Dividend-paying stocks may look awfully appealing, but you should be able to separate the truth from fiction before you jump into these investments. Here are seven common myths about dividend-paying stocks.
Myth No. 1: Dividends hold up in bad markets.
There is a perception that dividend-paying stocks will hold up better when the market declines. But General Electric paid a quarterly dividend of $0.31 per share in 2008. In 2009, during the global recession, GE cut its dividend to $0.10, commencing in the second quarter of 2009. It was not alone. In 2009, a whopping 57 percent of dividend-paying companies either reduced their dividends or eliminated them altogether.
Myth No. 2: Dividend-paying stocks outperform the market.
From 1991 to 2012, the average annual returns of dividend-paying stocks and the global stock market were both 9.1 percent. During the same period, stocks not paying dividends had an average annual return of 11.1 percent, although the higher returns came with greater volatility.
Myth No. 3: Dividend-paying stocks provide adequate diversification.
If you focus only on investing in dividend-paying stocks, you'll ignore 39 percent of the global companies that do not pay dividends. Someone who invests only in dividend-paying stocks is sacrificing diversification. Consider that approximately 53 percent of global small-cap stocks pay dividends. If your portfolio is made up entirely of dividend-paying stocks, you will exclude 47 percent of global small-cap stocks.
Myth No. 4: Dividends are a reliable source of future income.
A change in tax policy can dramatically affect future payment of dividends. In the U.S., dividends are taxed favorably compared with ordinary income tax rates. For individuals in an income tax bracket not exceeding 35 percent, dividends are taxed at only 15 percent. However, there isn't any assurance that this policy will not change or that foreign countries will not alter their tax policy toward dividends.
Myth No. 5: Dividends are tax-efficient.
Dividends are more tax-efficient than ordinary income because they are taxed at a lower rate. However, they are less tax-efficient than capital gains, because you are taxed on dividends in the year in which they are paid, but you are not taxed on capital gains until you sell the stock.
Myth No. 6: Buying dividend stocks is a prudent way to obtain exposure to value stocks.
Gregg S. Fisher, president of investment management firm Gerstein Fisher, analyzed more than 30 years of high dividend-yielding stocks and compared those stocks' returns with the broader stock market. He concluded that it wasn't the dividends associated with high-yielding stocks that drove performance. Fisher wrote in a paper that the "yield factor associated with high dividend-yielding stocks actually detracted from performance."
Myth No. 7: Dividend-paying stocks are a substitute for bonds.
Some investors believe they can improve their yields without taking additional risk -- by dumping bonds from their portfolio and substituting higher dividend-paying stocks. This is incorrect. First, dividend-paying stocks have significantly greater risk than high-quality, short-term bonds. Second, the better way to increase expected returns is to increase stock allocation. The purpose of bonds is to lessen periods of volatility.
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