Should You Invest In High-Dividend Stocks Or Index Funds?

February 21st, 2022
24

I’m a big advocate of index funds in investing. It’s simple, and you can get a diversified portfolio with just a few mutual funds.

However, another common investment philosophy is to purchase a diversified portfolio of stocks with high dividend yields.

One of the most common debates in investing is whether to invest in dividend-producing stocks index funds. In this article, I make the case against dividend stocks.

Why invest in dividend stocks? Cash Flow!

People love dividend stocks because it can enable you to generate a recurrent cash flow with your portfolio.

If you build up a large enough portfolio with a high-enough dividend yield, you could potentially “live off the dividends of your portfolio.” For example, let’s say you have a $3 million portfolio that is invested in stocks with a 4% dividend yield. You would receive $120,000 in dividends per year, which you could use to fund your retirement lifestyle. Theoretically, you could live off the dividends without eroding the “principal” on your stock investments.

I understand the attractiveness of dividend stocks. Especially among those investors who also used to investing in real estate, the concept of receiving dividends from your stock investments feels like receiving rent from your tenants.

In real estate, there is a strategy where you build up a portfolio of real estate properties, and retire on the cash flow from your tenant’s rent checks, while you retain the property and capture its appreciation. Many investors apply this mentality to stock investing, leading them towards high-dividend stocks.

Downsides of Dividend Stocks

While I did have a period in my life where I invested in high-dividend stocks, I currently invest in index funds and do not seek out high dividend-yield stocks. Here’s why:

Dividends incur taxes

The least attractive aspect of dividend stocks is its tax inefficiency. By paying out more money in taxes, it erodes your returns.

Dividends in taxable accounts are subject to taxes. The tax rates of dividends are either the long-term capital gains rate for qualified dividends or as ordinary income for non-qualified dividends.

If you are young and don’t actually need the dividend to spend (i.e. you would reinvest the dividend back into the stock), then you are paying taxes on some of your investment early rather than letting it continue to compound in your account.

Compared to if the stock had not paid the dividend, this distribution creates a tax drag on your portfolio, lowering your total stock return.

The paying of dividends does not directly add value to a company

One of the most common misconceptions about dividend stocks is that dividends directly add to a stock’s return. They believe that if a stock is expected to return 8% without a dividend, then a stock that offers a dividend yield of 4% should expect to return 8% + 4% = 12%. There is a misconception that the payment of a dividend does not affect the expected return from stock price appreciation.

The payment of a dividend is not a bonus. It is splitting the value of the stock into a dividend and the rest of the stock. On the morning of the “ex-div” date (the day after the day when current stockholders will receive the dividend), the stock price usually goes down by the amount of the dividend.

The company is worth the same before and after the ex-div date ($50 = $48 + $2)

If the stock did not fall by the amount of the dividend on the ex-div date, then traders could generate a risk-free profit (arbitrage) by buying the stock on the day before the ex-div date (and qualify to receive the dividend), and then sell on the ex-div date. They would get the dividend essentially risk-free. They cannot perform this arbitrage because the stock falls by the amount of the dividend on the ex-div date.

For some stocks with high dividends, this can cause some distress among new investors. When a number of REITs went ex-dividend on the same date in December 2017, investors on the White Coat Investor and the Bogleheads forums were not sure why there was a temporary “drop” in their REIT stocks In actuality, the REITs just went ex-dividend and they would be recouping their “losses” through a large dividend payment within a few days or weeks.

So while the total return of a stock is its stock appreciation plus its dividend, the total return of a company is not significantly changed just because it pays out a dividend. If a company increased their dividend yield by 1%, their expected return would not increase by 1%.

Dividends are an indicator of health, until they cut the dividend

When you see that a stock has a high dividend yield, you have to figure out why the dividend yield is high. Is it because they offer large dividends as a company policy? Is it because the stock is undervalued? Or is the company under distress and about to cut its dividend?

Many times a stock may appear to have a high dividend yield, but that’s only because it has fallen significantly in the previous 3 months. If the underlying financials of the company are unstable, they may be at significant risk for cutting their dividend. In that case, you would not be receiving the yield that you were hoping or planning for.

There is a common strategy of purchasing stocks that have increased their dividend for 25 or 30 years. The theory goes that these companies have stable dividends. Unfortunately, this might be a case of selection or survivorship bias. Just because a company has succeeded for the last 20 or even 30 years doesn’t mean that it will continue to be successful. Sears Roebuck had been a successful company for over a century, but then struggled and cut their dividend.

 

Make your own dividend whenever you want

The great thing about not owning dividend stocks is that you can make your own dividends whenever you want. This has been advocated by other personal finance bloggers such as Physician on FIRE or Big Law Investor. You don’t have to wait for the quarter to end or for the company to pay out the dividend. If you need cash flow, just create some cash flow by selling some stock.

Remember that the payment of dividends does not significantly change your expected total return, so if you were comfortable receiving dividends from the companies you own, then you should be fine creating your own dividend through selling shares.

Some have suggested intentional purchasing low-dividend stocks. For example, Physician on FIRE holds Berkshire Hathaway, Warren Buffett’s conglomerate company, in his taxable account. Because Berkshire Hathaway pays out no dividends, it is more tax-efficient than investing in the total stock market, which has a dividend yield of approximately 1.7%.

I personally do not invest in such a strategy, as Warren Buffett will likely no longer be with us when I would want to liquidate my taxable account. His portfolio, while diversified, is tilted to certain sectors, and is not as diversified as a total stock market index or even the S&P 500. We also do not know how Berkshire Hathaway will be managed when his successors take the reins of the company.

Conclusion

I understand the attractiveness of dividend stocks, but ultimately its benefits can be replicated by creating your own dividend by selling your stocks. The payment of a dividend does not add value to a company, as is demonstrated when the stock drops by the amount of the dividend on the ex-div date. Dividend stocks are tax-inefficient compared to the total stock market in taxable accounts. I do not believe dividend stocks will outperform non-dividend stocks beyond its potential as a play on value stocks.

What do you think? Do you invest in high-dividend stocks, index funds, or a combination of both?

24 COMMENTS

  1. Hey WSP, thanks for the post. I actually was having this argument the other day (in good fun). He invests in 25 individual stocks in his taxable account that all pay dividends. I was trying to reason with him that he is taking some unmitigated risks by not diversifying more. (A random walk down wall street says somewhere around 60 is the number to really minimize certain risks).

    I am curious to know (and will likely research this to write my own post) if there have been any financial studies comparing the returns on the two different techniques. This may be tough because it depends on which stocks we choose. Lots of evidence there to show we are not very good at picking the winners. None the less, thought I’d ask.

    Good food for fodder! Thanks.

  2. I don’t pay taxes on my Dividend Index funds because they are in my tax deferred accounts. I think the big reason to do a dividend approach is because of stability of income. One example is the recent volatility of the stock market that corrected to 1000 points. The dividend investor have a peach of mind that they are not selling stocks at a lower price.
    Thanks!

  3. In Canada, our taxes are a bit different. We get a dividend tax credit that results in a very low tax rate or even a negative marginal tax rate if you are in a low income bracket. If in a higher income tax bracket, capital gains are taxed significantly lower than eligible dividends and deferred until they are realized. I am in a high bracket and have been using swap based ETFs that essentially track the total return (dividends and cap gain) of an index, without giving dividends, to avoid the tax drag. My wife is in a low tax bracket, so we have some eligible dividend payers in her account since the tax credits reduce her tax bill a bit.

      • I just recently learned of them. In Canada, there are only a few on the TSX, all by Horizon. Some were worth it for us – HXT.TO (tracks TSX) and HXX (foreign developed markets). Those two had fees similar to their regular ETF counterparts and the HXX one in particular was good for us by changing foreign dividends (fully taxed) to capital gains (deferred and half taxed). I don’t know of any in the U.S. – may not be the market for them there with the tax differences.

  4. I’ve never understood the fascination with dividends. They’re the portion of total return that you have no control over and get the worst tax treatment.

    I own millions in stock index funds, but own only one individual stock. Berkshire Hathaway. You know what I love about it? No dividend.

    Cheers!
    -PoF

    • I’m pretty sure it’s the attraction of a passive stream of cash flow. They consider the dividends to be passive income, even though, as you said, you have no control over the amount of the dividends a company will pay out.

  5. I don’t disagree with anything here. But I guess I’m a little bit “fascinated with dividends.” Buffett is too.
    He doesn’t pay a dividend, but he buys companies that are consistent dividend payers. There are some benefits. Dividends are real. Not faked numbers. The management has to have financial discipline. Those stocks do tend to outperform others (according to Jeremy Siegel’s research). With a wide portfolio of dividend-paying stocks you can get very regular and predictable income. Dividends don’t decline as much as prices in a crash or bear. Dividend investors are less likely to panic and sell in a downturn since the income is flowing. It protects you from SOR risk since you won’t have to sell shares for income after a market crash. I know some rich people who live very well off dividends and never “kill the goose that is laying the golden eggs.”

    • OK …I think I am always agreeing with WealthyDoc across several blogs.
      I have never pursued the dividend strategy, but as I am about 5-6 yrs out from getting out of clinical medicine and likely retiring fully I am thinking of moving some money over in the next few years to build a dividend portfolio. I like cash flow, and and I don’t like tapping principal or liquidating shares to do so. I am not going to try to pick individual stocks but will likely use a Vanguard dividend fund among others.

      Dividends and real estate …they make me happy.

  6. I will also admit my attraction to a passive income stream in the form of dividends. For some reason, it seems more tangible to me than an increase in stock price. I don’t invest specifically in high dividend stocks, but as my index fund portfolio grows, it is nice to see the dividends grow as well, and I can imagine the attraction of simply living off the dividends in retirement. This is also one of the reasons that I invest in the vanguard intermediate term tax exempt municipal Bond fund. This fund privides some tax-free cash flow every month, although I understand that with rising interest rates the principal value is declining concurrently.

  7. I am not a dividend investor. I find that as my index portfolio has grown that I can live off the dividend and muni interest alone without liquidating anything. Full disclosure I own some Apple. It does pay a dividend but it did not when I bought it. On a purely psychological level I think in retirement it will be easier to spend dividends than sell shares. Heresy I know.

  8. The reason to own BRK.B is

    1. It’s the 8th largest company in the world
    2. It correlation to VTI is .57 which is better diversity than you get from buying REITS. BRK.B is a little more volatile than VTI but in about a 48%:52% ratio you get a blended stock with less volatility and more return than with VTI alone.
    3. It is tax efficient.
    4. It’s not GE or SHLD well known widow and orphan dividend stocks that have fallen prey to moronic management and creative destruction.

    I own some BRK.B (about 2%) as part of my asset mix. I don’t see any reason to assume BRK.B is going to do badly if Buffet bites it. The railroad, insurance, and candy companies makes money if Buffet is alive or dead and considerable forethought has gone into succession. If he dies and the stock goes down, my suggestion is buy more. It’s extremely well run.

    I have no problem selling stocks. You don’t sell “principal” you sell what you need, and if you tax loss harvest or sell only to the top of the 12% bracket (104K married jointly over 65) you don’t pay any taxes on the cap gain. So why would you choose an asset that forces you to pay taxes on ordinary income. You sell only when you need some cash which gives you great control on taxes.

  9. I plan on doing both, index and dividend investing.

    In Canada if you buy Canadian stocks or Canadian listed ETFs that hold only Canadian stocks then Canadian dividend tax credits will give you some tax relief. The Canadian corporations have already paid the taxes on the Canadian dividends. If the investors pays tax on it then it is double taxation on the dividends. In the best case scenario, say your spouse is a homemaker with no income, up to $50K of Canadian dividends can be taxed free. If you are concerned about dividend taxes you could buy dividend stocks inside your tax sheltered accounts.

    Dividend investors like the power of dividend compounding (or share compounding) when DRIP-ing It can be as powerful as compound interest. Dividend books like to compare two portfolios side by side. One with dividend compounding and one without. The one with is a larger amount over a long period of time. In Canada, a lot of the ETFs’ top 10 to 25 stocks have consistently paid dividends for many years, have good dividend yields or have dividend annual yield increases (most are blue chip too) so dividend investors figure why not just own the stock (get most of the benefit of the ETF fund) and not pay any MER fees. Let the ETF index fund managers do the research in selecting the top 10 to 25 stocks.

    Dividend investors don’t want to spend down the principal in their retirement years (e.g. 4% rule), theoretically, they can leave their portfolio to their heirs when they pass.

    When stock prices drop or we are in a bear market, assuming the dividends have not been cut yet, the DRIPs will buy more shares at lower prices. These extra shares will help the portfolio to rise faster when prices rise and the market is recovering. In the 2008/2009 crash most dividends were not cut (Canadian ones at least), some dividends may have even increased. In a prolonged bear market there is the possibility that dividends may be cut.

    I also like index investing and I only buy Vanguard ETFs. Canada’s market is too narrow, not too many sectors, so I diversify my portfolio by buying VTI, bond and international index funds. Hence, I am a fan of both, index and dividend investing.

  10. Ive never understood this argument from the antidividend crowd. im confused why you think creating your own dividend by selling your stock is better than just receiving a dividend without having to sell any of your stock? If given the option of both, why would anyone choose to take money by selling a portion of what they own rather than just collecting the fruits of the labor of what they own? If you had 100 apple trees on your property, would it make more sense to dig up 20 trees and sell them for money, now leaving you with only 80 apple trees, or would it make more sense to continuously use the apples that grow on the trees every year for income? This idea that selling shares of stock is somehow better than a dividend that you receive regularly without reducing the amount of the companies you own is really perplexing to me.

    Look at another example – you own a profitable business and you need money for groceries; would you argue that its better to sell some of your company for money to buy groceries as opposed to…using the actual income produced by the business…for income? Dividends are literally income from the profits of a profitable business that you have some percentage of ownership of. Why would i choose to sell portions of a business i have an ownership stake in rather than just collecting profits which is the whole reason for owning a business in the first place?

    If you are a physician that owns your own practice do you sell parts of your practice for income or use the profits from the business you own for income? because thats what dividends are, portions of profits from businesses you have ownership in

    • Thank you for your comment.

      I’m not really a fan of creating dividends by selling a stock either. I’d rather take that money and reinvest it in the business, earning compound interest. To use your analogies:

      1. If I had 100 apple trees producing apples for me each year, rather than eat/sell the apples (taking a dividend), I’d use them to plant even more fruit-bearing trees (reinvesting).

      2. My selling of publicly-traded shares does not affect future dividends or success of the corporation.

      3. If the physician chooses to keep the income generated from the business within the corporation (that he/she owns), the value of the corporation goes up by that amount.

      Remember that a company’s dividend payment lowers the company’s stock value by the amount of the dividend. The actual payment of a dividend adds no value to the company.

      • “Remember that a company’s dividend payment lowers the company’s stock value by the amount of the dividend. The actual payment of a dividend adds no value to the company.”

        This is a very confusing statement and I wonder why you think this is useful information. If it were that simple then really no company would ever pay a dividend and no one would invest in dividend paying companies. That statement you made is really fundamentally not a very useful statement because it really provides almost no useful information. Its basically the same thing as saying that the value of any company lowers every time they pay their employees. I mean its a factual statement but its also fundamentally useless.

        Any time any company pays anyone whether its employees, vendors it does business with, or shareholders, the value of the company obviously must decrease because the money used for those payments must come from the finite assets that creates that company’s value. A company’s value is the sum of its total assets, so when portions of those assets are used to pay others, then yes the value of said company has decreased by that amount. Again though, I am not sure why you think that is a notable observation. Have you never seen a company’s stock price regularly increase despite the fact it pays a regular dividend, much like the value of a company can, and frequently does, increase even as they pay income to employees?

  11. oh and having said all of that, i personally dont invest in any dividend paying single stocks or single stocks of any kind for that matter. All of my investments are mutual funds and etfs but I do invest in some dividend focused etfs like vym, vig, and sphd.

  12. My name is Tom Peacock from USA, I want to say thank you to Dr Emu for the good thing he has done for me, Though am not sure if this is the best forum to show my joy and happiness for what he has done for me but i can’t hide my happiness and my joy so i have to share it with people, my marriage got crashed about two years ago and i tried all i could within my power but to no avail. I saw a post and testimonial about the good things Dr Emu has been doing so I decided to give it a try. though he is always a busy man but when he responded back to my email, he gave me 48 hours for my marriage to be restored really just like he said my marriage was restored since then I am happy and i am living happily i am so grateful to Dr Emu you can always email him here: {emutemple@gmail.com} or WhatsApp: {+2347012841542}

LEAVE A REPLY

Please enter your comment!
Please enter your name here