6 Benefits of Dividend Stocks (and 4 Downsides)

Dividend stocks offer several benefits, not least of which is the fact that they offer regular payouts. However, you still might need a little convincing: Why should you go this route when you're getting ready to invest?

So, what are the benefits of dividend stocks? We'll go over the definition, benefits, and downsides of owning dividend stocks so you can make the right decisions for your own specific investment needs and priorities. 

What Are Dividend Stocks?

What are dividend stocks, anyway? 

Dividends are stocks of companies that offer periodic payments to shareholders. Companies offer dividends because they make money and put a priority on sharing some of that revenue with investors. Companies that issue dividends do so in order to thank shareholders for their support by offering them shares of investments in the company or through hard, cold cash.

Pros of Dividend Stocks

Dividend stocks offer several advantages. It's a good idea to be aware of dividend stock benefits so you can decide whether you really want to invest in them. Let's take a look at some benefits.  

Benefit 1: Offer you a regular income source. 

Dividends can offer a consistent income stream on a regular basis. Dividends usually come from companies in the form of cash to investors. They usually pay out on a quarterly basis, though some dividends pay out on an annual or semiannual basis. Some also pay out on a monthly basis.

No matter how often you receive your dividends, you can depend on a regular dividend income stream from dividends, even in times of market volatility.

Benefit 2: Give you access to passive income.

Passive income refers to income you receive without having to do a lot of labor in order to earn it. You also don't have to put forth a lot of effort in the future to earn passive income. In addition to dividend income, passive income methods might include maintaining a blog, generating rental income, taking advantage of affiliate marketing, peer-to-peer lending, and other methods in which you don't have to expend a lot of effort to earn. It's completely different compared to a nine-to-five job.

Benefit 3: Can carry fewer risks.

Dividend stocks have historically outperformed the S&P 500. A Factset study showed that dividend-paying stocks outperform non-dividend-paying stocks by a large amount. In fact, from 1991 through 2015, non-dividend paying stocks earned just +4.18% return per year while dividend-paying stocks significantly outperformed with an average annual return of +9.7%.

However, it's important to make sure you're diversified in your investments. Diversification means that you spread out your investments so that your exposure is limited to many investment types. Doing so can reduce the volatility of your portfolio over time. For example, if you invest in many sectors, you'll be more diversified than if you invest in a single stock or a single sector.

Benefit 4: Can fight inflation. 

Inflation refers to an increase in the cost of services and goods in an economy. Inflation eats away at your purchasing power over time, especially if you have a budget to watch! As long as you select dividend stocks the right way, they can offer you a hedge against inflation because they offer a regular income stream and appreciate in value.

Benefit 5: Can reinvest your dividends. 

You don't have to take dividends in cash, especially if you don't need the money right away. If you want to keep earning more dividends, you can reinvest them using an automatic dividend reinvestment plan (DRIP), which you can set up through your brokerage or the company you've invested in. 

You can then purchase more shares of the stock and keep the funds.

It's important to remember that if you set up a DRIP through a brokerage firm, you might have to pay commissions. 

Benefit 6: Offer more than one advantage.

Dividends offer more than one benefit — they offer a regular income stream and also appreciate in value. Both sources can add up over time. If you eventually decide to sell the stock, you can benefit from your initial stock purchase because of this appreciation. 

For example, if you initially bought a stock for $10 per share and then 40 years later, sell it for $500 per share, you'd have quite a lot on your hands — in addition to the dividends you've been collecting over 40 years!

Learn more: Are Dividend Stocks Worth It?

Cons of Dividend Stocks

It's also important to consider the downsides of dividend stocks so you can make the right decisions for your portfolio. 

Downside 1: Lower potential for massive returns.

A dividend stock may not offer the type of high returns that you might receive from a different type of investment. For example, if you invest in a startup that takes off, you might receive higher returns compared to what you might earn with a dividend stock. 

The average dividend yield on S&P 500 index companies typically ranges between 2% and 5%, whereas a startup that you invest in might see much higher growth. However, it's important to consider all the risk factors in this situation.

Downside 2: Dividends aren't always guaranteed.

Companies may cut their dividends. If a struggling company cannot pay out dividends, it may have to cancel them altogether. Companies might also change their capital allocation policy, which means that it changes the way it uses its cash. For example, a company may choose to change how it grows its business, decides to invest in a different arm of the business, chooses to pay down debt, and more. 

You may want to consider investing in the Dividend Kings or Dividend Aristocrats. These are stocks that have continued to give out dividends over the course of 50 and 25 consecutive years, respectively. These are generally "never-fail" investments because you're investing in solid companies that will likely continue to offer a dividend year after year.

Learn more: Dividend Kings vs. Dividend Aristocrats: Which Should You Choose?

Downside 3: You can run into high-yield dividend traps. 

Tremendously high yields can seem appealing at the outset, but they can actually mean that potential risks happen down the road. It's important to learn the reasons a company is experiencing an overly high yield. (The calculation is Dividend Yield = Cash Dividend Per Share / Market Price Per Share x 100.)

For example, let's say the cash dividend per share is $9 and the market price per share is $60. The yield would be $9/$60 x 100 = 15%, which is really high. When you encounter high yields, take a look into the deeper reasons they might be high. The company might have excessive debt, have a high payout ratio, and have little or negative cash flow. 

Companies that have excessive debt may have to cut dividends when the economy takes a tumble. That's why it's a good idea to take a look at the debt-to-equity ratio of a company and those in similar industries.

A company's annual dividend payout ratio measures the company's annual dividend payout ratio/earnings. A high payout ratio (one between 75% to 95% is considered very high) could mean that a company's dividend isn't sustainable — in other words, it doesn't have enough of a profit to pay its dividends.

It's important to pay attention to cash flow, which is the difference between the money that goes in and out of the business. It could signal that something is "off" with the business itself, which could also result in a stock price decline.

Downside 4: You'll pay taxes on dividends.

Just like with any type of income received, you'll pay dividends on it. Qualified dividends, which are dividend payments, are taxed at long-term capital gains tax rates as long as they are held for a certain amount of time — generally 60 days for common stock and 90 days for preferred stock. These rates are lower than ordinary income tax rates. 

Qualified dividends tax rates are based on the capital gains tax rates, which are based on a 0%, 15% or 20% tax rate and depend on your filing status. To get the best bang for your buck, you must hold the stock in your portfolio for more than 60 days during a 121-day period. You must begin this process 60 days before the ex-dividend date. 

Ordinary dividends are taxed based on your federal income tax bracket at a rate of up to 37%, depending on your tax bracket.

Do Your Research into Benefits and Drawbacks Before You Invest

Can you now list several significant reasons why you may want to target dividend stocks and put them in your portfolio?

The moral of the story: It's important to understand the pros and cons before you invest. In fact, you don't want to even think about investing before you do your research first. It requires some time and research, particularly if you're picking individual stocks.

Knowing about the benefits and drawbacks of dividend investing is a good first step to determining whether it's the right investing method for you.