Knowledge
Investing in high-quality dividend stocks requires investment research. And, knowledge about how to construct a dividend portfolio.
Specifically, a successful dividend investor must be able to execute their dividend investing strategy on 4 levels.
Level 1: Cons Of Finding Dividend Stocks
First of all, the dividend investor must know how to find and identify dividends stocks. There are certain dividend metrics to look for. And specific places to find good dividend stocks.
One of my favorite places to find dividend stocks is the Simply Investing Report. Simply Investing delivers high-quality dividend stock recommendations to my inbox every month.
Simply Investing reduces the work in finding and analyzing dividend stocks. You can learn more about Simply Investing here.
This leads me to my next point…
Level 2: Cons Of Analyzing Dividend Stocks
Furthermore, a dividend investor must know how to analyze dividend stocks once identified. And be comfortable reading financial reports.
Some questions to find answers to include:
Is the company’s dividend safe from a reduction?
Does the stock price represent good investment value?
Will management increase the dividend in the future?
What is the dividend payout ratio?
Two of my favorite sources for dividend stock analysis are:
Motley Fool addresses non-dividend stocks too. If you find the cons of dividend stocks are not to your liking.
In either case, having financial reports like these is important. They remove some of the time, work, and stress out of dividend investing.
If you are like me, saving time and reducing stress is very important. After all, life is busy. Let’s make it as easy as possible.
Level 3: Cons Of Constructing A Dividend Stock Portfolio
Then, an investor’s dividend stocks must be assembled into a portfolio. So, knowing how to build a diversified portfolio paying dividends is critical.
To reduce investment risk. And provide for monthly dividend income.
Level 4: Cons Of Monitoring Dividend Stocks
Finally, circumstances changes. Some dividend stocks underperform.
Others do very well. That they must be sold to rebalance the portfolio.
Dividends are received. And to benefit from the compounding of investment returns. They must be reinvested wisely.
So, a good dividend investor must continue to monitor his or her stocks. And their overall portfolio.
Managing Dividend Stocks Vs Growth Stocks
In fairness, this is not too different when comparing dividend stocks vs non-dividend stocks. Or dividend stocks vs growth stocks.
These other investment approaches require research, analysis, and monitoring too.
Pros And Cons of Dividend ETFs And Funds
Finally, a dividend investor may choose to execute a dividend investing strategy in an easier way. Through the use of mutual funds or exchange-traded funds (ETFs).
Doing so reduces the need for research and knowledge. Which was the last of our 5 disadvantages of stock dividends investing discussed today.
But individual stocks vs index funds can lead to a lengthy debate. So, I will save it for another day.
Alright. That concludes our discussion about the pros and cons of dividend investing. Which is closely related to the pros and cons of dividend stocks.
If this all seems too complicated. Let’s simplify.
I manage my entire financial picture with Personal Capital. It pulls together all of my spending and investments in one place online.
It’s easy to use. And saves time when trying to manage finances and make the most of your money.
Best of all, Personal Capital is free to sign up and use. You can learn more about Personal Capital here.
Pros And Cons Of Dividend Stocks: FAQs
Next, let’s address a few frequently asked questions about dividends and dividend investing. Then, I will wrap it up.
Are Dividend Stocks Worth It?
Yes. I believe dividend stocks are worth it.
Because historically, about 40% of investment returns from the stock market have been generated by dividends.
Furthermore, dividends create a passive income stream of cash. And the dividend investor can do with that cash as they please.
Unlike gains in stock prices. Cash dividends, once paid, can never be taken away.
Can You Lose Money With Dividend Stocks?
Yes. You can lose money with dividend stocks.
Because any stock and its associated price can and will go down. More than offsetting the dividends received from the stock.
However, by selecting the highest-quality dividend stocks and holding them for the long-term in a diversified portfolio. Significantly diminishes the risk of losing money.
How Much Investment Is Required To Get Dividends?
Dividend investing does not require a lot of money. You can start dividend investing with a goal for monthly income in the future. But you need just a few dollars to begin today.
Recent developments in stock investing have allowed investors to buy less than 1 share of a dividend stock. Known as fractional shares.
Furthermore, most brokerage accounts now provide free stock trading. So, feeling like you do not have enough money. Is no longer an excuse for not beginning your dividend stock investing journey.
Finally, I buy and sell my dividend stocks for free. Using my Webull app.
Webull is fast and easy to use. It also has great stock research capabilities. And stock alerts. So, you never miss a trade that you want to make.
You can learn more about Webull here.
How Much Do I Need To Invest To Make $1,000 A Month?
To make $1,000 a month in dividend income you’ll need to invest between $200,000 and $400,000.
The exact amount of money invested to create $1,000 per month from a dividend income portfolio depends. Specifically, it depends on the dividend yield of the specific dividend stocks that you choose.
You can build a quality dividend stock portfolio. With an average portfolio dividend yield of between 3% and 6%.
Higher dividend yields are possible. Which reduces the amount of investment required.
But, higher dividend yields are associated with greater investment risk. So, it takes more money to make more dividends.
Okay. That’s it for today.
Hopefully, you now understand the pros and cons of dividend stocks. And the pros and cons of dividend investing.
Now, you can decide if dividend stocks. And, dividend investing is the right choice for you.
Let’s wrap with a summary…
10 Pros And Cons Of Dividend Stocks: Wrap Up
Today, we discussed 5 advantages of dividend stocks. And 5 disadvantages of dividend investing and dividend stocks.
The benefits of dividend investing are:
- Passive dividend income stream
- Solid total investment returns
- Dividend reinvestment for compounding returns
- Hedge against inflation
- Preferential tax treatment
While the disadvantages of cash dividends are:
- Tax inefficiency
- Investment risk
- Sector concentration
- Dividend policy changes
- Investment research
More Reading About The Pros And Cons Of Dividend Stocks
To be honest, I mostly write about the pros of dividend stock investing. How to implement a dividend stock investment strategy. And good dividend stocks to fill out a dividend portfolio.
That being said, here are some articles you may enjoy…
- How Dividends Work: A Guide For Beginning Investors
- Itemized access to all of our dividend articles
- 5 steps to dividends every month
Dividend Stocks Pros And Cons: Best Finance Resources
First of all, I mentioned several of my favorite investing and financial resources in this article.
Furthermore, whether you choose dividend stocks, or not. Each of these resources can play a big role in making finance easy. And making it fun. Plus, allow you to make the most of your money.
Finally, I have summarized my favorite resources here for your convenience. All of them are easy to sign up for and use.
And best of all, most of them are free!
- Trade stocks for free with the Webull app
- Get dividend stock recommendations from Simply Investing
- Get top stock picks from Motley Fool
- Manage all of your finances with Personal Capital
- Use Rakuten to save on your online purchases
Author Bio: Tom Scott founded the consulting and coaching firm Dividends Diversify, LLC. He leverages his expertise and decades of experience in goal setting, relocation assistance, and investing for long-term wealth to help clients reach their full potential.