Dividends are Important, but probably not as important as you think

Photo by Anna Nekrashevich

I used to get a lot of questions about dividend investing. Dividends have a special place in the hearts of many investors, and it's easy to see why. It's nice when the shares in the company you own send you a check every quarter (as a nice little treat). It is a very tangible way to see a return on your investment. For individuals who wish to live off that income, it's an easy way to put cash in your pocket without having to actually sell stock. 

Emphasis on dividends usually came from two main groups of clients:

• Retires who wanted to live off a stream of income in their portfolio
• Young investors, following the ways of their parents and grandparents, who want to build a portfolio that would pay them a stream of dividend income when they eventually retire.

The investment world has shifted, though, and while I think dividends should not be ignored, they may not carry the weight of importance that they used to.

The most important value a dividend provides in the current era of investing is likely the buffer against market downturns. However,

• Dividends come with a tax consequence, 
• Transaction costs for buying and selling investments are lower than ever,
• Dividend yields have fallen,
• Chasing a high dividend yield comes with higher risk.

Let's dive into each of these points and see if our discussion pays, well, dividends.

Dividends do provide some enhancement to market returns and some buffer against downturns.

When we look at returns for an individual investment or a market index, we review that investment's growth (or decline) over a specific period. We generally think about the change in price of that investment over time, but an additional component of the complete return picture is the dividend yield. See the graph below from Charles Schwab, which shows the price change for the S&P 500 index over the last 10 decades in light blue and the additional dividend return in dark blue. 

In every decade, dividends added a nice additional return, and in the 1930s and the 2000s, it helped offset a decade of losses, reducing the sting. An important additional consideration is that the dividends in this comparison aren't just paid out in cash and don't just sit there. The dividends are reinvested, furthering the compounding of growth in your accounts. And those couple of percent in dividends each year, when reinvested, can really add up; see the chart below on the last 5-year returns of the S&P 500 index. 

Without dividends, the index has done an impressive total of 81% over the last five years. But add the dividends in and reinvest them? The return is over 96% for the last five years. That's real money as a result of reinvested dividends. And when the market declines, you have cash coming through in the form of dividends, allowing you to buy shares while the market is depressed. 

‍Oversold benefits of dividends

On the flip side, though, I think it's important not to get too laser-focused on dividends as a core investment strategy. Dividends are a nice icing on the cake, but they do not guarantee outsized returns and suffer from a few issues. 

‍Dividend yields ain't what they used to be.

For many years before the 1960s, the dividend yield on stocks was frequently above 4%. That's not bad if you want to generate some income and have the possibility of investment growth. Then, from the 1960s to the 1990s, they were a respectable 3%, often popping higher in times of price decline. Today? A measly 1.25%, give or take. 

What happened? The market changed. Energy, financial, and utility companies are traditional dividend payers and are still out there. However, the market behemoths have largely given way to technology and other new industries, which typically pay much lower dividends and choose instead to invest cash back into developing the business. Major players in today's market, like Nvidia (NVDA), Apple (AAPL), Google (GOOG), Meta Platforms (META), and Netflix (NFLX), all pay dividends under 0.50%, if at all. 

These lower dividend payers have also seen their total return, the change in price plus the dividend, outpace many of the big dividend payers by many multiples. Companies your parents or grandparents might have gone after for a big dividend, like Verizon (VZ), AT&T (T), Dow Chemical (DOW), or Consolidated Edison (ED), have had total returns over the last few years far short of the broader stock market. 

‍Dividends create immediate taxable income.

Dividends create taxable income when they pay out. Even if you reinvest the dividend, you must report the income. 

Fortunately, if you meet certain holding period conditions, the dividend gets a favorable 15% tax treatment. That's not always going to be the case, though, and when they are not qualified dividends, they are taxed at your regular income tax rate. So, assume at least a 15% reduction in the payout every time a dividend is received. 

There is another little secret about dividend payouts. The share price of the stock or fund will drop by the dividend amount a couple days before it pays out. That is because the company is literally paying out a portion of the company's value, represented by the value of the stock, to you as a dividend. Now, stock prices can move quickly, and sometimes, this slight change isn't even noticed amid all the market noise, but I can assure you it happens. Occasionally, a stock might pay a "special dividend" of several dollars a share. I assure you it gets noticed then. So a dividend, in some ways, is a little mini-sale of the stock returning money to you but creating a taxable event. 

Now, don't you get taxed on stock sales as well? Yes, but at least when selling a stock, you might have some control over when and how much, and you might even have the opportunity to sell something at a loss and avoid capital gains tax altogether. Alternatively, you could hold dividend-paying stocks primarily in an IRA or Roth IRA account to avoid tax on dividend payments. 

‍Low transaction costs mean selling a stock doesn't carry the costs it used to.

Years ago, selling stock or mutual fund shares carried a significant commission to the broker, possibly hundreds of dollars. When discount brokers entered the scene, taking commissions under a hundred dollars, it was better, but that still might take a bite out of a monthly check for a couple thousand dollars. When I started in this business in 2003, it was at a well-known firm that charged just $7 for a trade placed on the computer. Now, commission costs are $0 at many firms, so selling a few shares here and there to create monthly income isn't as big a deal as it used to be. 

‍High dividends aren't a "free lunch."

We say in finance and economics that "there is no such thing as a free lunch," and it's just a wonky way of saying you don't get something for nothing. Dividend yields are the same way. Big dividends can come with potential big problems. 

Sometimes, dividend yields are high because the company is down on its luck. They are still paying out a dividend, but the stock price is down, meaning the ratio of the price vs. the dividend creates a high yield. Maybe the company price is down unfairly due to some bad news, but the company is in good health and can recover and continue to pay its dividend. But sometimes the stock is down deservedly, and you might get a nice dividend but see the share price languish when the rest of the market goes up. Worse yet, if the company is in real trouble, they could stop the dividend altogether, stopping your income stream along with it.

This was a real problem in the wake of the 2008 financial crisis, when many well-known companies, big banks in particular, severely cut or even stopped paying dividends. These were companies often with years of dividend-paying history. Some took the somewhat comical step of paying out $0.01 per share to tout a history of "never stopping their dividend." In contrast, others simply couldn't pay it. 

‍Embrace the concept of "Total Return"

Dividends have value, but I encourage clients to embrace the idea of the total return on their portfolio: investment growth plus dividends. Even if they are retired and living off the portfolio. Dividend income expectations in the current environment are not realistic (do you have any idea how much money it takes to generate $3,000/month at 2%)? Dividends could create unnecessary taxes, and you could miss out on significant gains in growth stocks by chasing dividends in other industries. These days, transaction costs are near zero, and yield opportunities can be found with more relative stability in the bond market. 

If you need help building a portfolio that delivers the returns and income you need, contact us for an opportunity to discuss your long-term strategy.