The 3 Biggest Misconceptions About Dividend Stocks (2024)

One of the first things most new investors learn is thatdividendstocks are a wise option. Generally thought of as a safer option thangrowth stocks—or other stocks that don't pay a dividend
—dividendstocks occupy a few spots ineven the most novice investors' portfolios. Yet, dividend stocks aren't all the sleepy, safe options we've been led to believe. Like all investments, dividend stocks come in all shapes and colors, and it is important to not paint them with a broad brushstroke.

Here are the three biggest misconceptions about dividend stocks. Understanding them should help you choose better dividend stocks.

Key Takeaways

  • Many investors look to dividend-paying stocks to generate income in addition to capital gains.
  • A high dividend yield, however, may not always be a good sign, since the company is returning so much of its profits to investors (rather than growing the company.)
  • The dividend yield, in conjunction with total return, can be a top factor as dividends are often counted on to improve the total return of an investment.

High Yield Is Best

The biggest misconception of dividend stocks is that a highyieldis always a good thing. Many dividend investors simply choose a collection of the highest dividend-paying stock and hope for the best. For a number of reasons, this is not always a good idea.

Remember, a dividend is a percentage of a business’s profits that it is paying to its owners (shareholders) in the form of cash also quoted as its payout ratio. Any money that is paid out in a dividend is not reinvested in the business. If a business is paying shareholders too high a percentage of itsprofits, it may be a sign that management prefers not to reinvest in the company given the lack of upside. Therefore, thedividend payout ratio, which measures the percentage of profits a company pays out to shareholders, is a key metric to watch because it is a sign that a dividend payer still has the flexibility to reinvest and grow its business.

Some sectors of the market have a standard for high payouts and its also part of the sector’s corporate structure. Real estate investment trusts (REIT) and master limited partnership (MLP) are two examples. These companies have high payout ratios and high dividend yield because it is ingrained in their structure.

Dividend Stocks are Always Boring

Naturally, when it comes to high dividend payers most of us think ofutility companiesand other slow-growth businesses. These businesses come to mind first because investors too often focus on the highest-yielding stocks. If you lower the importance of yield, dividend stocks can become much more exciting.

Some of the best traits a dividend stock can have are the announcement of a new dividend, high dividend growth metrics over recent years, or the potential to commit more and raise the dividend (even if the current yield is low). Any of these announcements can be a very exciting development that can jolt the stock price and result in a greater total return.Sure, trying to predict management’s dividends and whether a dividend stock will go up in the future is not easy, but there are several indicators.

  • Financial flexibility: If a stock has a low dividend payout ratio but it is generating high levels of free cash flow, it obviously has room to increase its dividend. LowCapExand debt levels are also ideal. On the other hand, if a company is taking outdebt to maintain its dividend, that is not a goodsign.
  • Organic growth: Earnings growth is one indicator but also keep an eye oncash flowand revenues as well. If a company is growing organically (i.e. increased foot traffic, sales, margins), then it may only be a matter of time before the dividend is increased. However, if a company’s growth is coming from high-risk investments or international expansion then a dividend could be less certain.

Dividend Stocks are Always Safe

Dividend stocks are known for being safe, reliable investments. Many of them are top-value companies. The dividend aristocrats—companies that have increased their dividends annually over the past 25 years—are often considered safe companies. When you look at the S&P 100, which provides a list of the largest and most established companies in the U.S., you will also find an abundance of safe and growing dividend payers.

However, just because a company is producing dividends doesn’t always make it a safe bet. Management can use the dividend to placate frustrated investors when the stock isn't moving. (In fact, many companies have been known to do this.) Therefore, to avoid dividend traps, it's always important to at least consider how management is using the dividend in its corporate strategy.

Dividends that are consolation prizes to investors for a lack of growth are almost always bad ideas. In 2008, the dividend yields of many stocks were pushed artificially high due to stock price declines. For a moment, those dividend yields looked tempting. But as the financial crises deepened, and profits plunged, many dividend programs were cut altogether. A sudden cut to a dividend program often sends stock shares tumbling, as was the case with so many bank stocks in 2008.

What Is the Dividend Yield?

The dividend yield, expressed as a percentage, is the amount of money a company pays shareholders for owning a share of its stock divided by its current stock price. Dividends are typically paid on a quarterly basis, and mature companies are the most likely to pay dividends.

The dividend yield may help investors decide whether a company's stock can be a good addition to their portfolios. but they should remember that higher dividend yields do not always mean good investment opportunities: a high dividend yield may result from a declining stock price.

What Is the Difference Between a Stock Dividend and a Cash Dividend?

A stock dividend is paid out in the form of company shares, and it's not taxable until the shares are sold. A cash dividend, on the other hand, is paid out as cash and is taxable for that year.

What Is the Difference Between Dividend Stocks and Dividend Funds?

A dividend stock is an individual stock, and a dividend fund is a mutual fund or ETF that invests in multiple dividend stocks.

The Bottom Line

Ultimately, investors are best served by looking beyond the dividend yield at a few key factors that can help to influence their investing decisions. The dividend yield, in conjunction with total return, can be a top factor as dividends are often counted on to improve the total return of an investment. Looking only to safe dividend payers can also significantly narrow the universe of dividend investments.

Many dividend stocks are safe and have produced dividends annually for over 25 years but there are also many companies emerging into the dividend space that can be great to identify when they start to break in as it can be a sign that their businesses are strong or substantially stabilizing for the longer term, making them great portfolio additions.

The 3 Biggest Misconceptions About Dividend Stocks (2024)

FAQs

What is the problem with dividend stocks? ›

Dividend stocks are vulnerable to rising interest rates. As rates rise, dividends become less attractive compared to the risk-free rate of return offered by government securities.

What is the downside to dividend stocks? ›

Other drawbacks of dividend investing are potential extra tax burdens, especially for investors who live off the income. 3 Once a company starts paying a dividend, investors become accustomed to it and expect it to grow. If that doesn't happen or it is cut, the share price will likely fall.

What's the catch with dividend stocks? ›

Dividends can be cut: Dividends are not guaranteed and sometimes companies are forced to cut them or eliminate them entirely due to financial difficulty.

What is the argument against dividends? ›

Arguments Against Dividends

Some financial analysts believe that the consideration of a dividend policy is irrelevant because investors have the ability to create "homemade" dividends. These analysts claim that income is achieved by investors adjusting their asset allocation in their portfolios.

Is it risky to invest in dividend stocks? ›

Dividend Stocks are Always Safe

However, just because a company is producing dividends doesn't always make it a safe bet. Management can use the dividend to placate frustrated investors when the stock isn't moving. (In fact, many companies have been known to do this.)

Do dividends actually matter? ›

Dividend-paying stocks can also improve the overall stock price, once a company declares a dividend that stock becomes more attractive to investors. This increased interest in the company creates demand increasing the value of the stock.

Are dividend stocks good in retirement? ›

Dividends are particularly valuable in retirement because they provide a consistent stream of income that can help cover living expenses. And, unlike bonds, dividend stocks offer the potential for capital gains as well as income. That means your portfolio can continue to grow even as you withdraw money from it.

Do dividend stocks lose value? ›

After a stock goes ex-dividend, the share price typically drops by the amount of the dividend paid to reflect the fact that new shareholders are not entitled to that payment. Dividends paid out as stock instead of cash can dilute earnings, which can also have a negative impact on share prices in the short term.

Do stocks lose value when they pay dividends? ›

With dividends, the stock price typically undergoes a single adjustment by the amount of the dividend. The stock price drops by the amount of the dividend on the ex-dividend date. Remember, the ex-dividend date is the day before the record date.

What stock pays the highest dividend? ›

20 high-dividend stocks
CompanyDividend Yield
Franklin BSP Realty Trust Inc. (FBRT)11.60%
Angel Oak Mortgage REIT Inc (AOMR)11.58%
Altria Group Inc. (MO)9.79%
Washington Trust Bancorp, Inc. (WASH)9.16%
17 more rows
Apr 17, 2024

Is Apple a dividend stock? ›

Dividend Yield

Apple's annual dividend in 2021 was $0.88 ($0.22 paid quarterly). Based on Apple's stock price as of March 1, 2022 of around $163 per share, the dividend yield is approximately 0.50%.

Why do stocks fall after dividends? ›

Conversely, a stock can drop if investors think a company is paying out too much of its profit in dividends, which could leave less cash for investing in new businesses. But slow and steady prevails often enough that dividend stocks deserve a place in your portfolio.

What stock pays dividends monthly? ›

7 Best Monthly Dividend Stocks to Buy Now
StockMarket Capitalization12-month Trailing Dividend Yield
Modiv Industrial Inc. (MDV)$112 million7.7%
LTC Properties Inc. (LTC)$1.3 billion7.2%
Realty Income Corp. (O)$44 billion6.4%
PermRock Royalty Trust (PRT)$53 million10.3%
3 more rows
Feb 29, 2024

Does Amazon pay dividends? ›

Does Amazon distribute dividends? We have never declared or paid cash dividends on our common stock.

What is a good dividend yield? ›

What Is a Good Dividend Yield? Yields from 2% to 6% are generally considered to be a good dividend yield, but there are plenty of factors to consider when deciding if a stock's yield makes it a good investment. Your own investment goals should also play a big role in deciding what a good dividend yield is for you.

Are dividend stocks bad for taxes? ›

How dividends are taxed depends on your income, filing status and whether the dividend is qualified or nonqualified. Qualified dividends are taxed at 0%, 15% or 20% depending on taxable income and filing status. Nonqualified dividends are taxed as income at rates up to 37%.

Why do people think dividends are free money? ›

Dividends feel like “free money,” but they're not

However, most investors are not rational, and they have a firewall in their minds that separates dividends from capitals gains. Dividends are viewed as “real” money that can be spent. Capital gains are viewed as “temporary” money that should not be touched.

Why is selling dividends bad for the customer? ›

Key Takeaways

Dividend selling is an unethical sales tactic used by some brokers. Dividend selling involves encouraging a client to invest in a dividend-paying company under false pretenses, usually to generate commission revenue for the broker.

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