Are Dividends an Investor Trap?

dividend, investing

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Dividends hold a unique power over the investor’s psyche. There are whole corners of the Internet where bloggers display and trade their dividend stock holdings, bragging about the size of their ‘dividend streams’. Browsing mainstream investment websites, you will without fail see sponsored links promising “Top Dividend Stocks”.

Dividends are one of the simpler financial concepts. They are no more than cash payments that publicly owned companies make to anyone who owns their stock. The amount of cash a shareholder gets per year is listed as its yield, which is a percentage. Microsoft currently offers a yield of 2.55%, meaning that each year, a shareholder will receive $2.55 for every $100 of Microsoft stock they own. This is money in the investors’ pockets, which they are free to keep or re-invest. The analogy you often hear is that of the cow: while you own the cow, you get its milk for free. What could be better than that?

Except, I don’t think I like dividends. I’ll explain why, but first I have to pause and stress that I am not a professional investor or money manager. I hold no certifications, and there is a distinct lack of acronyms following my name. I am just an amateur personal finance enthusiast who tries to marry a moderate amount of knowledge with good old-fashioned common sense. It’s in this spirit that I will explain my ambivalence of dividends. If my logic is wrong, I welcome corrections.

When a company distributes dividends, it is taking a chunk of its cash and slicing it off to dole out to investors. This necessarily reduces its financial reserves. Since a company’s stock price is in part based on its cash on hand, a dividend disbursement should, in theory, decrease a company’s stock valuation.

When Microsoft pays its dividend, this money is gone from its balance sheet, and the stock price should reflect that fact. I realize that the market doesn’t work with perfect logical precision, but by definition this should happen. If so, the dividend given to the investor would have been given to them anyway in the guise of a higher stock price. By this logic, dividends aren’t so much a benefit as a choice: money now, or money later.

The problem is that money now equals taxes now. A dividend is a taxable event in the year it is given, whereas a stock price increase is not taxable until the stock is sold. As a dividend stream grows, this tax burden will become a significant yearly expense, morphing it into a fire hose that the investor cannot avoid. Compare this to a stock, where the investor can choose when to sell (and which shares to sell) to better control taxes from year to year.

The aura around dividends persists, I believe, because stocks are abstract to the average investor. A dividend is cold, hard cash, proof that these ‘crazy stock things’ are even real. And with dividends, the investor can avoid the most stressful question in investing: when should I sell? Because in a dividend portfolio, the answer is: you don’t sell. You just sit back, earning dividends. And though I see the appeal, it is still not a benefit as much as a choice.

I’m not saying to avoid dividends, exactly. That would be hard to – even index funds that I buy have some kind of dividend component. I’m more cautioning against going ‘all in’ on a dividend portfolio of individual stocks at the expense of diversity. It appears to offer more than it does. You are not getting the milk for free; you are getting a piece of your own cow, sliced off and given to you, whether you want it or not. And Uncle Sam will be by to count the number of new steaks in your chest freezer.

Written by Simon Moore, MBA, CFA. The views expressed represent the opinion of the author and are not intended to reflect those of FutureAdvisor or serve as a forecast, a guarantee of future results, investment recommendations, or an offer to buy or sell securities.