Pros and Cons of Dividend Investing

Our topic on this episode of the Ready for Retirement podcast is about the pros and cons of dividend investing.

Questions answered: What percentage of my portfolio should be coming from dividends in retirement? What strategies can I implement to improve my financial future? What is the best approach for my individual situation? 

Are you ready to start focusing on the things that truly matter when it comes to your financial future?

Key Points

• Dividend Investing
  • Why do stocks have value?.
    • When you purchase a stock, you’re purchasing ownership in a company. 
      • You expect future or current profits that you have a right to as an owner.
      • Dividends are one way a company compensates its shareholders.
  • Dividend Example
    • Dividends represent real, tangible value. 
    • Dividends accumulate as cash and you can use them in everyday living expenses.
  • When you own a stock or mutual fund, it doesn’t feel as real.
    • Although owning a stock or mutual fund represents ownership in a company and you receive profits from that holding, it doesn’t always feel that way.
    • People like dividends because you’re able to track a real cash dividend on a recurring basis.
• Pros of Dividends
  • You receive a cash dividend on a recurring basis.
  • It represents one way to access income in retirement to meet living expense needs.
  • It feels more real then investing in a mutual fund or ETF.
  • Dividends increase faster than inflation.
    • Example: The dividend of the S&P 500 in 1960 was $1.98. In 2020, the dividend of the S&P 500 was $56.70.
      • The compound growth rate is ~6%/year.
    • Dividends grow at a rate of ~6% historically which helps combat inflation.
    • In 1960, the CPI (Consumer Price Index) was at 30. 
    • In 2021, it’s at 267. The CPI has a historic growth rate of 3.65%.
      • Dividends are up 30x as compared to the CPI (inflation), which is up 9x.
  • Dividends remain resilient as stock prices fluctuate.
    • If dividends dropped every time the stock market dropped, it wouldn’t be very reliable.
    • In retirement, we want a reliable income source like dividends. We can’t afford our portfolio to fluctuate throughout retirement because we need to live off of the income.
    • Example: January 1973 – October 1974
      • Over 20 months, the S&P 500 declined by ~50%.
        • On an annual basis, the dividend on the companies inside the S&P 500 didn’t decline at all.
        • This wasn’t a fun time for you if you were in retirement when you checked the value of your portfolio, but the good news is your income received by being a shareholder in 1973 didn’t decrease throughout the market decline.
      • March 2000 – October 2002
        • The S&P 500 dropped ~ 50%.
          • The dividend on the S&P 500 declined by 2% from 2000 – 2001 and began growing from 2002 – 2003 and it had reached all-time highs in 2003.
          • Example: If you expected $1,000/year in dividends, you would have received $980/year.
      • October 2007 – March 2009
        • The S&P 500 declined ~57%.
          • Dividends decreased by 23%, not necessarily a fun experience, but not to the extent the market decreased.
          • By 2020, dividends had doubled.
    • Companies have the right to cut their dividend at any time, but what we see historically is that companies tend to continue paying dividends and cutting them very little, if at all, during downturns.
      • This is reassuring as a retiree as you can count on your dividends to be a primary income source throughout retirement.
• Cons of Dividend Investing
  • Companies that pay dividends see less in price appreciation.
    • Example: If you’re a company selling products for a profit, you have two options at the end of each year.
      • You can take profits and reinvest them into the business for growth.
      • You can distribute profits as cash to shareholders (dividend).
    • If companies see an incredible opportunity to reinvest for growth, most companies are going to do so.
    • Other companies anticipate they don’t have room to grow and prefer to pay to investors.
      • Companies that pay dividends tend to have less growth potential.
  • Example: Amazon is the most successful company of all-time since its IPO.
    • Amazon has never paid a dividend. 
      • They keep reinvesting to increase the value of their stock price.
      • Rather than making shareholders happy in the short-term, they choose to invest in themselves for the long-term to participate in growth.
    • Facebook, Google, etc. have never paid dividends.
    • Alphabet, inc. posted revenue of $55.3 billion in Q1 of 2021. $18 billion was net profit that could have been distributed to shareholders, but they reinvested it to continue to grow.
      • The value to shareholders is as a rising stock price, rather than as a cash dividend.
    • 85% of all S&P 500 companies pay a dividend, but the other 15% invest a all of their funds for future growth.
  • If you only invest in dividend-paying companies, you’re missing out on great appreciation.
    • In general, companies that pay dividends see less in price appreciation over time.
    • Smaller companies tend not to pay dividends as they focus on long-term growth and thus have historically grown by 12%/annually compared to 10% (S&P 500).
  • Diversification
    • Dividend-investing is important, but you want to make sure you own companies designed for growth as well.
    • It’s about finding a balance that is designed for your goals.
  • Dividends Aren’t Tax Efficient in a Taxable Account
    • Example: Imagine you have two companies that have a price of $100 and you buy 1 share of each
      • Company 1’s stock rises to $105 and distributes a $5 dividend. 
        • The value of the stock decreases by $5 immediately to $100.
          • Dividend payouts decrease the value of the stock the day that it’s paid.
        • Let’s assume you’re in a tax bracket of 30%.
          • 30% of $5 goes to taxes, which is $1.50, leaving you with $3.50.
        • You end with a stock value of $100 and you have $3.50 in cash.
        • You have a total of $103.50.
      • Company 2 is a company designed for growth and also had profits of 5%.
        • This growth company realizes they have $5 worth of profits and decides to invest $5 worth back into the company.
          • You don’t receive a dividend, but you do now own a stock worth $105.
          • You also don’t owe any taxes.
          • You are only taxed on capital gains when you decide to sell, whereas dividends are a taxable event.
        • In this example, you ended with $105, as opposed to $103.50.
      • If you later sell the investment that grows in value, this is taxed at Long-Term Capital Gains which is more favorable than Short-Term Capital Gains Rate (Ordinary Income).

Timestamps

1:44 – Introduction

3:20 – Why Do People Like Dividends?

4:49 – Inflation vs. Dividends

7:30 – Dividends of the S&P 500 Companies

10:25 – Dividend Cuts In History

13:10 – The Growth of Amazon

15:29 – The Power of Reinvesting Dividends

18:07 – Tax Efficiency of Dividends

20:45 – Aligning Your Investments With Your Financial Goals

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