When it comes to investing, there are usually detailed, seemingly murky, questions that often arise which require some digging into. For example: Should I be investing for dividend yield? Is it safer to invest in dividend stocks? Are dividend stocks good to own in retirement?
Abacus’ advisors regularly field many questions about investing in dividend stocks. It’s not surprising. We often get inquiries about whichever investment approach is in the news.
Let’s explore and find some clarity.
What is Investing for Dividends?
First, let’s define what investing for dividends means. An investor’s total stock return is derived from two sources. One is capital appreciation, or an increase in the stock’s price. This is similar to your home increasing in value. You can’t spend the gain until you sell the house, but you are also not taxed until you sell.
The second source of stock returns is dividend yield, or payments made by companies to shareholders at regular intervals. This is like receiving rent for leasing your house. You are taxed every time you receive them. Together, capital appreciation and dividend yield comprise total stock return.
Want smart updates on the world of money?
How Dividend Investing Works in Practice
Let’s look at two very different examples of dividend paying stocks.
The past four quarterly dividends paid by Apple have been $0.25 as of February 2025. Based on Apple’s 2/7/2025 intraday price of $228.46 per share, that equates to a dividend yield of 0.437%. Apple’s shares also increased in value by 20.87% over the prior 12 months. For Apple, dividends have been and are expected to play a small role while capital appreciation has been and will likely remain the main driver of its returns.
Johnson & Johnson’s dividend, over the same period, paid a 3.23% dividend yield, more than six times greater than Apple. Dividends are a far larger portion of its long-term expected returns. Investment funds that target dividend paying stocks focus more on companies like Johnson & Johnson and less on companies like Apple.
Looking at the Vanguard Russell 3000 Index Fund (symbol VRTTX) which tracks the 3000 largest publicly traded US Most companies, paid a dividend yield of 1.40% as of the close of market on 1/31/2025. Many larger companies pay a dividend while fewer small companies do.
How Dividend Paying Stocks Underperform
If you care about maximizing your income, focusing on dividend paying stocks has not been an effective strategy. Dividend paying stocks, as exemplified by what Morningstar declares as the best dividend funds (as shown in the article linked below), have underperformed stocks in general over the long term.
In December of 2024, Morningstar published a list of “The Best Dividend Funds: These dividend ETFs and mutual funds earn high ratings from Morningstar in 2025.” That seems like a fair representative sampling of desirable dividend focused mutual funds and ETFs. Five of those funds (or their predecessor share classes) have been in existence since at least 5/31/1992. And if we compare them to the Vanguard 500 Index Admiral fund, an index fund that has been around since 1976, over the period from 5/31/1992 to 2/6/2025, a bit over 42 years, the dividend funds have not done as well as the S&P 500, often thought of as “the market.”
Source: Vanguard 500 Index Admiral VFIAX. 5/31/1992 to 2/6/2025. Morning Star. https://www.morningstar.com/funds/xnas/vfiax/chart
Whereas, VFIAX clocked an average annual return of 10.05% over the entire period, all of the compared dividend funds trailed, meaningfully, in ways that really add up over time. It makes sense. The appeal of a dividend fund is generally that it is less risky. As risk and return are correlated, we would expect a lower risk fund, in general, to do worse than a high risk fund.
There are other reasons not to favor dividend stocks. A focus on dividend yield sacrifices sector diversification. High dividend yields tend to occur in companies concentrated in consumer staples, utilities, telecoms, energy, and real estate. This can expose an investor to significant sector-specific risks.
Why a Diversified Portfolio May Be a Better Choice
A diversified portfolio, on the other hand, spreads investments across all sectors, thereby mitigating the risks associated with any one sector’s poor performance.
Dividend focused funds tend to be highly concentrated in US stocks. The best performing of the above dividend focused funds, BlackRock Equity Dividend Institutional (MADVX) is typical of these funds with 81.51% of its holdings in US stocks. Not having an international exposure could be costly.
For example, US stocks, as exemplified the S&P 500 index had a negative 0.91% average annual return from 2000 to 2009. That is a decades-long cumulative loss of roughly 8.78%, as exemplified by VINIX, a popular mutual fund that provides exposure to the index. Some refer to that period of time as the United States’ ‘Lost Decade’. Meanwhile, international stocks, as exemplified by VTIAX, bested US stocks over the same period by an average of 3.20% annually. We don’t like our clients losing decades, especially in retirement.
Dividend focused funds tend to be highly concentrated in large stocks which are far more likely to pay dividends. At Abacus, we actually overrepresent small stocks in our client portfolios, because small company stocks have had a higher return historically. That return derives from their higher risk. Heightened expected risk has a heightened expected reward. Smallness in market capitalization is a source of higher expected returns that is not available when investing for dividends.
What are the Taxes for Dividend Investing?
Dividend yield is less tax efficient than capital appreciation. Qualified dividends and capital gains are taxed at the same rate (20% Federal). But dividends are taxed every time they are received, whereas capital appreciation is only taxed when you sell. Imagine a tree that grows 10 inches every year. And then every year, two inches are cut off. That is similar to how dividends are taxed. Capital appreciation is a tree you only trim when you need some wood.
In Exhibit 2 below, two investments have the same rate of return and taxation – the only difference is one is entirely dividends being taxed annually and the other entirely long-term capital gains being taxed at the very end. Long-term capital gains enjoyed a roughly 15% advantage in after-tax returns over 15 years. Time compounds this effect.
Source: Own Work. Hypothetical Numbers.
Disclosure: For illustrative purposes only. This example is based solely on straight calculations of rate of return and tax rate. It does not take into consideration any other financial, investment, or personal factors. It also assumes a 20% tax rate applicable for the 2025 tax year. This material is not intended to serve as personalized tax and/or investment advice since the availability and effectiveness of any strategy is dependent upon your individual facts and circumstances. Abacus Wealth Partners, LLC is not an accounting firm. Please consult with your tax professional regarding your specific tax situation when determining your personal tax rate and if any of the mentioned strategies are right for you.
Other Dividend Investing Tips to Remember
People often fail to appreciate that dividends can be (and have been) cut. Companies sometimes decide to reduce or eliminate their dividends during difficult economic times or due to poor company performance. This could lead to significant declines in stock prices, as has happened to many financial and energy firms during economic downturns. In 2020, during the height of the pandemic, global dividends fell by $220 billion – or 12% of total global dividends.
Dividend stocks especially received a lot of buzz due to their outperformance in 2022. But dividend stocks are perennially popular despite evidence to the contrary. Why? Perhaps it is easier to conceptualize dividends than to think about selling shares. One can imagine people failing to realize that a stock’s price declines by the exact amount of the dividend that has just been paid. Comparing the two examples in Exhibit 3 below, you can see that whether via dividends or via a sale of shares, both paths are mathematically identical.
Source: Own Work. Hypothetical Numbers.
Disclosure: Stocks ABC & XYZ are fictitious companies and the examples shown are for illustrative purposes only. Past performance is no guarantee of future results, and there is no assurance of price increase or dividend guarantee. This material is not intended to serve as personalized tax and/or investment advice since the availability and effectiveness of any strategy is dependent upon your individual facts and circumstances. Abacus Wealth Partners, LLC is not an accounting firm. Please consult with your tax professional regarding your specific tax situation when determining your personal tax rate and if any of the mentioned strategies are right for you.
Staying the Investment Strategy Course
Always remember that the financial press is selling clicks. They don’t necessarily have your best interest at heart. Next time you read or hear anything from the media, take it with a grain of salt. They can hawk any idea that captures eyeballs without having to comply with government oversight or actually being accountable to a client.
There are any number of investment strategies you will read about over your lifetime. Whatever you do, don’t switch investment strategies repeatedly. Indecision can convert a suboptimal approach into a potential investment trainwreck.
At Abacus, we apply investment principles based on academic research. This research has a high degree of statistical confidence that, when maintained over long periods of time, is expected to be both increasingly dependable and provide a higher return than alternatives. Narrowing the range of outcomes over time is what makes our financial modeling so powerful. That is what allows you to be intentional about your life and financial choices.
If you’re curious how Abacus can help you better understand investment strategies that work for your unique situation, schedule a call with one of our financial advisors today.
