If you scroll online, you are bound to come across thousands of financial experts and money blogs claiming that dividend investing is the way to achieve financial freedom.

And it can be overwhelming and frustrating to try and make sense of all the advice out there.

While dividends play a role in investment returns, choosing a stock purely on its current dividend yield can be quite risky and create a false sense of security.

Let’s break down the truth about dividend investing.

Here are three key things I will cover in this article:

1. What exactly are dividends?
2. What are the advantages & disadvantages of dividends?
3. Why consider a holistic investment approach instead (Total Return)

Understanding the role of dividends in a well-rounded investment portfolio will help you have an investment strategy that could better align with your overall goals.

What Exactly Are Dividends?

Let’s take a moment to explore the concept of dividends, using a simple lemonade stand analogy.

Imagine you own a lemonade stand with your friends.

Every time you sell a cup of lemonade, you have two options.

1. Keep the money and use it to buy more supplies, like lemons and sugar, and then reinvest to grow the lemonade business.
2. Divide the money among yourselves and take the money home.

This same principle applies to public companies.

They can use their earnings to grow the business or distribute them to shareholders in the form of dividends.

However, there’s a catch…

When dividends are paid out, the cash leaves the company’s balance sheet, which can lead to a decrease in equity value.

Let me illustrate this with a hypothetical scenario.

The graph here shows the value of Lemonade, INC. shares before vs. after a dividend is paid out.

As you can see, when a dividend gets paid out, the share price drops because the value of the cash is no longer on the company’s books.

That means, all else being equal, an investor who receives a dividend may also be left with a less valuable equity holding.

Therefore dividends are not “bonus cash” because your equity value drops by the dividend amount.

However, dividends do offer some benefits and drawbacks, and it’s important to consider them when developing an investment strategy.

Let’s explore the advantages and disadvantages of dividends in more detail.

What Are the Advantages and Disadvantages of Dividends?

Investment strategies come in all shapes and sizes, and dividend investing is no exception.

Let’s take a look at some of the advantages and disadvantages of this type of investment.

Advantages

1. Income. 

One of the biggest advantages of dividend investing is the regular income it provides.

As a shareholder, you receive a percentage of the company’s cash payouts based on the number of shares you own.

For example, let’s say you bought 100 shares of Lemonade, Inc., if they were to pay a $1 annual dividend, you would receive $100 in cash. Many companies will pay this out on a regular basis to keep investors happy, thus making it a nice source of income for investors.

In addition, if you are in a low enough tax bracket, these dividends (if qualified) can be federally tax-free.

2. Reinvestment.

Another advantage of dividend investing is reinvesting those dividends into more shares.

By reinvesting dividends you can potentially benefit from the power of compounding over time.

3. Not selling from principle.

By receiving dividends, investors can receive a stream of income without having to sell their shares. A dividend-paying company lets an investor continue to own part of the company and still benefit financially.

Now that we know what dividends are and some of their advantages, let’s talk about some of the drawbacks when it comes to dividend investing.

Let’s take a look at three of the main disadvantages.

Disadvantages

1. Taxes. 

One of the downsides of dividend investing can be the tax implications.

As you may know, dividends can be subject to taxation at varying rates depending on your holding period, ranging from 0% to 37% (for non-qualified accounts).

This can result in something known as tax drag.

Tax drag happens because realized dividends are taxed every year, and the amount paid in taxes reduces the amount that can be reinvested. The longer your investment horizon and the higher the dividend yield, the greater the potential tax drag.

2. Diversification.

Another disadvantage of dividend investing is the lack of diversification.

When you only focus on companies with high dividend yields you are doing the opposite of diversification. This makes your investments riskier. On average, the proportion of firms paying dividends in the US was only about 52% from 1963 through 2019. (1)

An investor focusing only on those stocks is missing out on nearly half of investible US companies. By definition, a less diversified portfolio is less efficient. For example, well-known companies like Apple, Amazon, and Google do not pay a dividend.

3. Valuations.

Lastly, it’s important to consider the valuation of the stocks you are investing in.

There is a big difference between buying a high-quality high-dividend-paying stock and a low-quality high-dividend-paying stock.

Simply put, valuations measure how overvalued or cheap something is and can be even more important than taxes.

Buying a high-dividend stock that is expensive and has bad financials is not a good investment. Thus having a high yield creates a false sense of security.

If you buy something when it’s cheap, you can sell it when it becomes more valuable and turn a profit. If you buy something expensive, on the other hand, you’ll lose money if you sell it after it loses value.

In summary, while dividends can provide certain advantages, it’s important to understand the drawbacks before making a decision. Focusing solely on dividend-paying stocks may not be the most effective investment strategy for all investors.

This is why investors should consider focusing on more of a holistic approach when it comes to investing.

The Benefits of Taking a Holistic Investment Approach (Total Return)

As an investor, it’s easy to get caught up in the latest investment trends and strategies. And we know that will be a factor till the end of time.

But when it comes to investing, it’s important to remember that total return is what truly matters over the long run.

Cold hard cash from a dividend might make investors feel all warm and fuzzy inside, but it’s crucial to consider all forms of income that can come from your investments.

Total return takes into account both dividends and the increased value of your investment over time.

When you invest for total return, you look at all the money you get from your investments. Not just dividends.

However, the evaluation of an investment should never come down to solely dividend yield and ignore total returns. Instead, formulate a systematic and holistic investment process that aligns total return with your overall goals.

Footnotes:

1 Dimensional, using data from CRSP. Stocks are sorted at the end of each June based on whether a dividend was issued in the preceding 12 months.