Why Dividend stocks aren’t as good as they sound

So, you have started your research into what to invest into (after you have followed the golden rules about getting rid of debt & having an emergency fund), and the first thing you notice? Wow, there are a lot, and I mean A LOT, of things you could invest into.

Without even just talking about stocks- there are commodities (like oil, gold, or, well, anything- coffee?) Even if you ignore all the none stocks- there are, well, thousands upon thousands of companies you could invest into. This post is only going to be about stocks that are listed on a stock market- nothing else.

To make this post quite a bit simpler- I’m only going to put stocks into 2 categories. Those that pay dividends, and those that do not. Now I realise, that there is a lot more to this, but before we go down that rabbit hole- let’s just keep things (relatively simple)

Dividend Stocks

So what are dividend stocks? Well, they are shares held within a company (or sometimes group of companies), that will pay a dividend. This is usually on a quarterly basis (3 times a year), but might be as frequently as monthly- or less frequently, say yearly.
It is completely up to the company as to whether or not they will pay a dividend or not. The amount is also NOT fixed, and may go up or down as the company does well- or less well. They might also choose to reinvestment the money that would have paid as dividends back into the company. Basically- although it might seem that the dividend would always get paid- it is not a guarantee.

Dividend stocks

Non Dividend Stocks

Some companies advertise the fact that they do not pay out dividends- and do not expect to do so any time soon. Instead, they use all their profits to reinvest into their business- to hopefully increase the profits in the longer term. A good example of these types of companies would be some of the tech giants- like Amazon/Google. They have never paid a dividend, and it’s looking likely that they won’t for some time yet.

So, if you had to pick- dividend stocks are better?

If your still with me (which I hope you are), then surely if you had the choice between a stock that paid out a dividend, and one that would likely never pay a dividend, then surely you would pick the dividend stock? Right? Well, let’s work through an example that shows that actually, it’s not quite that simple:

Dividend StockNon Dividend Stock
Stock Price£1£1
Profit£0.05£0.05
Dividend £0.05£0
Stock Price after dividend£1£1.05
Total holding (stock+cash)£1.05£1.05

Can you see, assuming that everything is exactly equal (just for this example), that actually it doesn’t matter if the stock pays out a dividend or not. Your holding at the end is exactly the same- just if you held the dividend stock, you would have both stock + cash, rather than just stock. But, importantly, the total holding is exactly the same !

So, if the end result is the same, does it matter?

Yes! For 3 reasons, basically. Firstly- if you get paid a dividend, then it will just sit in your account (whatever broker that is), as cash. This is pretty useless (most of the time, until you need it when you retire)- as you really want it invested, to continue making money ontop of the money (See: Compound interest).

Secondly- depending exactly how you are holding this, you might need to pay tax on the dividend. Now, in the UK, there is quite a nice dividend allowance of £2,000 a year (Though, it used to be £5,000 a year). So, if you don’t have your own business, and your dividend amounts are under this- you don’t need to worry about paying tax on them.
You also don’t need to pay tax on dividends if the stocks were held within a S&S ISA (and if you aren’t making use of your ISAs, get them moved across!)

The third reason is the most important though- and its the type of stocks that are dividend (and those that are not). Companies almost always only pay a dividend when they can think of nothing else to do with the profits of their business. So, instead of reinvesting- creating a new product line, manufacturing plant- or whatever it maybe, they don’t- they just give it out to their investors as cash. What does this say about their business? Either, they are utterly the leader of their field (but, if they aren’t reinvesting, then will they stay that way?)- or they have expanded as far as they can.

Good examples of this, are companies such as Shell/BP- they have the cash on hand to invest in new oil fields, if they thought that it would be profitable to do so, but instead they pay out dividends to shareholders. What does this say about their company? It’s unlikely that they are going to continue to grow- and rather they have reached the “maximum” size that they are going to get to.

Let’s compare this to a technology company, like Google/Amazon- neither has ever paid a dividend (so far). Instead, both of these companies are using all the profit they generate, to reinvest into the business. What does this say about the business model that they follow? They obviously believe that they can grow revenue (and therefore profit) further, else they wouldn’t use this money in this way.

Growth v Dividends

So, now if you had to pick between a growth or a dividend stock, what would you pick? You might base your decision on your retirement status/age. Why do I say that? Well- if you are already retired (whatever age that is), then the idea of having a stock solid (well, ish) payment every single month/quarter could cover all your living costs. You aren’t actually interested in chasing growth (especially as it could go to zero), and would in fact rather something that pays less- but with more stability.

On the opposite hand- you might be far away from retirement/young, and want the very best chance of retiring early by investing in some very high growth area’s (eg. technology). In this case, you will likely want to avoid dividend paying companies- since they will only blunt the return that you could otherwise obtain by only focusing on growth.

Either way- you should already know that investing in a single company is very risky- and instead you should use index funds wherever possible to reduce this risk.

But but dividends pay out every month/quarter/year

Well yes, I don’t deny that they do that- but hopefully you can now understand why they do that. Do they really belong in your portfolio? Well, only you can answer that, and perhaps you are risk adverse and don’t want to invest in technology stocks- I mean, the dom.com boom of 2000 wasn’t that long ago. I’d go further and suggest there are lots of new/tech companies that have huge valuations which will be really difficult to show value- using the metrics that are usually used to value companies (think P/E ratios etc). An example could be Uber for example- never profitable, yet apparently worth $60 billion or so- and yet its never produced a profit. That’s a pretty big bet on their business model producing a profit in the future (when exactly, seems still to be determined).

If you are already in retirement- and just drawing your 2/3/4% to ensure your capital remains, then dividend stocks could indeed be a good pick for you- since they tend to be in more stable companies. Though- you would be missing out on the growth of other companies- so you don’t get those dividends for nothing!

Dividends for FIRE

I’m still not quite sure why so many people who advocate FIRE focus on dividend income quite so much. Is it that you have worked out the yearly income you need to replace with this dividend income? I mean, it sounds great- but, as shown above- especially if you are only just starting your journey, you are missing out on other growth. You don’t need the stability of dividend income at this point in your journey (and anyway, it’s going to be a tiny amount of your money for quite some time).

What do you think? Have I got it wrong? Comments please!

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