Dividend stocks, part 2

Regular income

One of the biggest advantages of dividend stocks is the steady income they can potentially provide. This can be especially appealing if you’re looking for a regular source of passive income or if you’re retired and want to supplement other income sources. While not guaranteed, companies will usually make every effort to maintain the dividend.

Reinvestment opportunities

Many investors take advantage of Dividend Reinvestment Plans (DRIPs). Instead of taking your dividend payout in cash, you reinvest it to buy more shares of the stock. This can help your investment grow faster over time thanks to compounding. Over the long term, this strategy can significantly increase the number of shares you own, boosting your future dividend payments and potential capital gains.

Stability and confidence

Companies that pay regular dividends over the long term are often seen as stable and financially healthy. They’re making a healthy profit, enough to consistently share the profit with their investors. This can be a sign that the company has a solid, focused business model and a steady stream of earnings. For many investors, this stability is reassuring, especially during volatile market periods. Knowing that a company can afford to pay dividends regularly can instill confidence in the company’s long-term viability.

Potential for capital gains

While dividends provide regular income, there’s also the potential for capital appreciation. In other words, if the stock price goes up, you’ll benefit from that growth too. Over time, this combination of dividends and capital gains can lead to higher total returns, making dividend stocks a compelling choice for long-term investors.

Tax advantages

In Canada, dividends from eligible Canadian companies benefit from a dividend tax credit, which can reduce the amount of tax you owe. This makes dividends from eligible Canadian companies more tax-friendly compared to some other types of investment income such as interest income. The tax treatment of eligible Canadian dividends makes them an efficient way to generate income, especially if you’re in a higher tax bracket.

Dividend cuts

Just as companies will try to maintain their dividends, they may also cut or eliminate them if they run into financial trouble. If you rely on dividends as an important source of income, this could be an unwelcome surprise. Dividend cuts might also lead to a drop in the stock price. Investors might sell the stock because they take this as a warning sign that the company is having difficulty or because they can find higher-yielding investments elsewhere. Investors need to be aware of the financial health of the companies they invest in and be prepared for the possibility of dividend cuts, especially during recessions.

Slower growth potential

Companies that pay high dividends might reinvest less of their profits back into the business. This can lead to slower growth compared to companies that plow all their earnings back into expansion and innovation. If you’re looking for rapid growth, dividend stocks might not always be the best choice. Growth-focused investors might want to select companies that reinvest profits to fuel further expansion rather than distributing them as dividends. However, dividend stocks could still play a role in growth portfolios. Depending on your own circumstances, it often makes sense to diversify and include both growth stocks and more stable companies, including dividend-paying companies, spread across a broad range of industries.

Tax implications

Canadian dividends are tax-advantaged when compared to investment income but may or may not be taxed at a lower rate than capital gains, depending on your circumstances.¹

Dividends from foreign companies are treated as regular income and taxed at your highest marginal tax rate. This can reduce the overall return on your investments in foreign dividend-paying stocks. Foreign stocks hold an important place in many portfolios, especially for diversification purposes, but it’s important to consider tax implications when evaluating these investments.

Market risk

Like all stocks, dividend stocks are vulnerable to market risk. Their prices can go up and down based on market conditions, economic factors and company performance. Even if a company is paying dividends, the stock price could decline, affecting your overall portfolio value. Diversifying your portfolio can help manage this risk, but it’s important to remember that no investment is completely risk-free.

Interest rate sensitivity

Dividend stocks can also be sensitive to changes in interest rates. When interest rates rise, income-seeking investors might shift their focus from dividend stocks to fixed-income securities like bonds, which may offer higher yields. This shift can put downward pressure on dividend stock prices and make them less attractive.

Dividend stocks offer a mix of consistent income, stability and growth potential that makes them attractive for many investors. However, they also come with risks and limitations that should be carefully evaluated. Whether you’re looking for steady income or a balanced approach to growth, understanding the advantages and drawbacks of dividend stocks, especially within the Canadian tax context, can help you make informed investment decisions.

Next up is Dividend stocks, part 3: Choosing dividend stocks