When you want your portfolio to generate income, dividend-paying stocks seem like a no-brainer. These are assets that can generate stock-market returns while also paying out regular cash distributions. That all sounds pretty good.
However, while dividend stocks can indeed be a worthwhile part of an income investing strategy, purchasing them still involves risk. As a result, you’ll want to familiarise yourself with the pros and cons of purchasing these assets.
If you’re new to the concept of dividend stocks, then check out our handy article on investing terms for beginner investors.
"Dividend-paying stocks tend to be more established, mature companies. This means they are likely to be more stable in unpredictable markets compared to stocks that are still growing."
Benefits of dividend investments
For the long-term investor, there are numerous potential benefits of dividend-paying stocks. Here are a few of them:
Additional income: The first, and somewhat obvious, point to make is, if you choose the right companies to invest in, they generate additional income for you in the form of dividends while appreciating in value over the long term. These dividends can be used as income or reinvested back into the market.
Strong historical performance: Dividend growth stocks have – generally – outperformed broader stocks markets over the past couple of decades. The S&P 500 Dividend Aristocrats Index, which contains companies that have grown their dividend for at least 25 consecutive years, has outperformed the S&P 500 by roughly one percentage point over the last 19 years. Of course, past performance is not an indication of future results.
Less volatility: Dividend-paying stocks are often framed as being more stable in times of uncertainty than other companies. This is because companies that pay dividends tend to be more established businesses. Once again, past performance is not an indication of any future returns.
The value of compounding: Reinvesting dividends over the long term can result in compounding growth, as the investor receives dividends from reinvested dividends, resulting in a virtuous cycle of growth.
"Dividends aren’t guaranteed. Companies can and do stop paying them if times become tough."
Disadvantages of dividend paying stocks
There are also a few drawbacks of dividend-paying stocks that you should be aware of:
Taxes: Unless taking advantage of certain tax deductions, you’ll pay tax on dividends received above a certain amount. Tax treatment will depend on your individual circumstances and could potentially change in the future.
Uncertainty: Dividends aren’t guaranteed. Companies can and do stop paying them if times become tough.
Stock movements after ex-dividend date: Dividend stocks often experience a temporary drop in value after the ex-dividend date, as investors factor in the reduction in the company's cash reserves following the dividend payment. Additionally, the stock may be less appealing to any potential new investors since they won’t be entitled to a dividend until the next one is announced.
Imagine you purchased an aeroplane ticket that included checked baggage in the price. Now imagine your friend purchased the same ticket, but it didn’t include a checked bag. Your pal would naturally want to pay less for the ticket than you did. That’s similar to some of the psychology that drives dividend stock prices down when investors know they don’t qualify to receive the upcoming distribution.
While the fall in value may well be temporary, you need to be aware of this dynamic if you’re planning on buying stocks to take advantage of the dividend payments before ditching them.
As with any investment, it’s important you do your own research and know what you’re getting yourself into before you put money to work. Dividend stocks can be an attractive option for many, but making sure you understand how these securities typically behave can help you avoid shocks along the road during your investing journey.
Important: This article is for general guidance purposes only and should not be considered investment advice. If you are unsure about the suitability of an investment, please seek out advice. When you invest, your capital is at risk. Tax treatment will depend on your individual circumstances and could potentially change in the future.