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People LOVE dividends and dividend investing.
Making money through the stock market is a topic that has blown up in popularity ever since the start of the pandemic, and dividend investing is no exception.
Dividend investing is a strategy that utilizes stock dividends as their main source to grow wealth. There are many people that use this strategy and only invest in stocks if it has a high dividend yield in order to take advantage of this free money. There are even cult-like groups on the Internet, especially on sites like Reddit.
However, today I will show you why dividends are in fact not free money.
What Are Dividends?
First, I want to briefly explain what dividends are.
Stocks can distribute dividends. Some distribute every quarter, some every month, and some stocks don’t distribute dividends at all.
When you buy a stock, you are buying a portion of ownership of the business. For example, if I were to buy one share of Apple stock, I technically have partial ownership of Apple.
Every business needs to generate profit for their owners. As Apple generates revenue by selling their electronic products, a large portion of the revenue goes into the hands of their owners. This is exactly what dividends are. Because I have partial ownership of Apple, I am rewarded with a small dividend.
Why Is Dividend Investing Bad?
Dividend investing is not bad. It’s just that many people don’t properly understand the concept of dividends, and therefore, use the wrong investing strategy. I will explain more about this strategy later in this article.
Dividends are not the same as interest you receive from a bond, or the yield on a CD (certificate of deposit).
When you are paid a dividend, the price of the stock is marked down by the amount of the dividend. It’s like receiving your own money.
Say for example, you opened a savings account in order to store your emergency fund. You put away a total of $1,000 in your new savings account. The bank is offering an APY (annual percentage yield) of 2%, meaning you’ll receive 2% of the money you have in the account every year. In this case, you’ll receive $20. Now, you receive the $20 dollars just as the bank promised. But you look at your balance and nothing has changed. Turns out, the bank subtracted $20 from your total balance and paid you the APY with your own money.
This is exactly how dividends work. Don’t believe me? Don’t take my word for it. Samuel M. Hartzmark published an academic paper called The Dividend Disconnect. Let’s take a look at the paper’s conclusion.
As you can see, dividends mechanically reduce the price of the stock when paid out.
An Illustration To Better Help You Understand Dividend Investing
Below is a graph I have made to better help you understand.
Let’s say that there is a stock that pays a dividend and another that does not, and they both had the same returns.
As you can see, the “total return” of the stock is the same for both. With the dividend stock, the dividend is part of the total return. The dividend did not increase the total return, but because you were paid a dividend, the stock price has been reduced by the amount you were paid.
In other words, getting paid a dividend is like selling your stock and pocketing your own money.
Dividends Are Forced Taxation
If your intent is to build wealth, focusing on buying stocks with high dividend yield for the sole purpose of receiving the dividend is the wrong thing to do.
Not only are you getting your own money back, but you are also experiencing forced taxation.
You don’t have to pay taxes when the price of the stock you own goes up in value. You only would pay if you sold the stock for a profit. However, since you are receiving a dividend, if you are not using a tax-sheltered account, you will have to pay taxes upon receiving the dividend.
Using Dividend Investing The Proper Way
Don’t get me wrong, dividend investing is not bad, it’s just not for millennials.
People living off of their investment portfolio can use dividend investing, which usually occurs later on in life. Instead of having to sell their stock, all they have to do is live off of the dividends.
Millennials are young, and they should focus on growing their capital. They should focus on buying stocks of good businesses that show continued growth and constant revenue. One of the best ways to do this is through investing in index funds. The hard part of stock-picking is done for you – all you have to do is focus on saving your money and investing in the fund.
Conclusion
Millennials should not use the dividend investing strategy because they should be more concerned with building their wealth and investment portfolio.
When you are paid a dividend, the price of the stock is mechanically reduced – you are being paid your own money.
Instead of buying stocks just for the high dividend yield, you are better off focusing on the total return of the stock. That means price appreciation + dividends. The 3-fund portfolio is also a great strategy to passively make money in the stock market.
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Until next time.
Millennials should just focus on working instead of looking for handouts! Just kidding. I wanted to leave a comment here so you can see how this part of your site works and get some practice managing it too.