By Steve Tepper, CFP®, MBA and ChatGPT
Clients often talk about living off the interest generated by their portfolios, and they are not usually referring to just the bond interest they receive but also the dividends from the stocks they own. I even hear clients talk about their investment income that way when their portfolio is not designed to capture dividends and interest to withdraw and live off of in retirement but to generate capital gains that meet or exceed their income needs.
The subject can be confusing, so here’s a brief primer:
Dividend investing can be a good strategy for certain investors, but like any investment approach, it has its pros and cons. Whether dividend investing suits you depends on your financial goals, risk tolerance, and investment timeline.
A dividend investing strategy is simple: You invest in companies that pay shareholders a stable dividend regularly, which provides a relatively predictable series of cash flows. Here are some considerations to help you decide if dividend investing aligns with your investment objectives:
Pros of Dividend Investing
Regular income: Dividend-paying stocks can provide a steady stream of income, making them attractive to income-seeking investors, especially those in or nearing retirement.
Potential for growth: Some companies increase their dividends over time, providing investors with the potential for income and capital appreciation.
Lower volatility: Dividend-paying stocks, particularly those of established companies, tend to be less volatile than high-growth or speculative stocks.
Dividend reinvestment: By participating in dividend reinvestment programs (DRIPs), investors can automatically reinvest dividends to purchase additional shares, potentially compounding their returns over time.
Historical performance: Over the long term, dividend-paying stocks have historically provided competitive returns and can be a defensive strategy during bear markets.
Cons of Dividend Investing
Limited growth potential: High-growth companies often reinvest their earnings into expanding the business rather than paying dividends. As a result, dividend stocks may not experience the same rapid price appreciation as growth stocks.
Dependency on stable companies: Relying heavily on dividends can lead investors to focus on mature, stable companies, potentially missing out on higher-growth opportunities in emerging industries.
Interest rate sensitivity: In a rising interest rate environment, dividend stocks may become less attractive compared to fixed-income investments.
Dividend cuts: Companies can reduce or eliminate dividends in challenging economic conditions, leading to decreased income for investors.
Tax implications: Dividends are typically taxable income, which may impact the after-tax returns for investors in taxable accounts.
That last item is maybe the most important consideration, and the one that drives me as an investment advisor to steer most clients away from a strategy that is overly focused on generating income through dividend investing, particularly for higher income earners: A strategy that focuses on growing a portfolio through capital gains will be much more tax efficient than one designed to generate high dividends because the long-term capital gains tax rate is significantly lower for people in most tax brackets than the tax rate on stock dividends and bond interest.
Conclusion
Dividend investing can be an essential component of a well-rounded investment portfolio, especially for income-oriented investors and those seeking a more conservative approach. However, tax implications are a critical consideration, and it’s essential to diversify your investments and consider your overall financial goals, risk tolerance, and time horizon.
A balanced portfolio may include a mix of dividend-paying stocks, growth stocks, bonds, and other asset classes to achieve the desired level of risk and return that aligns with your individual needs. It’s always a good idea to consult a financial advisor to develop a personalized investment strategy tailored to your circumstances.