(Chuck Saletta)
Dividend stocks can be a great way to build wealth over time. Still, investing isn’t just about watching your dividends roll in, focusing too much on those payments can get you into trouble.
As an investor, it’s important to find a balance between your dividend stocks and the rest of your portfolio. These four reasons to avoid dividend-paying stocks can help you find balance while still keeping yourself on track for a brighter long-term financial future.
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No. 1: You are trying to reduce your income
While cash from dividends is fine, it does count as dividends if you receive them in an after-tax account income When calculating your adjusted gross income. Obamacare premium subsidies, Medicare Part B premiums, and your federal income tax bracket are all heavily affected by adjusted gross income.
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If you’re looking to lower your total income to stay on the good side of tax brackets or subsidies, minimizing your exposure to dividend-paying stocks can help you do just that. After all, dividends you don’t receive will never show up in your adjusted gross income.
2: You need to spend cash from your portfolio
It’s easy to think of dividends as a reliable source of spending cash that you can use from your portfolio to make ends meet.The challenge with this approach is that the dividend is no way Guaranteed payment. To make matters worse, if a company is forced to cut its dividend, its stock usually plummets too. This leaves neither of you with a source of income and enough cash to make up for lost income elsewhere.
Rather than relying directly on dividends to pay out cash, use them as part of a plan to maintain an investment-grade bond ladder or other higher-certainty form of cash. That way, if your dividend does get cut, you have a better cushion that better protects your ability to meet your current spending needs. If nothing else, that should at least buy you more time to build a stronger recovery plan from any unfortunate dividend cuts that may occur.
No. 3: Yield looks too good to be true
The only way a company can sustain its dividend over the long term is to pay it out of its continuing earnings or operating cash flow. If a company’s dividend can no longer be supported sustainably, its stock tends to fall in anticipation of a possible future dividend cut. The drop in the stock price has caused the company to look like a high yield because that yield is calculated by comparing its most recently or newly declared dividend to its stock price.
In fact, that’s only attractive if the company manages to recover from a going concern to the point where it can support its dividend over time. If not, the more likely outcome is a dividend cut and further stock price declines, as the yield trap will eventually be exposed.
No. 4: Rapid growth potential is more important to you than current income
If there’s a structural downside to dividends, it’s that every dollar the company pays in dividends is a dollar it can’t invest in growing its business. This often means that companies that don’t pay dividends have the opportunity to grow faster than other equivalent businesses that pay dividends. So if your goal is to maximize your portfolio’s potential for growth, looking for companies that actively reinvest every dollar in their growth opportunities may be a better option.
Just be wary of “empire building” or something among some corporate leaders. Those who do are looking to grow the business or organization more to lead the larger organization rather than maximizing long-term returns. Be sure to check the financials and listen to the company’s financial calls to ensure the business is focused on the right long-term goals. Otherwise, it’s hard to justify a company keeping this cash rather than distributing it to shareholders.
Investing in healthy companies for the long term
No matter what type of business you are investing in, focusing on the long term is a very important part of giving you the chance to succeed. Both dividend and non-dividend stocks may play a role in your portfolio, but neither is a suitable investment for your near-term cash needs.
Focusing on the long-term value of the companies you invest in and your long-term mindset when investing makes it easier to make informed buying and selling decisions during turbulent times. This can help you build a better foundation for the long-term wealth you hope to build, whether or not the stocks you buy pay dividends.
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Chuck Saletta has no positions in any of the stocks listed above. The Motley Fool has no positions in any of the stocks listed above. The Motley Fool has a disclosure policy.
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