Investors seem to love dividend paying stocks. The appeal of these stocks rests largely on the idea that a dividend paying stock allows an investor to collect income while leaving the principal intact. Safe, easy money, right? Not quite.
The first thing to recognize about dividends is that the when a company makes a dividend payment, it reduces its cash on hand, effectively reducing the value of the company. This is why a company’s stock price usually declines once a dividend is paid. If a company did not pay a dividend, an investor could generate the same cash by selling shares at the higher price.
Next, it is important to recognize that dividend-yielding stocks cannot always be relied upon to generate income. Unlike a bond where a company has a contractual obligation to make interest payments and return the principal, a dividend-yielding stock has no such obligation – to pay the dividend or to return principal – even if those stocks have dependably delivered their dividends in the past.
Furthermore, while dividend paying stocks may offer a slightly more consistent cash flow than their non-dividend counterparts, at the end of the day, they are still stocks, and stocks are risky. In 2007 for example, banks and financial stocks that had steadily been paying dividends to investors not only stopped paying those dividends, but their stock prices fell significantly.
And yet another trap that many dividend investors fall into is to narrow their portfolio to only high dividend paying stocks. This is likely to result in a less diversified, and therefore much riskier portfolio. Even for a retiree looking for income, a portfolio should be diversified across dividend and non-dividend paying stocks, as well as safer bonds to dampen volatility.
So while the allure of dividends is understandable, at the end of the day, dividends are a trade-off between cash today and a lower share price going forward, and they generally bear the same risks as any other stocks. Capital markets rarely offer a free-ride, and this is certainly the case when it comes to dividend paying stocks.