Investors commonly view dividends as a method for creating income. But dividend strategies are not the only method to produce cash flow, and it’s important for investors to understand the tradeoffs when they focus solely on a dividend investment strategy. In this blog post, we lay out what happens to stock prices when dividends are paid out, tax implications of dividends, the volatility of dividend stocks, and ‘creative’ methods companies can use to pay dividends.

What Happens to Stock Prices When Dividends are Paid

Here’s something investors often miss: When a company pays out dividends, its stock price usually takes a dip, almost equal to the dividend amount. Imagine it like this: If you own a stock that doesn’t pay dividends and you sell a bit of it, it’s somewhat similar to what happens here. For example, if a company hands out $1 per share in dividends, its stock price might drop by about $1 on the ex-dividend date. It’s like a mini sell order of your investment in a non-dividend stock.

The Tax Side of Dividends

Dividends are a way for companies to share their profits, but did you know from a tax perspective, investors might be better served if the companies implemented share buy-backs instead? That’s right, dividends are taxable events that you as the investor have no control over. When the dividend is paid out, investors pay the tax on the full value distributed (assuming a taxable account).  On the flip side, other ways companies share value, like buying back shares, have no immediate tax impact for the individual investor. If an investor decides they want cash, they can sell what they need, and the shares sold will be a combination of growth and return of capital. This means the tax from the sale of stock will be less than the full value of the cash received which reduces the immediate impact of taxes. This method reduces current tax liability while also giving the investor more control over when to realize taxes.

Are Dividend Stocks Less Volatile?

Dividend stocks, as measured by the S&P Dividend Aristocrats, have experienced slightly lower volatility than S&P 500 over 10-, 15- and 20-year intervals but not by much! For example, during the 10-year period ending December 31, 2021, the S&P 500 recorded a standard deviation, which measures volatility, of 15.34%, while the S&P Dividend Aristocrats index was slightly lower at 14.55%. [1]. The crucial takeaway here is that stock investments which pay dividends can be just as much of a roller coaster ride as stocks that do not. If an investor is seeking stable long-term returns, like that of a retirement investor, then having 100% exposure to dividend paying stocks may not be the best strategy.

Not All Dividends Come from Earnings

Here’s a crucial point: Dividends don’t always reflect a company’s current earnings. Some companies might even dip into their savings or borrow money to pay dividends, which isn’t a great long-term strategy. Take AT&T, for example. There were times when their dividends weren’t fully backed by their cash flow, raising a few eyebrows about their future sustainability.

Looking Beyond Dividends for Growth

When you’re eyeing stocks to invest in, don’t just focus on their dividend history. Think about the future return potential and the opportunity for higher expected returns based on profitability, price, and company size. And remember, dividends aren’t a magic ticket to stability or lower risk, and they are not the only method of providing current income. Dividend strategies come with tradeoffs, so make sure your investment strategy takes a more holistic view rather than narrowly focusing on the method by which the company provides income. Happy investing!

 

*Past performance is not a guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Short term performance results should be considered in connection with longer term performance results.