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Dividend stocks are sometimes viewed as outdated, especially when tech and growth stock prices are increasing quickly. But dividend stocks have pros and cons making them attractive.
In addition, investors have focused on trendier alternative investment classes like cryptocurrencies, startups, and NFTs (non-fungible tokens) in the past few years. But the bear market of 2022 and the recent banking crises in the United States and Europe illustrated risks in alternative investments without long track records. Bitcoin (BTC) and other cryptocurrencies plunged. Moreover, some alternative investments are now worthless.
On the other hand, old-fashioned dividend stocks perform slowly and steadily. Dividends are essential because it is one-way companies return cash to shareholders. Also, they are more conservative and usually less volatile. But any investment has pros and cons.
Dividend Stock Basics
A dividend stock pays cash to shareholders from net profits. Dividends are income to shareholders. Many retirees use dividends to supplement their retirement income.
In the United States, dividends are customarily paid quarterly. However, dividends are usually paid semi-annually or annually in Europe, Japan, or India.
Companies also pay special dividends outside of the normal schedule. Additionally, some companies pay a regular dividend and a fluctuating variable dividend annually.
Now that you know the essentials of dividend stocks, here are the pros and cons of dividend stocks.
Pros of Dividend Stocks
Generate Income
Unlike tech and growth stocks, and many asset classes, dividend stocks generate income for shareholders. The same cannot be said about gold, cryptocurrencies, commodities, NFTs, etc. These asset classes derive their total return only from price gains or losses and have other disadvantages. On the other hand, dividend stocks’ total return is from dividend yield, price changes, and price-to-earnings ratio (P/E ratio) expansion or contraction.
Dividends are cash paid to shareholders, which goes directly into your brokerage account. People can use this money for living expenses in retirement.
Also, investors can reinvest the money in the same or a different stock, buying more shares. The dividend growth investing strategy follows this method: buying stocks that pay a growing dividend each year and reinvesting them, compounding returns. Over many years, the income will grow significantly.
Less Volatile
Another benefit of dividend stocks is their low volatility compared to stocks that do not pay dividends. Research has shown dividend stocks are less volatile than those that do not pay a dividend, maintain a constant one, or even worse, reduce or omit their dividend.
In all comparisons, the beta, a measure of volatility, or the standard deviation, a measure of the variability of returns, were lower for dividend growers or payers. A higher beta and standard deviation indicate more volatility.
As a result, a major pro is that dividend stocks perform better with lower volatility over time.
Better in Bear Market Performance
The third pro for dividend stocks is typically better bear market performance. According to the S&P Global, dividend stocks performed better than non-dividend payers during the dot-com crash and the subprime mortgage crisis bear market. One exception is that they performed worse during COVID-19 because of unprecedented global dividend cuts and eliminations to conserve cash.
Tax Advantages
Next, in some countries, dividends have tax advantages compared to regular income. For example, in the United States, qualified dividends are taxed at 0%, 15%, and a maximum rate of 20%. However, ordinary dividends are taxed at the regular income tax rate, which may be higher.
In some European countries, like Estonia, Latvia, Greece, and others, the dividend tax rate is lower than for capital gains. Similarly, Brazil does not tax dividend distributions for residents.
Cons of Dividend Stocks
Tax Disadvantages
In some countries, like South Korea, Belgium, Switzerland, Turkey, etc., dividends are taxed more than capital gains, which is a disadvantage. Often, the percentage difference is significant. For instance, the capital gains tax in South Korea is zero percent, but the top dividend tax rate is 44%.
Moreover, in some cases, the dividends are subject to double taxation. Governments tax company profits, and since dividends are paid from profits, this is a first tax. Countries also tax dividend income for investors, which is the double tax.
Another disadvantage is that taxes on capital gains can be deferred until shares are sold. On the other hand, dividend taxes are paid when received.
Dividend Policy Changes
Dividends are not guaranteed. A company’s board must authorize the dividend. If a firm performs poorly or has a loss for the year, the dividend may not be paid to investors. A dividend cut will usually cause a stock to perform poorly because investors relying on dividend income will probably sell the stock causing the share price to decline. In the worst case, a business may eliminate the dividend resulting in the share price dropping quickly.
Investment Risk
Sometimes, dividend stocks perform weakly if other investments create more income. For instance, if savings accounts, certificates of deposit, and bonds have greater interest rates than average yields, the share prices of dividend stocks will decline. This action creates losses for investors. The reason is that people often view savings accounts and bonds as safer than stocks.
Bottom Line
Dividend stocks have several advantages compared to other asset classes and non-dividend-paying stocks. But they also have some disadvantages. Therefore, investors should know the pros and cons before investing in them.
