The Pitfalls of Focusing Too Much on Dividends

Dividends can be a good way to get investment income, but many investors focus on this so much that they reduce their potential total portfolio gains. 

In recent years, dividend investing—assembling a portfolio of stocks that have historically paid reliable dividends—has gained popular renown as many books and articles have been published on the subject.

For some investors, buying dividend-paying stocks has become an obsession because they believe it’s a silver bullet for retirement income. Many are quick to lunge at stocks just because they currently pay substantial dividends.

But investing just isn’t that easy. Investors over-emphasizing dividends in many cases take excessive risk and neglect the importance of assessing potential for total returns. This practice can also result in high-risk asset allocations.

On the plus side, qualified dividends can be taxed at a lower rate than ordinary income. Yet, an over-emphasis on dividends is prompting many retirees and near-retirees to pursue dividend-paying stocks to the exclusion of stocks with greater potential for capital gains, which can mean higher net stock returns over time. Also, capital gains can give investors greater control over cash flow in retirement. But these gains aren’t possible if investors don’t assure return of principal by managing risk. Obsession with dividends can distract investors from this priority.

Dividend enthusiasts like the idea of keeping their principal intact and living off dividends through retirement. But for individuals with substantial resources, sound retirement planning often assumes the liquidation of appreciated assets for withdrawal.

To the extent that these individuals won’t need all of this money for their legacies, the mentality of living off dividends—as opposed to taking capital gains by selling shares—may constrain spending to the point where they don’t enjoy retirement as much as they otherwise might.

What’s more, the misguided strategy of planning to live off dividends can lead to a risky asset allocation from choosing stocks solely on the basis of dividends. This can leave portfolios over-exposed to some equity sectors. And it can mean overall portfolios that are too stock-heavy—lacking in allocations to other asset classes, mainly bonds, to reduce risk during retirement.

A balanced portfolio can deliver solid growth and shareholder value through capital gains, while managing risk. If you can get good dividends, too, so much the better.

When shopping for stocks, dividends are just one thing to consider. As with all stocks, investors evaluating dividend stocks must do their homework, looking for companies with strong balance sheets, which assure that dividends will continue. On these balance sheets, look for dividend increases and decreases, a solid management team and the company’s overall financial position.

Dividends are sometimes quite temporary, and the same weaknesses that might crater the stock price could cut or end current dividends. The point is to do the research—or to assure that your advisor is doing it--to determine whether dividends are likely to continue and to assess the potential for share-price growth to deliver capital gains. Solid stocks have potential for both.

Good dividends seem to reflect fiscally healthy companies, but appearances can be deceiving. Companies that are having trouble may continue to pay good dividends for a time merely to attract investors. In this scenario, dividends can be like the sirens’ song to sailors in The Odyssey, luring investors to crash on the rocks after companies cut dividends. In turn, the share-price growth that these dividends had been spurring, by attracting investment, often dwindles.

Some of the most reliable dividend-paying companies are mature companies with a record of revenue and income growth over the years. This reflects strong fundaments that justify paying of dividends. On the other hand, some companies, including those who haven’t paid dividends long, have financial conditions that don’t justify these payments. But they feel they must keep them up to attract investment and keep the stock price elevated, sometimes to their operational detriment.

Even companies on solid footing may slash dividends if things get bad enough. This is what happened in the second quarter of this year, when the economic impact of the coronavirus pummeled U.S. companies that in turn cut dividends by a total of $42.5 billion, according to S&P Dow Jones Indices, though the pace of cut announcements slowed in June. These companies included 41 in the S&P 500.

Companies that were less than robust before the shutdown will have to struggle to restore dividends—and may not be able to declare them at the same level. For investors with these stocks in their portfolios, dividend income for 2020 will likely be lower than they had anticipated.

Dividends are just one of the four main components of investing for retirement. The other three are capital gains, interest and return of principal. To build and maintain retirement resources, you need all four.

David Robinson, a Certified Financial Planner, is founder/CEO of RTS Private Wealth Management, an SEC-registered firm in Phoenix that provides fiduciary services to help clients achieve their financial goals. His practice focuses on helping wealthy individuals with custom financial plans, using a holistic approach to grow/protect wealth, manage taxes, identify insurance solutions, prepare for retirement and manage estate plans.