Part II – Dividend Investing Basics
Sid Roy & Sanjib Saha
22 December 2024
5. What is Dividend Investing then?
Dividend Investing is simply investing in stocks that issue dividends to their shareholders. The focus of Dividend Investing is to receive regular income from stock holdings. As such, Dividend Investing influences selection of stocks and prioritizes companies or industries that deliver relatively bigger dividends.
Investors of well-diversified stock funds, including broad market index funds, periodically receive dividends simply because many of the underlying companies issue dividends. However, this isn’t Dividend Investing, as the receipt of dividends is just a passive side-effect, rather than a result of selecting dividend-focused investments.
6. Is it more profitable to invest in a dividend-paying company instead of another identical company that doesn’t pay dividends, since I’d keep getting cash from the first but not the second?
Not necessarily. The performance of two investments should be compared on a “Total-Return” basis (i.e., assuming that any dividend paid is immediately used to repurchase additional shares of the same company), instead of a “Price-return” basis (i.e., just looking at the change in the share price during the holding period). Furthermore, investment returns should be “risk-adjusted” for comparison, since the gain or loss from a riskier stock is expected to be higher than that of a stable stock.
In the hypothetical example of two identical companies – one paying dividend and the other not – the Total Returns of the two should theoretically be the same, assuming that (a) the companies remain identical throughout the holding periods, (b) there is no external influence on the share prices, and (c) there are no dividend-related tax consequences. The share price of the second company will grow faster than the first, but the number of shares held for the first company will keep rising as the shareholder reinvests its dividends to purchase additional shares. At the end of the holding period, the total investment value – the final share price multiplied by the number of shares held – should be the same for both the companies.
7. Why should I consider Dividend Investing?
Whether dividend-paying stocks perform better or worse is highly debatable, as the performance should be measured on a risk-adjusted “Total Return” basis. Still, certain psychological and convenience related factors make Dividend Investing attractive to some investors.
First, investing in stocks that pay dividends and offer modest growth might appeal to some people who need periodic income, or who cannot tolerate the gyrations of the stock market.
Second, withdrawing money from an investment portfolio without having to sell anything gives a sense to investors that their investment principal is intact. Conversely, having to sell investments to raise money creates the feeling that the investment portfolio is being depleted. This is a strong psychological factor for retirees.
Third, selling investments to raise cash is an active decision to be made by the investors, who might hesitate to sell if the market is down. Dividend-focused investors enjoy the luxury of delegating such decisions to the boards of the respective companies, who decide whether to continue paying dividends or to preserve cash for the business.
8. Is there any downside in pursuing Dividend Investing?
Despite the psychological benefit and convenience, Dividend Investing has a few downsides.
First, meaningful diversification is a powerful risk-reduction technique. Investing in various types of companies across the world ensures that investment risk is not concentrated on a smaller subset of companies, and that the investor benefits from the outperformance of the future winners. Since Dividend Investing involves active stock-picking and many stocks are screened out, such approach reduces diversification and thereby increases concentration risk. History has shown time and again that it’s extremely difficult for an active stock selection strategy to beat the average risk-adjusted return of an efficient market.
Second, there are certain tax consequences for dividends, as they are usually taxable income when the investments are in taxable financial accounts. They make it difficult to control or predict tax liability of a particular tax year, especially to the tax-sensitive investors in a progressive taxation system like the US. Some companies (e.g., Berkshire Hathaway) purposely refrain from paying dividends just for this reason – to avoid imposing unpredictable tax burden on the shareholders.
Furthermore, some foreign countries deduct tax at source of dividend income. Typically, such foreign government withholdings can be recouped as Foreign Tax Credit in the Investor’s tax-filing country. However, this Foreign Tax credit cannot be reclaimed if the foreign stock dividends are deposited in tax-sheltered accounts (retirement accounts, Health Savings Account, 529 Investment accounts, etc.).