Our income investing series continues with Part 4. You can check out Parts 1, 2 and 3 here, here and here.

Dividend stocks are a crucial component of an investor’s portfolio, and rightfully so. This group of stocks bring a list of benefits to the investor which other stock types do not offer.

Here, we discuss the pros and cons of owning dividend stocks.

Pros

Investors have two options in handling their dividend pay-outs. They can receive the dividends as cash or directly reinvest the dividends into the company’s stock.

If no action is taken, the former will take place. The latter is known as the Dividend Reinvestment Plan (DRIP).

Both options have their merits, and we will illustrate this with an example. In the example, we track Johnson and Johnson’s (NYSE: JNJ) stock for a period of 10 years, from July 2010 to July 2020.

Buying 200 shares @ US$58.09 in 2010, the total initial asset value will be $11,618. Let us take a look at the outcome as of July 2020.

If you had not chosen DRIP, your total asset value from this stock would be US$35,258, a 203% increase.

This can be broken down into two components: capital appreciation and dividends received. US$29,308 from holding 200 shares @ US$146.54 and US$5,950 in dividend pay-outs.

This means that you have your initial 200 shares and have received an average of US$50 / month in pre-tax income from 2010.

This passive income is available in your bank account for your spending.

The point to make here is that if you believe the cash is better utilised by yourself rather than in management’s hands, then it makes sense to accept cash rather than participate in the DRIP.

On the other hand, if you had opted for DRIP, your total asset value from this stock would be US$39,991, a 244% increase. You will be holding 272.9 shares of Johnson and Johnson @ US$146.54 in July 2020.

In this case, your dividends are reinvested into the company. Over the years, these dividends have compounded.

Your original dividends have therefore been utilised to generate even more dividends. This process continues until you choose to opt-out of DRIP.

For the above example, you will end up own 36.5% more shares over the course of ten years.

As a result of owning more shares, you will also receive 36.5% more dividends than an investor who did not opt for DRIP.

In the event of a crisis, most companies will suffer a fall in share price as demand for goods and services declines. Some of these companies may not be affected by the crisis, with their business continuing to run smoothly.

For dividend stocks, capital appreciation is only part of the equation. Although stock prices may have decreased due to the panic, resilient companies will still be able to pay out stable dividends.

This continued payout provides a safety net for investors during bear markets.

Cons

Risks should be factored in for any investment you make. Here are some cons to consider for dividend stocks.

All companies have options on how to utilise their cash.

By paying dividends to the investors, the company ends up with less cash for reinvestment.

This may hinder the company’s ability to improve its processes and/or grow, which might affect its capital appreciation.

Interestingly, growth and dividend pay-outs are interlinked. A company which has achieved growth over the years is better able to pay out higher dividends, while increasing dividend payouts over the years is also a reason for capital appreciation.

Dividend traps

Dividends allow you to experience the wonders of compounding interest, as well as provides a stream of passive income for your spending.

However, there are also side effects if you are not careful.

Known as dividend traps, these stocks pay-out attractive but unsustainable dividends.

Unlike REITs, dividend companies can alter their dividend pay-outs anytime. This means that they can increase or even stop their dividend payments at any moment.

Thankfully, these changes are often predictable if you keep track of the company’s business and financials.

Investors should pay extra attention to high-yield dividend stocks.

Next week, we will cover the key criteria to differentiate between good and bad dividend stocks.

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