Dividend stocks have many qualities, but they are not the best investment for all purposes. Different assets are optimized for different roles. When investors are developing a financial plan, it’s important to make sure you’re not using dividend-paying stocks when something else is better suited for a specific purpose.
1. Some Non-Dividend Paying Stocks Offer Higher Growth
If your priority is high growth, dividend stocks aren’t always the best tool to achieve it. Companies generally need predictable cash flows before they start distributing capital directly to investors. High-growth companies typically hold onto their money so they can invest in new hires, product development, and marketing. For this reason, dividend-paying stocks tend to be mature companies that offer stability, but they generally have limited growth prospects.
This relationship is illustrated by the total return graphs of the Vanguard High Dividend Yield ETF (VYM 0.02% ) and the Vanguard Dividend Appreciation ETF (VIG 0.59% ). These are two popular ETFs that hold a variety of dividend-paying stocks. One is managed to optimize yield, while the other targets greater price appreciation. Over the past 10 years, both dividend funds have lagged S&P500and they were almost doubled by the NASDAQ.
Dividend stocks always offer returns with price appreciation. They can play a role in any stock portfolio, especially for short-term investors. This is one of the reasons why they are so popular with young retirees. However, there are other stocks with higher growth potential. Young professionals saving for retirement may want to focus elsewhere.
2. Some other income-generating assets are lower risk
Dividend stocks are generally not risky when it comes to stocks. They tend to be among the most stable and reliable stock investments. However, income investors might consider better alternatives for low-risk returns.
Bonds are the most popular security for low volatility returns. Certainly there are risky bonds with volatile prices in the secondary market. However, higher quality corporate bonds and debt issued by creditworthy government agencies tend to carry lower risk of investment loss as well as reduced volatility compared to equities.
Certificates of deposit (CDs), money market deposit accounts and savings accounts are even further down this spectrum. These are some of the lowest risk asset classes out there, especially if they are FDIC insured. Investors should never rely on these cash-like assets to achieve securities-like performance. Their interest rates barely exceed inflation most years, if at all. They will never match the long-term performance of dividend stocks, but they are not volatile.
None of these investments are necessarily superior to dividend-paying stocks – they just behave differently. Bonds and cash might be better suited for certain roles in your portfolio if your goal is to minimize risk.
3. Some other assets may be more tax efficient
Many people rely on accountants to minimize their taxable income each year, but holding too many dividend-paying stocks could have the opposite effect. Dividend taxation is a complicated subject, so there is no one-size-fits-all approach that applies to every investment plan. It’s important to understand how returns from various assets fit into your overall tax picture, and shareholder distributions deserve special consideration.
Investors should be careful when it comes to dividend-paying stocks held outside of their retirement accounts. All returns to a qualified account such as a 401(k) or traditional IRA are taxed as income upon withdrawal, while Roth IRA distributions are tax-free. Things get more complicated for dividends received in a regular brokerage account. Distributions to shareholders that do not meet qualified dividend status are often taxed as ordinary income. Tax rates on ordinary dividends that do not receive the preferred qualified dividend treatment are often higher than tax rates on long-term capital gains. If the government takes a cut in yields greater than necessary, portfolio performance suffers.
This problem does not apply to everyone – it all depends on the financial situation and your state of residence. This is always something investors should consider when making a financial plan. Dividend stocks are not always the most effective tool. Investors might consider assets such as municipal bonds in these cases.
This article represents the opinion of the author, who may disagree with the “official” recommendation position of a high-end advice service Motley Fool. We are heterogeneous! Challenging an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and wealthier.