The Pros and Cons of Dividend Stocks

Dividend stocks provide tax-efficient income, but they are not without risks.

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A lot of investors in this extended low interest rate environment are turning to high-dividend stocks to give them a reasonable income in their retirement years. It's certainly true that dividend stocks can be good investments, providing current income as well as some promise of capital gains. But even dividend stocks expose investors to some degree of risk.

So, let's look at the pros and cons of investing in dividend stocks. Then you can decide if they fit into your portfolio.

Pro: The obvious reason for owning dividend stocks is that they pay shareholders real money in real time. You don't have to wait for some promised new product to prove itself in the marketplace, and then presumably drive a stock price higher. Dividend stocks pay you every three months, rain or shine. An electric ultility like Southern Company sparks out a 4.7 percent dividend every year. A telephone company like AT&T rings up 5.2 percent. An oil company like Conoco gushes 4 percent, and even old-line drug companies like Lilly and Bristol Myers squirt out a 3.5 percent yield. That's a lot better than a bank CD which pays less than 1 percent. [Full disclosure: I have several small investments in high-yielding oil and telephone stocks and a high-yield ETF.]

Con: A bank savings account is insured by the government. But there's no law that says a company can't reduce or eliminate its dividend. Dividend payments are distributions of company profits back to shareholders. If profits go down, then dividends are likely to go down. For example, many banks paid fat dividends in the early-to-mid 2000s, only to cut them drastically when the financial markets fell apart. Plenty of other companies cut their dividends, too. According to Fidelity, on average during the past two decades, 9 percent of stocks with the highest yields cut or suspended dividends within one year, and in 2009, during the great recession, that number reached 40 percent.

Pro: While companies do occasionally reduce dividends (especially companies that pay a high dividend but also carry a lot of debt), it's actually much more common for companies to increase their dividends. For example, oil company Chevron paid a $0.68 quarterly dividend at the end of 2009, but raised that payment to $1 by the end of 2013. More than 50 of the S&P 500 companies raised their dividend in the first quarter of 2014 alone. 

Con: Companies that pay generous dividends are concentrated in utilities and old-line industrial businesses. These stocks do not provide adequate diversification for investors. The majority of faster growing small-cap stocks do not pay any dividends at all, and many high-tech stocks don't pay dividends either. By focusing on dividend stocks you may miss out on the sometimes huge gains that can be provided by the next new thing from Silicon Valley, a miracle cure from a biotechnology company or a new trend from a hot retailer.

Pro: Over time dividend-paying stocks have been shown to provide returns that are comparable to the market as a whole, and they have produced those results with significantly less volatility. In other words, dividend stocks are safer. Dividend stocks lag on the way up, but they also tend to hold up better when the market goes down.

Con: Yet, investors cannot regard dividend-paying stocks as a substitute for bonds. While bonds themselves are not risk free, dividend stocks pose a greater risk than high-quality bonds, especially high-quality short-term bonds. Dividend stocks can certainly go down, and they will if a bear market growls its way onto Wall Street.

Pro: Dividends are more tax efficient than bonds or other ordinary income because they are taxed at a lower rate. People in lower brackets pay no federal income tax on dividends. And for individuals in an income tax bracket not exceeding 35 percent, dividends are taxed at only 15 percent. Although there's no guarantee that this tax-favored situation will last forever, this is definitely a bonus for dividend investors.

Many experts recommend investing in high-dividend mutual funds or ETFs rather than trying to pick individual stocks on your own. Fidelity offers the Fidelity Strategic Dividend & Income Fund (FSDIX) which offers a 2.4 percent yield. Vanguard has the Vanguard High Dividend Yield Fund (VHDYX) which sports a 2.8 percent yield. There are also several high-dividend ETFs such as the iShares Select Dividend (DVY) and Vanguard High Dividend (VYM), and both yield about 3 percent.