DIvidend stocks can be a great way to build wealth over time. Yet investing is about more than watching your dividends roll in, and focusing too much solely on those payouts can trap you in a world of trouble.
As an investor, it’s important to strike a balance between your dividend-paying stocks and the rest of your portfolio. These four reasons to avoid dividend-paying stocks can help you find that balance while keeping you on track for a better long-term financial future.
No. 1: You are trying to reduce your income
Although money from dividends is great to get, if you receive dividends in an after-tax account, it counts as Income when calculating your adjusted gross income. Things like Obamacare premium subsidies, Medicare Part B premiums, and your federal income tax brackets are heavily influenced by your adjusted gross income.
If you’re looking to keep your total income low to stay on the safe side of a tax bracket or subsidy, then minimizing your exposure to dividend-paying stocks can help you do that. After all, the dividends you don’t receive will never show up in your adjusted gross income.
No. 2: You need to spend money from your wallet
It’s very tempting to think of dividends as a reliable source of cash that you can dip into your wallet to make ends meet. The challenge with this approach is that the dividends are never guaranteed payments. Worse, if a company is forced to cut its dividend, its stock usually drops as well. This can leave you both without a source of income and without enough money to make up for lost income elsewhere.
Instead of relying directly on your dividends to spend money, use them as part of your plan to maintain your investment grade bond ladder or other safer form of money. This way, if your dividends are reduced, you have a buffer that better protects your ability to cover your current spending needs. If nothing else, it should at least buy you more time to build a stronger recovery plan from any unfortunate dividend cuts that may arise.
#3: Yield sounds too good to be true
The only way for a company to sustain its dividend over time is to pay the dividend out of its ongoing earnings or operating cash flow. If a company’s dividend can no longer be sustainably sustained, its stock tends to drop a little in anticipation of a likely future dividend cut. This decline in share price leads to the company being valued with what looks like a high yield, as this yield is calculated by comparing its most recent or newly announced dividend with its stock price.
In reality, this is only attractive if the company manages to recover to the point where it can sustain its dividend over time through continued operations. If not, the most likely outcome is a cut in dividends and further declines in the stock price, as this yield trap eventually reveals itself for what it was.
#4: Potential for rapid growth is more important to you than current income
If there’s a structural downside to dividends, it’s that every dollar a company pays out in dividends is a dollar it can’t invest in growing its business. This tends to mean that companies that do not pay dividends have the opportunity to grow faster than equivalent companies that pay dividends can grow. Therefore, if your goal is to maximize your portfolio’s growth opportunities, looking for companies that actively reinvest every dollar in their growth opportunities may be a better option.
Just beware that there is “empire building” behavior among some business leaders. People doing this seek to grow the business or organization more with the goal of running a larger organization rather than maximizing long-term returns. Be sure to check the finances and listen to the company’s financial calls to make sure the company is focusing on the right long-term goals. Otherwise, it’s hard to justify a company keeping that money instead of distributing it to its shareholders.
Investing in long-term healthy businesses
No matter what type of business you are looking to invest in, having an eye on the long term is an extremely important part of giving you a great chance of success. Both dividend-paying and non-dividend-paying stocks can play a role in your portfolio, but neither is an appropriate investment for your short-term cash flow needs.
By focusing on the long-term value of the companies you invest in and adopting a long-term mindset while investing in them, it becomes easier to make smart buy and sell decisions by period of volatility. This can help you build a better foundation for the long-term wealth you seek to create, whether or not the stocks you buy pay dividends.
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Chuck Saletta has no position in the stocks mentioned. The Motley Fool has no position in the stocks mentioned. The Motley Fool has a disclosure policy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.