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Last week, I wrote "19 Things I Like about Dividends." In the comments section, I sort of promised to write an article about the downsides to dividend investing. This is that article.

In addition to drawing on the 2013 edition of my annual eBook on dividend growth investing, I have dug back and found some of the objections to dividend investing that have turned up in articles and comments on SA and other places over the past couple of years.

Everybody knows where I stand on dividend growth investing. I do not consider some of the following to be much in the way of drawbacks, or even necessarily to be true. That said, some of the following items are important disadvantages that need to be seriously considered. I will refrain from editorializing, and I won't present the ways that a dividend growth investor can ameliorate the valid risks presented. My goal here is to present the downsides of dividend investing as straightforwardly as possible.

1. Market risk

While high quality dividend growth stocks are generally low-risk propositions, they are not without risk.

Investment-quality (that is, non-junk) bonds are, for all practical purposes, free of risk to the nominal value of your capital. With investment-quality bonds, you get all of your initial investment back essentially 100 percent of the time. In contrast, the capital value of dividend stocks can go up or down, because they are traded on the market.

You cannot eliminate market risk. If you sell a dividend stock, there is a chance that its price will have declined from your purchase price. You have no control over this. Furthermore, if the stock's price declined by an amount exceeding the dividends it paid while you held it, you will have lost money overall.

2. Dividend risk

Dividends are discretionary. Dividends can be frozen, cut, or eliminated. In contrast to bonds, the "right to receive dividends" discussed in last week's article is not a contractual right such as that conferred by a bond. It is not enforceable in a court of law.

Management may decide to change even long-established dividend policies, and they may take cash out of the dividend stream.

  • In 2009 Pfizer (PFE) cut its dividend in half to help pay for its acquisition of Wyeth, breaking a decades-long string of consecutive annual increases.
  • A company may fall on hard times-as happened to many companies in 2008-and therefore cut or eliminate the dividend. The companies in the S&P 500 collectively cut their dividends by 20% - more than $50 B in total - in 2009.
  • A company may suffer an operational calamity, as British Petroleum (BP) did in 2010 when its oil rig blew up in the Gulf of Mexico. Financial disaster will trump any company's desire and ability to keep sending out dividends.

3. You may not be able to make up for a dividend cut

If you combine #1 with #2, you will see that a dividend investor can end up in a very bad position: He or she owns a dividend stock that has cut its dividend, so the investor wishes to sell it. But if the stock's price has fallen too, the proceeds from selling it are less than what was invested in the first place.

That means that the investor does not have enough money to replace the income that was lost. Here's a very simple example. Say a stock was purchased for $100 per share, paying a 4% dividend at the time of purchase. For a variety of reasons, the company has a difficult period. The market price of the stock falls to $50 per share. Then the company cuts its dividend in half.

The stark reality is that the investor now holds a stock yielding half of what it did when purchased, and which can only be sold for half of what it cost. The investor's $4 per share of income per year has fallen to $2 per share, and each share is only worth $50. It happens.

4. Dividends are boring

Even when it does not happen, what fun is this?

(click to enlarge)

5. Initial low yield (sometimes)

The dividend yield on a quality dividend growth stock may initially be less than you could get from an investment-quality bond, or even from a certificate of deposit or money market account (all of which are essentially risk-free as to principal).

That said, currently dividend yields collectively are attractive compared to investment-grade bonds. The Fed's maintenance of rock-bottom interest rates means that right now, many stocks are yielding more than bonds and much more than CDs or money market accounts. Historically, though, this is unusual.

6. Dividends are taxed

When a company sends out your dividend, that is taxable income for you. The tax will either be at your ordinary income tax rate, or for "qualified" dividends it will be at the tax rate for long term capital gains.

It is common to hear the phrase, "dividends are taxed twice." What this refers to is that the corporation was taxed on its earnings (from which dividends are paid), and then the same money is taxed again to you when it is distributed as a dividend. Many investors feel that such double taxation is unfair, and that it renders dividend distributions an inefficient use of corporate profits.

7. Slower growing company

Dividend-paying companies are usually (but not always) among the slower growers in the corporate universe.

Some state that this is an inevitable effect of the payment of dividends. The reasoning goes that the payment of dividends is actually a wasteful use of corporate profits. If the money were retained (rather than distributed as dividends), it could be invested in corporate growth, efficiency projects, new product development, accretive acquisitions, or even to buy back shares.

Therefore, it is in shareholders' long-term interest for a company not to pay dividends but rather to plow all profits back into growth and improvement. Dividend-paying companies forego growth opportunities by distributing some of their profits as dividends.

8. Behavioral changes

It has been widely noted that dividend investors undergo behavioral modifications. In fact, they tend to suffer from a variety of biases and faulty thinking habits that inhibit their performance as investors.

Some examples:

  • Recency bias. Dividend investors tend to think that just because a company has paid dividends in the past, it will continue to do so in the future. In a similar vein, dividend growth investors often mistakenly assume that because a company has a track record of increasing its dividend for 10, 20, or 30 years in a row, it will once again increase it this year. As we saw earlier, companies can cut or eliminate their dividends at any time.
  • Survivorship bias. Dividend investors are prone to construct back-tests of portfolios that did not exist in the past, based on current data. Then they "rewind" them to some point years ago, play them forward as if they did exist at the starting time, and draw unjustified conclusions from the results. You can usually spot an erroneous back-test, because it begins with a sentence like this: "If someone had purchased $100 worth of McDonald's (MCD) stock in 1981…".
  • Herding. Dividend investors tend to hang out, mutually reinforcing their views and closing their minds to contrary data.
  • Overzealousness. Dividend growth investors' enthusiasm has been seen to lead to alarming behaviors, including intense or excessive devotion to the cause of dividend investing. This has led some investment experts to dismiss them as zealots, dreamers, and dividend lovers.
  • Complacency. Many dividend growth investors have been observed to believe they have found a "free lunch" where none actually exists. This leads them to buy stocks and never check them again, even holding onto them while the company goes bankrupt or is de-listed, its stock worthless. It also leads, I have been told, to dividend investors' proclivity to just invest in any dividend-paying stock.
  • Failure to analyze companies beyond dividend yield and growth rate. "The dividend-true-believers may pay lip-service to analyzing company fundamentals, when challenged, but their statements at other times prove they ignore future economic projections." [Source: "Evaluating Company Growth"]
  • Stock picking. Modern Portfolio Theory (MPT) teaches, in the view of many, that picking individual stocks is a fool's game, and that little of the total return of any investor comes from the particular securities selected. Rather, it comes from proper asset allocation. Many dividend growth investors, however, do pick individual stocks and come to believe that they can select stocks that are "better" than others.
  • Lake Woebegone syndrome. Most dividend growth investors believe that they are above average, which of course is impossible.
  • Yield chasing. "When people start investing in dividend stocks, they automatically gravitate to the high-yield stocks." [Source: "Common Dividend Investing Mistakes"]
  • Weak investment skills. It has been observed that dividend investing is suitable for those with weak investing skills. Such weakness, it may be surmised, results from some of the other behaviors already mentioned, such as complacency, recency bias, survivorship bias, yield chasing, and herding, all of which impede further learning.

9. Non-compounding ((I))

Some dividend growth investors take their dividends as cash and spend them. By not reinvesting the dividends, such investors miss out on the benefits of compounding, which they would enjoy if they would but reinvest the dividends.

10. The burden of reinvestment

Given the point just made, it is clear that for the best overall returns, the dividend investor should reinvest dividends, not spend them. But this raises another problem: Where to reinvest?

It is sort of a curse of dividend investing that once dividends are in hand, the investor must decide what to do with them. I have seen it said that dividends force shareholders to take cash whether they want it or not. It is also said that the dividend investor must be right twice: He or she must make a good initial investment. Then they have to be right again when making the reinvestment.

We saw above that stock picking is a dubious activity. To be able to do it right twice in a row is at least twice as hard, if indeed the difficulty does not grow at a geometric rate (making it 4 times as hard to do it right twice).

11. Non-compounding ((II))

If a company retains its earnings rather than sending them out as dividends, that allows the company to compound its earnings within the company. This is even more efficient than the reinvestment of dividends by the investor, because the dividends to the investor are taxed (as seen earlier) before they can be reinvested, not to mention that companies probably make better decisions about what to do with the money.

To see this more clearly, consider the following:

Withdrawing money from an account… reduces actual compounding…. Investors who think they can have growth and income will deceive themselves, unless they can reinvest at a rate high enough to overcome taxes. You can't have your cake and eat it too when investing; it is always growth or income.

…[P]aying a dividend is definitely inferior to good capital allocation by a well-schooled management. Here is why:

1. Dividends force all shareholders to take cash whether they need it or not;

2. Dividends are fully taxable. This is comparable to selling a zero cost-basis position;

3. It is actually worse, since dividends are paid in cash and therefore directly reduce book value;

4. while a sale of shares is at market, often a multiple of book.

(Source: "Understanding Compounding: Berkshire s Not-So-Hidden Dividend Contrarian Secret")

12. Stock prices drop by the amount of the dividend

Stock exchanges follow a long-standing practice. A few days before the "record date" of an upcoming dividend payment, they designate an "ex dividend" date. Before the opening of trading on that day, they reduce the quoted price of the stock by the exact amount of its dividend. Only those investors who owned the stock before the ex-dividend date get the dividend, and they then suffer the lower price. New buyers do not get the dividend, although they can purchase the stock at the lower adjusted price.

Because of this price adjustment, shareholders who hold on straight through see the price of their stock lowered by the amount of the dividend. So they do not "profit" at all from the dividend, as the market value of the shares has been reduced by the exact amount of the dividend they receive. Since the dividend then gets taxed as income to them, they are worse off than if the company had simply retained the money.

Source: 12 Things To Dislike About Dividend Investing