One popular style of stock investing is to buy individual stocks with steady or increasing dividend track records. The idea is that companies who commit to pay a dividend consistently arrange their businesses to have a profit, and share prices keep up with inflation. These companies then pay out a modest fraction of profits, ensuring the security of the dividend income. The benefit to the investor is a stream of fairly predictable and growing passive income.
Many companies allow investors to buy new shares with their dividends, through dividend reinvestment programs (DRIPs). While accumulating, dividends are re-invested each quarter, thus increasing the number of shares.
If stocks are not traded, most dividends qualify for favorable long-term capital gains tax rates. On dividends received, even though no cash is received, taxes are due every year.
Since these companies have committed to pay regular dividends, they tend to be more conservatively managed than companies that do not pay dividends.
There are some downsides to this approach.
Slow Growth: Dividend paying companies tend to grow more slowly because of the businesses they are in. Investors may miss out on growth stocks, while paying tax every year on their dividends. Growth stocks typically pay little or no dividends, choosing instead to reinvest in their businesses rather than paying shareholders.
Tax efficiency of non-dividend payers: Stocks that do not pay a dividend can defer taxes on the gains until the time of a sale. It is possible to time sales in a year when the taxpayer has little other income – and thus pay lower tax, or no tax at all, with appropriate planning. Reporting gains on the sale of a stock accumulated over many years of quarterly DRIP investments requires keeping good records and becomes complicated. Investors should ask themselves whether the extra recordkeeping is worth the effort if they are planning to be a “buy and hold” investor anyway.
Sector Imbalance Risk: Dividend paying companies tend to be concentrated in finance, transportation, telecommunications, real estate and utilities, and “vice” stocks, such as tobacco companies. A portfolio of dividend stocks is likely to have more exposure in these sectors. This turned out badly in the collapse of 2008, when many financial sector companies ran into big trouble. Before it went bankrupt, Lehman Brothers paid a hefty dividend. But that fact was little consolation for investors when it failed.
Holding individual stocks is not a requirement: Some mutual funds and ETFs follow a dividend investing strategy. By using a fund instead of buying a few stocks, the investor can achieve greater diversification. This does not completely get around the risk of sector concentration described, or the recordkeeping issues.
Broad diversification may be better: Avoiding concentration, taxation of reinvested dividends and sector imbalance can be achieved by owning highly diversified equity index funds which pay low dividends yet grow significantly over time. While a dividend investing strategy is not a bad one, it has its limitations and risks.