Thanks to the Federal Reserve’s commitment to ultra low interest rates, bond yields are now near historic lows. While some investors might be tempted to consider dividend-paying stocks as a way of generating income, before you decide to jump on that bandwagon there are three key points you need to reason through first:
1. DO THE MATH
When a company pays out a dividend, the stock price decreases on the ex-dividend date by an amount roughly equal to the dividend paid. For example, let’s say you are an investor holding 100 shares of a stock priced at $100 per share with a total account value of $10,000. If the stock pays a dividend of $5 per share, the stock price would generally drop to $95 a share on the ex-dividend date, so the investor’s overall account value doesn’t change despite the dividend payment. If the investor takes the dividend in cash, he would have $9,500 in the stock and $500 in cash. In fact, taking the dividend payment in cash for spending purposes actually reduces the principal value of the account. Fundamentally, it’s no different from selling the stock without waiting for the dividend payment. The same principle applies to distributions in mutual funds.
2. TOTAL RETURN
The total return of a stock is the sum of its dividend payments and price appreciation, and that sum is what should really matter to investors. Until recently, Apple chose to reinvest its profits rather than pay dividends, and over the past decade it has been one of the best-performing stocks in the US market. Should investors have stayed away from Apple just because it wasn’t paying dividends? Many small cap stocks reinvest their earnings and don’t pay dividends, yet as an asset class have higher expected returns than large cap stocks.
Not too long ago, many investors purposefully avoided dividend-paying stocks because of the high tax rates. Then in 2003, tax rates were lowered to 15% for most qualified dividends and investors weren’t quite so adamant about eschewing dividend-paying stocks. Well, that could change as soon as next year, unless Congress decides to take action. According to a report in the Wall Street Journal the top tax rate for the highest earners is set to jump to 43.4%. That is a maximum income tax rate of 39.6%—since dividends will once again be taxed as regular income—plus a 3.8% tax on investment income as part of the healthcare overhaul bill that was passed in 2009.
While dividend-paying stocks can certainly have a place in a portfolio, an investor should not forsake proper diversification just to include them, and should always be aware of risk and expected return of their portfolio.