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Many people invest only in dividend-paying stocks. More specifically, they only invest in stocks that have a good history of paying dividends. This means that these stocks do not cut dividends.
They expect that investing in these stocks will yield more returns than invest in the broad stock market. Some people plan to retire entirely based on the dividends.
As a result, many people ask me why I do not invest in dividend stocks instead of investing in the broad market. The reason is that there are several problems with dividend investing. So I want to talk about these problems in detail in this article.
1. Dividends are not tax-efficient
This first problem may depend on where you pay taxes. But in Switzerland, dividends are not tax-efficient.
In Switzerland, dividends are taxed as income. In your tax declaration, they get added to your income as a part of your taxable income. They are not taxed at a fixed rate but based on your marginal tax rate. So, if you have a large income, you can expect your dividends to be taxed at more than 30%. This is a large tax on investing.
Also, if you receive a lot of dividends, you will increase your marginal tax rate and, as such, get taxed more and more for your future dividends.
On the other hand, capital gains are tax-free in Switzerland (in most cases). When you are focused on dividend stocks, you are focused on getting dividends (income) instead of capital gains. So, you are trading a tax-free growth for a taxed growth. This will significantly lower the returns of your dividends.
Therefore, capital gains are more tax-efficient than dividends, at least in Switzerland.
2. Dividends reduce your diversification
If you are only investing in stocks with a good dividend-paying history, you are limiting yourself to a subset of the stock market. As such, you are reducing your diversification.
Diversification is the best way to increase your returns and reduce the volatility of your portfolio. It is also straightforward to diversify an ETF portfolio and simply invest in the entire world stock market. With this, we have diversification in several areas: international, industry, and even currency.
There are two ways to invest in dividend stocks:
- Invest directly in the stocks
- Invest in dividend funds
Either of these ways will have lower diversification than investing in the entire stock market. If you invest in a fund, you will likely have a better diversification than when investing directly in stocks. But, you will still get limited to only some companies that pay companies. And many companies with great returns do not pay dividends.
Some people will argue that having more than 50 stocks is not necessary for getting the benefits of diversification. This is true for the returns part of diversification. But diversification also reduces the dispersion of your outcomes.
It means that a well-diversified portfolio is more likely to hit its average outcome. On the other hand, a portfolio with lower diversification is less likely to reach its average outcome. And this dispersion is still reduced even when you already have many stocks.
Dividend investors think that companies with good dividend-paying history will have higher future returns.
However, there is no basis or empirical evidence that this is true. In practice, dividends do not explain future returns. Just because a company pays good dividends does not tell you anything about the future returns of owning their stocks.
Some dividend portfolios have indeed performed better than the market at times. But this was never due to the dividends, only to the factors that the investors were focused on.
If you want more details on this subject, I can recommend this great video by Ben Felix:
4. Dividends force you to withdraw
When you focus on dividends, you will often get large amounts of cash. When you are focusing on growth, you choose when you want to get cash.
During the accumulation phase, you want all your money to be in the stock market as much as possible. When you receive a dividend, you need to go back to your broker account and reinvest it in the stock market.
On the other hand, capital gains stay in the market. They have the advantage of letting you choose when you want to get money out of the market.
Some people argue that in a downturn, it is better to receive dividends than to sell shares. But these two are the same thing. If you get dividends from a stock, the value of the stock will decrease accordingly. The same as if you sold shares of this company.
5. Dividend stocks are expensive
Dividend investing is so popular, especially in the United States, that it drove the prices of companies paying dividends.
These days, the biggest dividend-paying stocks are extremely expensive simply because they pay dividends, and so many investors are buying into them regardless of other factors.
If you compare the price to earnings or price to book ratios of the most popular dividend funds, you can see that they are sometimes more than 50% more expensive than the stock market average.
6. Dividends are misunderstood
This is not directly a problem with dividends but rather some misconceptions by many investors about dividends. Indeed, many people do not understand dividends properly.
A dividend stock is not a bond! The first misconception is that some people believe that dividends are guaranteed. They are not. The dividend yield of a stock is simply the average historical dividends that the company paid. There is absolutely no guarantee that the company will pay the next dividends. Companies are free to change the dividends they are paying on each dividend period. If they are running out of money, they can entirely cut the dividends.
The highest-yielding dividends are not necessarily better! In general, a dividend investor will want stocks with higher yields. However, there are many exceptions. The highest-yielding stocks are generally also the riskiest and most volatile.
Dividend stocks are not always safer than average! The top stocks with the best dividend history are indeed safer than the average stock market. However, not all stocks with good dividends are safe. Several stocks with good dividend history have completely collapsed.
Should we avoid dividends?
So, with these six big problems with dividends, should we hate and avoid dividends? No!
Dividends are an important part of total returns. And dividends are always nice to receive. In fact, they can be extremely useful in retirement.
What we should avoid is investing specifically in companies based on their dividend history. We should invest in the broader stock market with low-cost index funds. This is the most efficient way to invest for most investors.
These are the 6 biggest problems with dividend investing. For me, dividend investing is nothing more than stock picking. Even if you invest through an index fund, this index will be picking stocks. There is no basis indicating that future returns are better for companies with a good dividend history.
Dividend investing is especially ill-advised in Switzerland, where dividends are significantly more tax-heavy than capital gains.
But this does not mean that dividends are bad. They are an important part of the stock market and the returns we receive from the stock market. However, it means that we should not focus on dividend-paying stocks but rather focus on the broader stock market.
What do you think about dividend investing? Are you investing in dividend stocks?