3 Reasons to Avoid Dividend Stocks - Experian (2024)

In this article:

  • What Are Dividend Stocks?
  • 3 Reasons to Avoid Dividend-Paying Stocks
  • 5 Alternatives to Dividend Stocks

Dividend stocks can provide regular payouts to stockholders. Buying them could create a source of additional income, but dividend stocks don't always guarantee steady returns. They have their own unique downsides and risks that are worth considering. Here are three reasons to avoid relying too much on dividend stocks, along with a handful of investment alternatives that might make sense for your portfolio.

What Are Dividend Stocks?

Some companies redistribute a portion of their profits to shareholders. These are called dividend payments, and they're typically issued quarterly, annually, semiannually or monthly. U.S. companies paid out more than $547 billion in dividends in 2022, according to the Janus Henderson Global Dividend Index.

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Dividend stocks are more common among well-established companies. Unlike startups and younger companies, they don't need to invest so heavily in growth. That allows them to redistribute some of their profits to stockholders. Dividend stocks are available through exchange-traded funds (ETFs) and mutual funds that focus on dividend-paying companies. Investors can also buy individual stocks that pay dividends, though individual stock picking is generally considered a riskier approach.

As part of a diversified portfolio, dividend stocks have their place. They offer relative stability, may pay increasing amounts over time and may provide steady income. But relying too heavily on dividend stocks as a primary investment approach could put you at risk and reduce your long-term investment gains.

3 Reasons to Avoid Dividend-Paying Stocks

Dividend stocks can provide steady income while helping to offset losses in other parts of your investment portfolio—but they do have their drawbacks.

1. Dividend Payments Aren't Guaranteed

Dividend payments can fluctuate. To estimate how much you can expect, look at the stock's dividend yield. This is expressed as a percentage of the current share price. Over the past decade, the average dividend yield within the S&P 500 has been about 1.86%. For a single stock that's worth $100, that translates to a dividend payout of $1.86 per year.

One strategy is to only invest in dividend stocks with high yields, but a higher-than-average dividend yield isn't guaranteed to last. An unknown risk is whether the company can continue paying those dividends. In the face of financial distress, they may choose to dial back dividend payments or pause them altogether. That can pose a problem when it comes to your long-term investing plan.

2. Dividend Income is Taxable

How are stock dividends taxed? It's important to understand that dividend payments count as taxable income. Your tax rate will depend on your income and whether the dividends are considered qualified or nonqualified.

  • Qualified dividends: These are taxed as long-term capital gains, which have a more favorable tax rate. Qualified dividends generally must be issued by a U.S. company, though there is some flexibility here. The stockholder also has to satisfy a holding period requirement.
  • Nonqualified dividends: If the previous requirements aren't met, dividend payments will be taxed as ordinary income—which is higher than the capital gains rates.

Investing heavily in dividend stocks could complicate your taxes. If you're curious about exploring this investment strategy, know that stock dividend tax will come into play.

3. Interest Rates Can Affect Dividend Stocks

Interest rate changes can impact dividend stocks, for better or worse. When rates are low, dividend stocks are generally more attractive because they tend to pay more than investments like certificates of deposit (CDs) or Treasury bills—both of which carry less risk. But as interest rates rise, the yields on those safer investments also increase. That could make them better investments than dividend stocks.

5 Alternatives to Dividend Stocks

Diversification is one of the best ways to protect your portfolio. It involves investing in a variety of different asset classes and industries to help spread out the risk. If dividend payments decrease, or dividend stocks simply underperform, stability in other parts of your portfolio can help soften the blow. Here are five investment alternatives to consider:

  1. ETFs and mutual funds that cast a wide net: These types of investment funds allow you to buy bundles of stocks or bonds in a single transaction. They provide automatic diversification and are also considered less risky when compared with individual stocks. Some ETFs and mutual funds focus squarely on dividend stocks, but investing in a wider range of securities can help balance your portfolio.
  2. Index funds: These are ETFs or mutual funds that track a certain market index, like the S&P 500. Index funds are considered low-cost, less-volatile investments.
  3. Bonds: A bond is a type of debt security that's issued by government agencies or corporations. When you purchase a bond, you're extending that entity a loan that's repaid in the future with interest.
  4. CDs: With a CD, you agree to lock up your investment dollars for a predetermined amount of time. When that maturity period ends, you'll receive your money back with interest. You'll likely be penalized for withdrawing your funds early.
  5. Money market accounts: A money market account earns interest like a savings account, but most come with a debit card or checkbook to allow for easier access. Think of it as a cross between a checking account and a savings account.

The Bottom Line

When it comes to buying dividend stocks, it's best to go with companies that have a solid track record of increasing dividend yields. But even then, there are some valid reasons to avoid loading up your portfolio with dividend stocks. Payments aren't guaranteed, and there are tax considerations to think about. Other lower-risk investments might also become more attractive when interest rates are on the rise. If you do decide to invest in dividend stocks, staying diversified can help mitigate risk.

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3 Reasons to Avoid Dividend Stocks - Experian (2024)

FAQs

3 Reasons to Avoid Dividend Stocks - Experian? ›

9 In other words, dividends are not guaranteed and are subject to macroeconomic and company-specific risks. Another downside to dividend-paying stocks is that companies that pay dividends are not usually high-growth leaders.

Why shouldn't you invest in dividend stocks? ›

9 In other words, dividends are not guaranteed and are subject to macroeconomic and company-specific risks. Another downside to dividend-paying stocks is that companies that pay dividends are not usually high-growth leaders.

What are the risks of dividend stocks? ›

Dividend-Specific Risks
  • High payout ratios.
  • Falling cash flow growth.
  • Limited cash.
  • Large debt burdens.
  • Layoffs.
  • Earnings misses.
  • Reduced guidance and estimates.
  • General industry softness.

What is the problem with stock dividend? ›

Disadvantages of a Stock Dividend

Market participants may believe the company is financially distressed, as they do not know the actual reason for management issuing a stock dividend. This can put selling pressure on the stock and depress its price.

What is the reason for not declaring dividends? ›

Financial Issues

This is the core reason a company that was paying dividends before might consider suspending it. The company might be too preoccupied with trying to keep its financial reserves safe for future expenses. As such, it could be a necessity tied to the survival or otherwise of the company.

What are the advantages and disadvantages of dividends? ›

Dividends can also attract investors who prefer a steady income stream or who benefit from preferential tax treatment on dividends. However, dividends can also reduce the value of a company by decreasing its retained earnings, which are the funds that can be used for reinvestment, expansion, or debt repayment.

What are the advantages and disadvantages of stock dividends? ›

A stock dividend may be paid out when a company wants to reward its investors, but either doesn't have the spare cash or prefers to save it for other uses. The stock dividend has the advantage of rewarding shareholders without reducing the company's cash balance. However, it does increase its liabilities.

What are the cons of dividend yield? ›

The following are the disadvantages: In case the dividend data is old or is based on erroneous information, the evaluation of a stock based on this information is incorrect. Sometimes high yield can be misleading since it may indicate a falling stock price instead of an increase in dividend payment.

Should I just invest in dividend stocks? ›

There are several benefits to investing in dividend funds. Cash flow: Dividend funds' distributions provide investors with a stable and consistent source of income. Yield: These funds often generate higher dividend yields than broad market indexes, which can appeal to income-oriented investors.

How do you avoid dividend risk? ›

One preventative measure you can take to reduce the possibility of facing dividend risk through assignment is to roll short ITM calls for a credit to a further date. This compounds extrinsic/time value on the call and ultimately buys time for the relevant put value to become greater than the dividend value.

Do stocks go down after a dividend? ›

With dividends, the stock price typically undergoes a single adjustment by the amount of the dividend. The stock price drops by the amount of the dividend on the ex-dividend date. Remember, the ex-dividend date is the day before the record date.

Are dividend stocks bad for taxes? ›

How dividends are taxed depends on your income, filing status and whether the dividend is qualified or nonqualified. Qualified dividends are taxed at 0%, 15% or 20% depending on taxable income and filing status. Nonqualified dividends are taxed as income at rates up to 37%.

When to stop reinvesting dividends? ›

There are times when it makes better sense to take the cash instead of reinvesting dividends. These include when you are at or close to retirement and you need the money; when the stock or fund isn't performing well; when you want to diversify your portfolio; and when reinvesting unbalances your portfolio.

Under what circ*mstances might a business wish to avoid paying a dividend? ›

The chief cause of a dividend suspension is the issuing company is under financial strain. Because dividends are issued to shareholders out of a company's retained earnings, a struggling company may choose to suspend dividend payments to safeguard its financial reserves for future expenses.

Is it illegal to not pay dividends? ›

Dividends are the payment of a corporation's profits to its shareholders. Payment of dividends are not mandatory; rather, the board of directors may use its discretion to decide whether to invest the company's profits back into the company pay them out in dividends.

Does Amazon pay dividends? ›

Amazon is the only company in the S&P 500 with a trillion-dollar market capitalization that doesn't pay a dividend. Microsoft, Apple, Alphabet, and Meta Platforms all pay. Even super-hot artificial intelligence stock Nvidia yields 0.02%. It pays 4 cents a quarter.

Is it a good idea to buy dividend stocks? ›

Dividend investing can be a great investment strategy. Dividend stocks have historically outperformed the S&P 500 with less volatility. That's because dividend stocks provide two sources of return: regular income from dividend payments and capital appreciation of the stock price.

Why is high dividend payout bad? ›

A high dividend yield can be appealing since you're getting more income per dollar invested, but a high yield isn't always a positive thing. It could mean that the company's stock price has been falling or dividend payments have been increasing at a higher rate than the company's earnings.

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