Investors may find dividend-paying stocks or funds to be intriguing and wonder if they make sense for their portfolio. Dividends may represent an additional income stream that can help supplement stock returns. When considering a dividend-focused strategy for your own portfolio, it is important to understand the benefits, drawbacks, and how it fits your personal situation.
What Is a Dividend-Focused Strategy?
A dividend is a distribution to a company’s shareholders, typically in the form of a cash payout. The difference between a dividend-focused strategy and a total stock market investing strategy is the types of stocks purchased. A dividend-focused strategy primarily invests in stocks that pay a higher-than-average dividend. These companies tend to be more stable and mature but may not grow as quickly, meaning that both share price appreciation and volatility will be lower. By contrast, a total stock market strategy will include a blend of characteristics, including both dividends and capital appreciation. That way, an investor can participate in a more balanced return profile of both growth and income.
What Are the Benefits of Dividend-Focused Strategies?
An investor may choose a dividend-focused strategy because it provides steadier cash flow. This may be beneficial for retirees who rely on their portfolio to supplement their income, as dividends generate cash flow to withdraw. Another benefit is that an announced dividend payment signals financial strength, profitability, and management confidence in future earnings, which may lead to lower volatility and a smoother ride. For investors who are nervous about the market environment, this approach may help cushion the portfolio during market downturns, as investors can generally expect dividend payments regardless of whether it is a good or bad year. However, this is not always the case. During the COVID-19 pandemic, some dividend funds had greater drawdowns than the broad market. This is because dividends are not static and can change. Companies can cut their dividends in tough times, and their stock price can be punished as a result.
What Are the Drawbacks of Dividend-Focused Strategies?
One drawback is that dividend payments are taxable. When a stock pays a dividend, the investor must pay taxes in the year incurred, regardless of whether the dividend is taken or reinvested. Dividends can either be classified as ordinary or qualified. Ordinary dividends are taxed at ordinary income rates, while qualified dividends are taxed at lower, long-term capital gains rates. Conversely, capital appreciation will be treated as unrealized gain until the asset is sold. In this way, taxes can be deferred until the stock is sold and gains are realized, allowing the investment to compound and grow without tax drag.
How to Know if a Dividend-Focused Strategy Is Right for You
The most important point to keep in mind is that historical returns for dividend funds and total stock market fund returns have differed meaningfully. For example, as noted from the investment research site, Morningstar Direct™, the Schwab US Dividend Equity ETF (SCHD) compared to the Vanguard Total Stock Market ETF (VTI). Including the reinvestment of dividends, over 10 years ending December 31, 2025, SCHD returned 11.5% per year compared to 14.2% for VTI. It is important to note that more than half of the stocks in a total stock market fund pay a dividend. Investors should also be cautious of chasing high-dividend-paying individual stocks. These stocks may be paying relatively high dividends due to declining stock prices, unsustainable payout ratios, or negative sector trends. All things considered, an investor must determine whether the predictability of dividends is worth the trade-off of less growth potential.
Part of the reason for the historical underperformance of dividend strategies is an inherent sector bias, as certain types of companies are more likely to pay dividends than others. A fund such as SCHD will be more heavily weighted toward energy, consumer defensive, and healthcare stocks. These sectors tend to be more stable dividend payers and more likely to withstand economic shocks. Conversely, a total stock market fund will be balanced with more growth-oriented sectors such as technology. Recently, technology stocks have seen tremendous growth amid investor enthusiasm surrounding artificial intelligence (AI). By using a dividend-focused strategy, an investor may be unintentionally exposing themselves to sector-specific risks and underweighting current trends driving the market.
How Forvis Mazars Can Help
In summary, investors who are not in retirement or don’t need current income from their portfolio may not benefit from dividend-focused investing due to the potential loss of growth and unintentional sector biases. Investors who need current cash flow from their stock portfolio can generate it simply by selling a portion of their portfolio in regular intervals. While dividend-focused investing does have uses, it’s not for everyone. Interested in learning more about how you can manage your wealth? Reach out to the Wealth Management team at Forvis Mazars Private Client.
Forvis Mazars Private Client services may include investment advisory services provided by Forvis Mazars Wealth Advisors, LLC, an SEC-registered investment adviser, and/or accounting, tax, and related solutions provided by Forvis Mazars, LLP. The information contained herein should not be considered investment advice to you, nor an offer to buy or sell any securities or financial instruments. The services, or investment strategies mentioned herein, may not be available to, or suitable, for you. Consult a financial advisor or tax professional before implementing any investment, tax or other strategy mentioned herein. The information herein is believed to be accurate as of the time it is presented and it may become inaccurate or outdated with the passage of time. Past performance does not guarantee future performance. All investments may lose money.