Investing in dividends offers an alternative strategy that allows investors to benefit from various aspects of investing while reducing reliance on volatile stock market prices. Dividend investing focuses on stocks that pay significant dividend payments, providing investors with a reliable income stream. In this blog post, we will explore the pros and cons of dividend investing, highlighting its potential benefits and drawbacks, along with real-life examples and data points.
Advantages of Dividend Investing
Pro #1: Insulation From the Stock Market
Dividend investing offers insulation from the unpredictable nature of the stock market. The stock market is influenced by the ever-changing demands of investors and the actions of large hedge funds and companies, making it difficult to predict its movements accurately. Renowned investor Warren Buffet himself admits that attempting to predict these actions is futile. By investing in dividends, investors can distance themselves from the constant market fluctuations driven by speculative trading. Unlike stock prices, which can be highly volatile, dividend payments provide a more stable and predictable source of income.
Pro #2: Varied Fluctuation
Dividends tend to fluctuate differently than stock prices. Dividend investing is based on certain assumptions that are inherent in every quarterly dividend payment. Young companies in their growth phase usually offer smaller dividends, as they rely on their increasing stock price to attract investors. Weaker companies, regardless of size, often lack the resources to offer dividends. On the other hand, established companies with steady cash flows and a history of paying dividends can be seen as reliable dividend providers. By analyzing a company’s financials and dividend history, investors can make informed decisions about which stocks are likely to offer consistent dividends in the future.
Pro #3: Dividends Can Provide a Reliable Income Stream
Dividend investing allows investors to pursue portfolio growth differently from traditional stock market investing. While stock market gains are often unpredictable, dividend investing emphasizes the power of compounding. Compounding refers to the process of reinvesting dividends, which, when combined with the dividend reinvestment plans (DRIPs), can significantly accelerate investment growth. The rule of 72, a heuristic used to estimate the time it takes for an investment to double, can help investors assess the potential of dividend investments. By dividing 72 by the current dividend yield, investors can approximate the time it would take for their investment to double through reinvested dividends alone. For example, a stock with an 8% yield could double from reinvested dividends approximately every 9 years. This compounding effect can be particularly advantageous during uncertain times or when other investment options, such as savings accounts, offer minimal returns.
Dividends also offer a reliable income stream, similar to real estate or bonds. Dividend payments occur on predetermined dates, allowing investors to plan and budget accordingly. This steady income can be appealing to those seeking to rely on investment income over an extended period. Additionally, investors can customize their dividend income to be more regular, as some companies pay dividends at different times throughout the year. The “check a month” strategy is an example of structuring stock purchases to ensure a constant stream of income, providing investors with a regular paycheck from their investments.
Disadvantages of Dividend Investing
Con #1: Less Potential for Massive Gains
One potential downside of dividend investing is the limitation on potential returns. While high-yielding dividend stocks may offer attractive rates of return, they typically do not exceed around 10% annually, especially in today’s low-interest-rate environment. In contrast, growth investing strategies, although riskier, can yield significant gains. For instance, individuals who invested in high-growth stocks like Apple in the 1980s would have achieved substantial wealth. Investing solely in high-dividend stocks may not lead to comparable levels of growth. Furthermore, dividend payouts can decrease over time if a company’s growth model changes, limiting the overall total return potential.
Con #2: Disconnect Between Dividends and Business Growth
Another potential drawback of dividend investing is the potential disconnect between a company’s business growth and the amount of dividends paid. While common stocks are not obligated to pay dividends, dividend cuts typically occur when a company is struggling to generate sufficient cash flows. However, there are cases where a company may reduce its dividend due to a change in capital allocation policy. The company may choose to invest more in business growth, fund acquisitions, reduce debt, or repurchase shares instead of paying dividends. In these instances, a company may still experience underlying business growth despite reducing or eliminating dividends. Dividend investing assumes a level of dependence on consistent dividend payments, which may not always align with a company’s long-term strategic decisions.
Con #3: High-Yield Dividend Traps
Investors must exercise caution when dealing with exceptionally high-yielding dividend securities. These securities, known as dividend traps, often carry a high risk of dividend reduction. It is crucial for investors to conduct thorough research and due diligence to understand the true nature of a company’s stock yield. Yield is a fraction dependent on both the dividend and the stock price. A high dividend yield may appear enticing, but it could be a warning sign that the dividend is unsustainable and may be reduced in the future. For example, if a company’s dividend is $1 and the share price is $50, the initial yield would be 2%, which is not particularly attractive. However, if the stock price drops to $10, the yield would increase to 10%, tempting investors seeking high yields. In such cases, if the share price remains low without any compelling reasons for an increase, the company may significantly reduce the dividend, resulting in a less lucrative investment.
Conclusion
Dividend investing offers investors a pathway to reliable income streams and insulation from stock market volatility. The strategy’s emphasis on dividends and compounding can lead to significant growth and a predictable income source over time. However, investors should also consider the potential limitations of dividend investing, such as a lower ceiling for gains, a potential disconnect between dividends and business growth, and the risks associated with high-yield dividend securities. Thorough research and due diligence are essential when considering dividend investments, enabling investors to make informed decisions based on their financial goals and risk tolerance.
References:
- Fisher, C. (2019, March 5). The pros and cons of dividend investing. Investopedia. Retrieved from https://www.investopedia.com/articles/investing/042816/pros-and-cons-dividend-investing.asp
- Little, R. (2021, January 5). Pros and cons of dividend investing. The Balance. Retrieved from https://www.thebalance.com/dividend-investing-pros-and-cons-4774685
- Lomax, T. (2021, February 23). Dividend investing pros and cons. The Motley Fool. Retrieved from https://www.fool.com/investing/2021/02/23/dividend-investing-pros-and-cons/