Dividends are a portion of profits that a company chooses to redistribute to its shareholders. Many investors swear by dividend stocks because you can make passive income just by holding your favorite companies’ shares. If you’re planning for retirement, dividend stocks may seem like a great way to compound your funds over time.
But there are major factors to consider before sinking any part of your hard-earned retirement funds into dividend stocks. Namely, they are stocks like any other, and that means there is an inherent risk that you could lose some, all or a substantial part of your investment.
Especially if your retirement timeline is years or decades down the road, it’s critical to invest in companies that will still be around (and churning out profits) at your retirement date. That means it’s important to fully understand the company’s underlying financials.
Even if the company is rock-solid, dividends aren’t guaranteed, and that’s why many investors choose mutual funds and ETFs for their portfolios. Dividend stocks require much more active management than a portfolio full of managed funds.
So are dividend stocks too risky for your retirement portfolio?
Risks of Investing in Dividend Stocks for Retirement
Companies provide dividends for many reasons. First, it sends a clear message to potential investors that the company is profitable and it’s willing to reward its shareholders. Second, it can keep current shareholders engaged in the company. Third, it can attract more shareholders to buy in and therefore drive up the stock price and the company’s value.
It’s important to understand that dividends aren’t a given. Many major companies like Amazon don’t offer a dividend at all. And just because a company paid a dividend of $1.00 per share last quarter doesn’t mean it will pay it this quarter. The company can reduce or increase the dividend amount any time it wants, or stop paying it at all.
If you’re a retiree depending on that dividend payment, exposure to a single stock for passive income can be risky. There is always the risk that the stock you considered a cornerstone of your portfolio decides to eliminate its dividend.
Hidden Costs of Dividend Stocks in Retirement
A little-discussed cost of dividend investing is the time required to research good plays.
It’s important to do your due diligence before investing in any individual stock. But researching and monitoring the stocks in your portfolio is a time-consuming job, and many investors don’t have the time or the inclination to manage a portfolio themselves.
Another cost not seen upfront is the potential portfolio loss when a share price declines by more than the dividend paid.
Losses could result from factors outside the company’s control. A great company could see its stock drop based on economic, political, or industry factors that are entirely out of its control. For example, the recent banking failures have affected stocks throughout the whole financial industry.
Risks of Relying on Dividend Yield
One of the key ways to measure dividend stocks is dividend annual yield. This is a common measure of how much of a company’s profits it’s returning to its shareholders. Dividend annual yield is calculated by dividing the dividend per share by the stock price per share.
Stocks can range from annual yields of less than 1% up to and approaching 10%. If you were solely buying on that metric alone, you might look at high-yielding stocks like Boston Properties, Inc. (NYSE:BXP), with an annual dividend yield of 8.2%, and Altria Group Inc. (NYSE:MO), with an 8.4% annual yield. BXP pays out a dividend of $0.98 per quarter, while MO pays out $0.94.
But BXP is not a traditional stock at all, it’s a Real Estate Investment Trust (REIT) that manages multiple properties. MO is a tobacco and cigarette producer. Even though these are very high-yielding stocks, neither one may be the right fit for your portfolio.
Even though dividend yield is an important factor, It’s more important to consider which companies you believe in when investing in stocks for your retirement portfolio.
Notably, when dividends exceed 5-6%, it’s worth looking very carefully at the company’s balance sheet to see if it can sustain the dividend or whether the payout ratio is too high relative to the cash on the books, and the odds are high the dividend will be slashed.
Alternatives to Dividends: DRIP Investing
Dividend Reinvestment Plan (DRIP) investments have been a perennial favorite for many long-term investors. Instead of simply pocketing your quarterly dividend, the money gets reinvested into the same company’s stock. That’s a great way to accumulate more stock without paying extra brokerage fees.
Oftentimes your dividend payout won’t be equal to the purchase price of a share, but most brokers will allow DRIP investors to purchase fractional shares. For example, if you were a Microsoft (NASDAQ:MSFT) shareholder of record on 05/17/2023, you would have received $0.94 per share.
If you owned 100 shares you would’ve received $94 dollars as a dividend. If you were a part of a DRIP plan, that $94 would have purchased .30 shares at that day’s stock price of $314. That would’ve increased your MSFT holding to 100.3 shares. It’s easy to see how continually reinvesting dividends can lead to larger shares and larger gains.
Dividend Paying Mutual Funds Vs ETFs
Mutual funds have been a popular option in retirement plans for decades. In a mutual fund, a manager personally selects the combination of stocks that make up the fund and changes them at their discretion. This personal touch isn’t free, and that’s why it’s important to understand the fees involved with mutual funds.
Exchange Traded Funds (ETFs) have become increasingly more popular than mutual funds because they have been able to mitigate some of the fees involved. Because these funds track major indexes like the S&P 500, they have been able to eliminate some of the human error that has plagued mutual fund managers. But ETFs aren’t fee-free either.
Dividend stock investors who are willing to research their stocks might feel like they can beat both mutual funds and ETFs on their own. While this may cut back on fees, ETFs and mutual funds offer another critical feature: diversification.
No one can predict the market, and individual stocks are vulnerable to huge losses. Even if a stock doesn’t plummet dramatically, if your picks aren’t performing at the level of the major indexes then you could be leaving critical retirement dollars on the table.
It’s also worthwhile to note that many mutual funds and some of the most popular ETFs like VOO and QQQ will still pass on dividends from their investments to their shareholders as well.
Dangers of Investing in Dividend Stocks for Retirement
Dividends stocks are highly sought after because they provide additional income from a stock investment. Whether you’re pocketing the dividend or reinvesting it into a DRIP plan, dividend stocks can quickly compound your investment over time.
But individual stock investments are active investments. Stock market losses are inevitable and can happen for a variety of reasons, so it’s important to be diversified. It’s also important to understand that dividends aren’t forever. Just because a company offers a dividend today doesn’t mean it will tomorrow.
If you’re retiring soon, individual stocks are probably risky for your portfolio. If your retirement timeline is decades away, it’s still essential to stay tuned in to how your individual stocks are performing. That doesn’t mean trying to time the market, but if you’re banking on dividend income and a company cuts its dividend, it may be time to reevaluate.
All in all, mutual funds or ETFs may offer more stability for the majority of investors. But if you’re willing to invest the time and do your research, these stocks may pay dividends in the long run.
The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.