Quite a few people select to invest only in stocks that pay (high) dividends. To them, the higher the dividend, the better. They believe that companies have the obligation to reward their investors, offering them back some of the earnings achieved during the quarter, or the year in cash. Is this strategy worth it though? You may be surprised, but despite what supporters of this strategy say, there are both pros and cons.

You get some cash back, but often not as much

Many governments choose to tax separately dividend income from regular income. And stockbrokers are often tasked to withhold the tax you would normally pay with your tax return. So, although the company you have invested is paying you say $1 in dividends, you end up receiving - depending on where you live - even as low as 70 cents. If you had invested the same amount of money in a company that is not paying any dividend, you would have to pay tax only if you had sold your stocks and made profit out of this trade. Moreover, your dividend income tax is not counting against your total tax obligations. If the tax you paid for any dividends you received is higher than the tax you would have to pay for your total income, you do not get a tax credit for the excess tax you paid through withholding.

Dividend is not interest

Inexperienced investors believe that dividends paid by the companies are similar to interest paid by your bank in your bank account. Truth couldn't be further than that. Your bank account is not related to the capitalization of the bank you have your account with. To your bank, you are just a vendor or supplier of money, not a partner. Interest payable is cost to your bank, not share of profit. Dividend in the other hand is a share of the profit the company you have invested in has achieved. The thing with profit (or EPS - Earnings Per Share), is that it is reflected in the stock price. Investors buy stocks in companies that are generating earnings (or are expected to in the future), and thus the intrinsic or book value of each stock will be higher in the future. When a company is paying dividends, this intrinsic or book value is reduced, because the company is voluntarily returning some of its intrinsic value back to its investors in the form of cash.

And guess what? This is reflected in the price of each stock. It is called Price Adjustment. If a company is paying a dividend of $1 on January 1st, and the closing price on December 31st is $100, in the morning of January 1st, the closing price is adjusted to $99, in order to reflect the change of value of the stock. Thus - at least in theory - you still have a stock worth $100; $1 in cash paid through the dividend, and another $99 in stock valuation. In reality though, if you are subject to tax withholding, your $100 are now worth $99.90 or even $99.70, because of the tax withholding.

Dividend reinvestment does not make sense

If you take your (taxed) dividend and you reinvest it in the company that paid it, is similar to not receiving any dividend at all. It's like taking money out of your right pocket and putting them in your left pocket. In the example above, if you own 100 shares of the said company and receive $100 in dividend (and no tax withholding is counted here), that you reinvest in the company for $99 (due to price adjustment), you now have 101 shares worth $9,990 and $10 in cash. If no dividend had been paid, you would have 100 shares worth $10,000. For the everyday investor, this doesn't make any difference. It would make a difference for wealthy investors, owning 10% or 20% in the company, since the dividend is financing any increase in their company ownership.

You can't make a living or retire on dividends

Despite what dividend investment strategy supporters preach, you cannot make a living on dividends, unless you have invested huge sums of money during the years, and the companies you have invested in have skyrocketed. At 3% annual dividend yields, even if your stocks are worth 5 times the invested value, in current terms to get even just $24,000 per year, you need to have invested about $200,000 in current value (and chances are that $24,000 per year will be pocket money in say 20-30 years time). In the other hand, companies paying high dividends always underperform compared to companies that do not pay any dividends at all.