In this article:
- What Are Dividend Stocks?
- 3 Reasons to Avoid Dividend-Paying Stocks
- 5 Alternatives to Dividend Stocks
Dividend stocks can provide regular payouts to stockholders. Buying them could create a source of additional income, but dividend stocks don't always guarantee steady returns. They have their own unique downsides and risks that are worth considering. Here are three reasons to avoid relying too much on dividend stocks, along with a handful of investment alternatives that might make sense for your portfolio.
What Are Dividend Stocks?
Some companies redistribute a portion of their profits to shareholders. These are called dividend payments, and they're typically issued quarterly, annually, semiannually or monthly. U.S. companies paid out more than $547 billion in dividends in 2022, according to the Janus Henderson Global Dividend Index.
Dividend stocks are more common among well-established companies. Unlike startups and younger companies, they don't need to invest so heavily in growth. That allows them to redistribute some of their profits to stockholders. Dividend stocks are available through exchange-traded funds (ETFs) and mutual funds that focus on dividend-paying companies. Investors can also buy individual stocks that pay dividends, though individual stock picking is generally considered a riskier approach.
As part of a diversified portfolio, dividend stocks have their place. They offer relative stability, may pay increasing amounts over time and may provide steady income. But relying too heavily on dividend stocks as a primary investment approach could put you at risk and reduce your long-term investment gains.
3 Reasons to Avoid Dividend-Paying Stocks
Dividend stocks can provide steady income while helping to offset losses in other parts of your investment portfolio—but they do have their drawbacks.
1. Dividend Payments Aren't Guaranteed
Dividend payments can fluctuate. To estimate how much you can expect, look at the stock's dividend yield. This is expressed as a percentage of the current share price. Over the past decade, the average dividend yield within the S&P 500 has been about 1.86%. For a single stock that's worth $100, that translates to a dividend payout of $1.86 per year.
One strategy is to only invest in dividend stocks with high yields, but a higher-than-average dividend yield isn't guaranteed to last. An unknown risk is whether the company can continue paying those dividends. In the face of financial distress, they may choose to dial back dividend payments or pause them altogether. That can pose a problem when it comes to your long-term investing plan.
2. Dividend Income is Taxable
How are stock dividends taxed? It's important to understand that dividend payments count as taxable income. Your tax rate will depend on your income and whether the dividends are considered qualified or nonqualified.
- Qualified dividends: These are taxed as long-term capital gains, which have a more favorable tax rate. Qualified dividends generally must be issued by a U.S. company, though there is some flexibility here. The stockholder also has to satisfy a holding period requirement.
- Nonqualified dividends: If the previous requirements aren't met, dividend payments will be taxed as ordinary income—which is higher than the capital gains rates.
Investing heavily in dividend stocks could complicate your taxes. If you're curious about exploring this investment strategy, know that stock dividend tax will come into play.
3. Interest Rates Can Affect Dividend Stocks
Interest rate changes can impact dividend stocks, for better or worse. When rates are low, dividend stocks are generally more attractive because they tend to pay more than investments like certificates of deposit (CDs) or Treasury bills—both of which carry less risk. But as interest rates rise, the yields on those safer investments also increase. That could make them better investments than dividend stocks.
5 Alternatives to Dividend Stocks
Diversification is one of the best ways to protect your portfolio. It involves investing in a variety of different asset classes and industries to help spread out the risk. If dividend payments decrease, or dividend stocks simply underperform, stability in other parts of your portfolio can help soften the blow. Here are five investment alternatives to consider:
- ETFs and mutual funds that cast a wide net: These types of investment funds allow you to buy bundles of stocks or bonds in a single transaction. They provide automatic diversification and are also considered less risky when compared with individual stocks. Some ETFs and mutual funds focus squarely on dividend stocks, but investing in a wider range of securities can help balance your portfolio.
- Index funds: These are ETFs or mutual funds that track a certain market index, like the S&P 500. Index funds are considered low-cost, less-volatile investments.
- Bonds: A bond is a type of debt security that's issued by government agencies or corporations. When you purchase a bond, you're extending that entity a loan that's repaid in the future with interest.
- CDs: With a CD, you agree to lock up your investment dollars for a predetermined amount of time. When that maturity period ends, you'll receive your money back with interest. You'll likely be penalized for withdrawing your funds early.
- Money market accounts: A money market account earns interest like a savings account, but most come with a debit card or checkbook to allow for easier access. Think of it as a cross between a checking account and a savings account.
The Bottom Line
When it comes to buying dividend stocks, it's best to go with companies that have a solid track record of increasing dividend yields. But even then, there are some valid reasons to avoid loading up your portfolio with dividend stocks. Payments aren't guaranteed, and there are tax considerations to think about. Other lower-risk investments might also become more attractive when interest rates are on the rise. If you do decide to invest in dividend stocks, staying diversified can help mitigate risk.
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