When listening to novices and cautious shareholders, one would think that the paved road to financial freedom (and sense of financial security) lies in a very specific place:
Namely, in dividend shares.
In this blog post, I will explain exactly what dividends are and why dividend-paying stocks are not a secure investment.
I’ll also explain which companies typically fall into this category, and you will understand why they are not always the best investment.
ABC… What Is a Dividend?
Let’s start at the beginning.
What exactly are dividend stocks?
On this blog, there’s room for both the investor with decades of experience and the ambitious newbie who is trying to figure it all out.
Let’s get the definition in place so everyone can join the conversation.
A dividend stock is really just a share in a company that pays dividends.
Maybe you’re asking, what’s a dividend?
When you are a shareholder, you become one of the owners of the company.
Dividends just mean that the owners get paid a part of the profits. It goes directly into your investment account as cash.
Why are Dividend Stocks Many Beginners’ Favorites?
When you start investing, you may well have a feeling that there’s a bit of an abracadabra with stocks.
Maybe shares feel a bit like play money, something that is not real (don’t worry, it’s real).
It may seem safe and perhaps a little fascinating that real money magically appears in your investment account. It’s real cash in your pocket that can be used out there to buy ice cream and t-shirts.
It gives you the feeling that it works when you are still unsure whether those stocks are real.
And as the saying goes: A bird in hand is worth two in the bush.
But when you think about it, why is that?
What is that bird doing in that hand at all? Is it sick? Can it not fly?
That brings us to the next point…
Why You Need to Be Careful With Dividend Stocks
There are two reasons why you shouldn’t fill your portfolio up with dividend stocks.
The first reason is that dividend stocks are an extremely conservative choice, which means that your portfolio will probably stagnate.
Companies that still have a world to conquer typically don’t pay dividends because they invest to exploit their future potential. They can spend money on product development, research, expansion, hiring new talent, acquisitions of other companies, and much more.
Companies that pay a lot in dividends are often mature companies that have reached a point where they’re present in all the markets and in all the product groups that make sense to their business. You can’t expect the share price to skyrocket.
Let’s make it real with some companies that everyone knows.
Coca-Cola is known as a dividend stock. The conglomerate is in all geographic markets and sells many kinds of sodas and snacks.
It’s not realistic that they will double their revenue, but it’s realistic that they will continue to have stable growth slightly above inflation.
Amazon and Google, on the other hand, even though they are already huge, are still conquering the world. They don’t pay dividends. They are aggressively investing in new business opportunities.
Apple is a company in between. They are still growing, but they also have a gigantic cash flow and huge profits. They reinvest and make acquisitions, but they also pay a small quarterly dividend.
Compounding Is Clipped
The second reason you should be careful about going all-in on dividend stocks is taxes.
When you receive dividends, you pay taxes, and that destroys the effect of compounding.
There are other ways a company can distribute a profit and reward shareholders.
They can choose to buy shares back (also called share buybacks).
The stock price will go up because the value of the company must be distributed over fewer ownership shares – and the shareholders won’t have to pay tax on the rising stock price as long as they don’t sell it.
Warren Buffett’s company, Berkshire Hathaway, never pays dividends but regularly buys back shares for this exact reason.
When you pay taxes, it chips away at the benefit of compound interest (that’s when the money grows exponentially because your return is reinvested).
Dividend stocks aren’t optimal if you’re at the beginning of your investment journey, where the money should grow over a decade or more.
Dividend stocks make more sense if you’re going to take advantage of your financial freedom and are ready to eat off your investments.
Hopefully, the investments you make at the beginning of your journey as an investor will later pay dividends as the company matures – and then you can just sit back and enjoy it.
Where Can You Find Dividend Stocks?
Are you still keen on the idea and want to find a dividend-paying stock?
There are lots of lists of dividend-paying companies on the big internet.
You can google “dividend kings” or “dividend aristocrats”, and you’ll see the giant, international dividend-paying stocks.
Since mature companies are often international, you’ll find many great deals.
You can find one of these lists here.
Whatever you choose – dividends or not – you must make sure you choose healthy, good companies at reasonable prices.
It’s not worth it to get a return of 2 % a year in dividends if the stock price drops 50%.
You have to follow a checklist and make sure you are investing in a good company at a reasonable price – dividends or not.
You can learn more about that in my investment book Free Yourself here.