While dividends create enticing streams of passive income, there are 3 major hidden downsides that new investors often overlook. Learn why you should invest elsewhere in your twenties.

Introduction

Many young investors grow enamored with dividend investing when they first learn about the strategy. I get it. The idea of being paid just for the act of buying and holding a stock almost sounds too good to be true. What a world we live in!

I love anything that builds enthusiasm around taking control over your finances and investing. I’m not here to crash the party. But I do want to temper the excitement and expose the hidden downsides that dividends create for young investors. And if you’re determined to build passive income without the downsides outlined below, start analyzing real estate.

A quick clarification before diving deeper: I think dividends play a crucial role in the portfolios of older folks and retirees who have already accumulated significant assets over their careers. Dividend investing works well when you reach the “harvesting” stage of your investing life.

This post is geared towards the younger investor who is many years away from the harvesting stage and hoping to grow their net worth exponentially.

Dividend Investing Pitfall #1 – Reduced Growth Opportunities

A dividend payment represents one of the most risk-averse, low-upside ways that a company can use the cash that it holds. Here are a few alternative uses for that cash:

  • Growth Opportunities – Invest in new projects, factories, international expansion, etc.
    • Higher risk with potential for massive returns
    • Generally signals company health and confidence about future operations
  • Mergers and Acquisitions – Buy a direct competitor or a company that provides expansion into a new / adjacent market
  • Deleverage – Pay down debt, lowering risk for equity investors
  • Stock Buyback – Buy shares of the company stock on the public market, signaling that the share price is undervalued
    • Companies hope to boost share price with this strategy, but markets often see through the charade

Given these options, what can we conclude about a company that chooses to pay a dividend?

It implies that management sees no better use for excess cash. No exciting new project. No opportunity for growth into a new market or promising product development to prioritize.

Shareholders will appreciate the income for now, but it casts a pessimistic shadow over a company’s future. This should raise red flags for the young investor.

Imagine Jack Dorsey, the CEO of Square, deciding that they should pay a dividend. Square is one of the most innovative companies in the world! Dorsey likely has a list of 100+ projects or priorities that could create exponentially more value for investors than paying a dividend.

Pursuing a dividend investing strategy means missing out on the outsize returns that the most innovative minds in the world will generate. Now sure, this growth comes with added risk, but that’s why I tout the benefits of index investing. Indexes allow you to grab a piece of that upside without the concentrated risk that single stock bets create.

Dividend Investing Pitfall #2 – Tax Inefficiency

Many young investors overlook the tax implications of dividend investing as well. Dividends get taxed twice!

First, a company pays corporate taxes on its earnings…no surprise here.

Unfortunately, when the company uses these earning to pay a dividend, it also creates a taxable event for the individual shareholder. In most cases, investors will pay a 15% tax on this dividend income. This varies depending on individual income and holding period, but I’ll save the nuance for Investopedia. The point here is that Uncle Sam takes a second cut.

In contrast, consider a company that pays no dividends and instead reinvests in internal growth projects. Perhaps this takes the form of increased research and development spending to enhance product efficacy and market adoption. Perhaps this means hiring a new West Coast sales force to expand geographic reach. There are infinite possibilities.

Just as dividends create a dual tax disadvantage, these internal investments create a dual tax advantage. See, the government allows companies to classify these sorts of investments as “expenses” on corporate income statements. In turn, this lowers a company’s corporate tax bill. Simultaneously, investors realize enhanced growth without an individual tax consequence.

Skeptics might point to the fact that individual investors will ultimately pay the same 15% capital gains tax when they sell stocks down the road. And yes, that’s true. However, investors can defer this tax payment for many years into the future, minimizing the impact on a present value basis.

Additionally, investors gain control over the timing of this tax event. This allows investors to implement additional strategies like tax-loss harvesting and other optimizations to offset this tax burden.

Dividend Investing Pitfall #3 – No Guarantees

There are no guarantees in life. This goes doubly for the world of investing.

Trends change, industry dynamics shift, new entrants emerge with solutions we never imagined. The world experiences a global pandemic.

Many investors view dividend payments as inevitable…a corporate obligation. They take comfort reviewing a stock’s consistent history of dividend payments throughout economic cycles and project that into the future. This is a dangerous practice.

No company is legally obligated to pay a dividend. Even one that generates massive profits and accumulates billions of dollars on its balance sheet. Corporate leadership can cut, suspend, or eliminate dividends at their sole discretion.

Granted, some companies out there that have increased dividend payments consistently for decades. Maybe they will forever. The key is that they don’t have to.

Ironically, companies might eliminate dividend payments at precisely the moment shareholders were counting on this income the most (like when a global pandemic grinds the world to a halt)!