The Risks Of A Dividend Stock Investing Strategy

The Risks Of A Dividend Stock Investing Strategy

Many people in the personal finance sphere use on a dividend stock investing strategy.

While I understand some of the benefits of investing in dividend stocks, I have a hard time seeing it as a sole viable investing strategy.

The benefits include:

  • You get frequent cash payouts without lowering the number of shares you own
  • In some countries you will pay lower tax on dividends compared to capital gains which is a benefit when you don’t want to reinvest anymore
  • You could save administration costs on normal index funds
  • You get paid often and it is more fun to follow

However, on average, focusing on dividend stocks can lead to higher risk and not necessarily higher returns.

You have to pay taxes

If you start investing before you actually need to spend your dividend payments, you need to pay tax each year on the dividend. This will lower your compound returns over time.

When a dividend is paid out, the value of the stock is lowered by the same amount. If you pay 15% tax on the dividend, you will have less money using dividend stock investing than traditional index fund investing.

For example, imagine you have a dividend investing portfolio paying out a 5% dividend of the total value of $100.

After the payout, the value of your portfolio and cash will be: $100 – $5 + $5 * 0.85% = $99.25

If you had invested in a traditional index fund paying a 2% dividend, the value would be higher: $100 – $2 + $2 * 0.85% = $99.70

You see why I wouldn’t focus too much on dividend stock investing when taxes erode the value over time all else being equal?

If you can re-invest dividends before paying taxes, then it will be the same outcome in both cases. Why would you then bother from a tax perspective?

Now whether dividend stock investing makes sense from a tax perspective depends on your country’s local regulation. If the following criteria are true, then it might make sense from a tax perspective:

  1. Taxes are lower on dividends than on capital gains
  2. You can reinvest dividends tax-free until you need them
  3. You will need to spend the dividends to finance your lifestyle eventually

However, there’s more to it than just tax.

You are dependent on history

Investing in dividend stocks make you dependent on history. This is one of the things I like the least about dividend stock investing.

Companies try to maintain the dividend payout levels over time. However, all companies can decide to lower or remove dividends from one day to the other. I often see companies doing this.

The dependence on past dividend payouts makes your investments highly uncertain and can lead to a sub-optimal portfolio of companies who once paid high dividends.

You have less diversification

Companies paying high dividends usually come in certain industry clusters. Often they are old, established companies in the industrial or utility sectors.

However, when you invest in companies solely based on their dividend payout ratio, you risk not getting enough diversification in your investment.

A traditional broad index fund will expose you to a variety of sectors, geography, growth/value and other characteristics.

A dividend stock investing portfolio might lack diversification and make you more exposed to certain unfavorable events.

You spend time

Putting together a good dividend stock portfolio takes a lot of time and analysis.

I like to put my investments on autopilot. I spend two minutes each month investing in index funds and get on with my life.

If you invest in dividend stocks, you will be spending significant time putting your portfolio together.

You can get dividends from index funds too

Dividend stock investors are not the only people receiving dividends.

In fact, many of Vanguard’s index funds pay out around 2% in dividends each year. I receive something similar from my investments.

If you want to, you can even select a high dividend index fund, which pays out slightly less than 3% if I remember correctly.

Why bother manually putting together a dividend stock portfolio carrying higher risk, less diversification, more tax and taking more time than traditional index funds? Even though traditional stock picking might not save you more time, it is still superior on all those other parameters.

I don’t hate dividend stocks

I know this post could spark a big debate, so let me be clear.

I don’t hate dividend stocks. I just fail to see how it can be a superior investing strategy and why so many people follow it.

If you invest in dividend stocks, I would love to get your input on this 🙂

6 comments

6 comments

European Dividend Blog August 16, 2019 - 11:25

Hi Carl
Great post and I agree – But why do I invest primarily in individual dividend stocks then? For me investing is also a hobby and it need to be fun for me as well. Dividend investing might not mean I get a better return over the years, but I’ll sure have some fun along the way. Because it’s a hobby of mine, I don’t mind spending time managing my portfolio.

I haven’t done the math, but if you accumulate an index fund for let’s say 10 years and then liquidate it, that might mean that, at least in Denmark, pay more tax on the return. In Denmark you pay extra tax when you earn more than appx 8.000$ from stock returns (profits and dividends). Dividends stretches these returns over 10 years but accumulating might mean, that you hit this max and end up paying 42% tax on your stock profits. Just a thought.

30% of my investment portfolio is invested in passive index funds (and a few bonds). Another advantage of your automatization of your investments is the benefits of dollar-cost-average.

Best regards
EDB

Reply
Carl Jensen August 16, 2019 - 21:38

Makes great sense 🙂 I understand how it can be a fun hobby to select different stocks to invest in. And yes, there might be cases in different countries where it makes more sense from a tax point of view, but that depends on your spending and need for dividends/capital gains to cover your cash flow 🙂

Reply
Omar August 16, 2019 - 00:38

Nice post, Carl. Thanks for that.
Something nice to add too your text, you can mention that in some countries the tax on dividends is 30% 🙁 but… Tax on capitals gains is … zero (Yes: Zero. Welcome to Belgium 🙂 )
I like an index fund that follows the S&P500 (Dividends for the S&P500 are about 1.85% per year), for a taxes perspective it would be even better to be on a fund where the dividends would be zero (meaning zero taxes paid) and everything would go to capital gains (Zero taxes, Welcome again in Belgium 🙂 ) but I didn’t find a Index Fund like that. I should also should recognize that is quite nice to receive a small “something” in dividends each 3months.
In any case, my motto: Index funds, the way to go! 🙂

Reply
Carl Jensen August 16, 2019 - 21:35

Great points, Omar. Thanks for adding those! Oh, and the 0% tax on capital gains definitely sounds interesting 😉

Reply
Ruben August 24, 2019 - 23:22

Actually, these funds do exist. You need to look for an accumulating ETF. An example for the S&P500 would be CSPX from Blackrock. This way, you only pay capital gains tax in the end when you sell and no dividend taxes. There’s a small extra tax included when selling, but if you keep the fund for more than a year, that difference is eliminated as well. This only works for equity ETFs, though. You will pay 30% taxes (in Belgium) on acvumulating ETFs that contain 10% or more bonds.

Reply
Carl Jensen August 25, 2019 - 20:17

Thanks for adding that, Ruben. In Denmark, foreign equity ETFs are taxed yearly (even though the gains have not been realized) making it a less attractive option.

Reply

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