Happy Holiday everyone, I’m back! When I started investing back in 2020, I only invested in growth stocks (think Tesla, Netflix, Nvidia, etc.), which more often than not happen to generate no profit or free cash flow. I was looking at the high potential upside in a short amount of time and did not even consider dividend-paying stock.
As I learn more about investing over time, I realized that while growth stocks provide huge upsides, they also come with huge downsides and high volatility. And as I established my goal of FIRE, I found that dividend investing is a better fit for me.
So with this post, I will lay out some of the advantages and disadvantages I learned that come with dividend investing. As you go through the post, I hope that this gives you a better idea of why people are for/against dividend investing and that you will start considering if this is a suitable investment strategy for you starting in 2023.
Advantages
1. Passive Income
First of all, dividend gives you another income stream. Dividends are cash that companies pay out to investors periodically as a form of profit sharing. It is literally cash that you earn just by investing in the company without having to do anything. You can use this to do anything you want, e.g. pay your bills, buy groceries, or buy more shares.
2. Compounding Effect
As mentioned above, you can use your dividend to buy more shares of the company. This is called the compounding effect, also called the snowball effect. This is the beauty of dividend investing. A company pays you a dividend, and you then use that dividend and reinvest it back into the company, getting more shares and dividends as a result!
3. Lower Tax
While dividend is another stream of income, the IRS does not treat it the same way they treat your salary. Salary is earned income, and it will be taxed based on which tax bracket you fall under. Dividend is taxed much less than earned income. For 2022, qualified dividend is taxed 0% if you make less than $44,625, 15% if you make between $44,626 and $492,300, and 20% after that. As you can see, most of us would probably pay between 0-15% on dividends (that is if you are not already super rich)
4. Less Fluctuation than Stock Price
Unlike stock price, dividend does not fluctuate on a daily basis. Once the company announced a dividend payout, you will get that amount based on the number of shares you have as long as you buy before the ex-dividend date. So it doesn’t matter if the stock goes up or down tomorrow, your dividend would still be paid once the announcement is made.
Disadvantages
1. Dividends are Taxable
While it’s true that dividends are generally taxed less than earned income, it’s still taxes that you have to pay unless your investments are under a tax advantage account. It is different from capital gain because you can control when you want to trigger a taxable event (e.g. selling shares for profit), but a dividend is taxable the moment you receive it.
2. Dividends are not Guaranteed
While dividend is a much more stable method of paying shareholders, it is at the mercy of the board of directors. The company’s board of directors can choose to reduce the amount of dividend or cut it entirely due to many reasons (e.g. cash is better used for other investments than paying dividends, the company is struggling financially, etc.)
3. High-yield Traps
This is one of the pitfalls that many dividend investors fall into. Investors should always be skeptical when they come across companies with an extremely high dividend yield (usually anything that is over 4%) because, more often than not, these companies have bad/deteriorated fundamentals and bad balance sheets; they usually have a high debt-to-cash ratio in order to fund their operations and high yield dividends to lure investors.
4. Potentially Lower Return
Another disadvantage of dividend investing is the potential of a lower return. Companies that pay dividends are usually established and mature companies with good records of profits and lower but more predictable growths. This is different from companies that are still in growth mode, which means that they have high revenue growth but are not yet profitable; hence, investors are paying with the expectation that they will turn a profit in the future.
Bottom Line
Overall, there will always be advantages and disadvantages associated with each of the investing strategies.
For me, dividend investing is a suitable option because it aligns with my goal of building passive incomes that could help me reach financial independence in the near future. In this case, the pros outweigh the cons because I get to invest in good companies with good growths, increase my passive income and take advantage of the compounding effect.
As always, do your own research! Figure out what your goals are and pick the investing style that suits your goals!