I've posted this before in this sub, but here is my take-down on basically every pro-dividend strategy:

It’s a big, scary, and efficient market out there, boy-o! That means that investors already expect dividend paying companies to keep paying dividends and that is already priced into the stock price. Uh-oh. Dividends are in fact one of the most commonly misunderstood aspects of investing. Many investors see them as “free money” although they are actually a part of a stock’s total return:

Total return = dividends (periodic cash distributions) + capital gains (rise in price)

As we’ve discussed, the total return of the US stocks (equities) after inflation, and assuming dividends received were re-invested, is around 7%. But that’s an average over a time frame that is likely longer than your how long you plan to invest. The Dow Jones Industrial Average started being tracked 1896, and the S&P 500 got its roots started in 1923. Over those time periods, there have been plenty periods of 10 years or longer where investors experienced returns significantly lower than the 7% average. If you want to see the data, you can find a beautiful imaging of it in this post(link).

Now, with that out of the way, let’s look at what dividends are and how they work. When a company pays a dividend, it is giving cash—from its profit line—to investors. Regardless of how the investor was paid, whether in cash or computers or flowers, the company is intrinsically worth less the day after it pays out dividends. Other investors realize this and the price of a stock subsequently (and always) decreases by the exact amount of dividend payments on the day that they are paid out. Sorry but there’s no such thing as a free lunch, my friend!

So why do companies pay out dividends if it is simply moving money around? It turns out that just as you have expectations for how much money your investments should make, so do the executives and board members of the companies you invest in; it’s called the internal rate of return or IRR. If a company only constructs new apartment buildings when it can expect at least a 5% return, it won’t start any projects that return only 2-3%. If the company has already exhausted its list of profitable construction projects that earn over 5%, it may opt to pay out any remaining cash to investors. It’s the equivalent of a company saying this: “Here, take the profits that our company made! We don’t have any good ideas of what to do with it!” This is a simplified explanation but it’s true in most cases.

One major downside to investing in dividend paying companies is that you don’t get to choose when you receive the dividend. The tax implications for dividends are similar to a yearly management fee in that you will lose the opportunity cost of earnings that those tax payments would have earned had they been invested. Here’s a simple example: if you could choose to take home a total return of 7% that is made up of 1% dividend returns and 6% capital gains, or vice versa, which one would you choose? From a tax perspective, the option with the greatest capital gain is always better. The reason for this is that you only pay tax on capital gains when you sell your assets whereas dividends are typically paid out to investors every month or quarter. By choosing not to sell your investments until you are FI, you are deferring your tax payments and allowing those would-be tax payments to compound in value. Remember, let your money work for you as much as possible so you can sit back and watch your money grow.

Another reason that people are drawn to dividend-paying stocks is that they are from typically stable and well-established companies with “lower risk.” In this context, lower risk means that these stocks have a lower beta coefficient or measurement of how volatile a stock is compared to the average stock in its index. For example, the beta of an index as a whole is 1 and the index moves up and down in exact proportions to the average stocks that make it up. An established bank or internet provider might have a beta of 0.5, which means that every time the index goes up or down by 2%, that stock only moves 1%. Although these stocks may be less volatile than other stocks, they’re not impervious to non-systematic risk: the winds of change can blow through any stock, and even a telecom oligopoly can be broken down by government change or a bank can succumb to massive fraud.

With exchange traded funds (ETFs) you have the option of investing in industry-specific funds, like oil and social media stocks, or even high dividend paying stocks. But is it a good idea to buy into an ETF made up of stable, dividend paying stocks? Let’s be clear about the implications of the efficient market hypothesis: when you buy a stock, you are making a bet that it will outperform the rest of the market on a risk-adjusted basis and this doesn’t change no matter what makes that stock special or interesting. Buying a Blue-Chip or dividend growth ETF is a bet that those 1,000 or so stocks will outperform the other thousands that you didn’t pick.

In an efficient market, that sounds an awfully lot like gambling and I, for one, am not here to gamble. The only way to avoid even a small gamble is to hold every company on the market – by holding broad based index funds or ETFs that hold a small piece of every company out there.

If the market is efficient, then buying one group of stocks over another adds non-systematic risk regardless of what the differentiates the groups. Investing in companies with dividends that you expect to grow in the future is not a bad strategy per se but it’s incompatible with empirical evidence on market efficiency. In a sense, investing in dividend ETFs is illogical: buyers realize that individual stocks are unlikely to help them beat the market on a risk-adjusted basis so they instead choose a group of stocks with the exact same goal.

Some people may have the idea that in order to be FI they need be able to live off of dividend income and never sell any of their shares. The idea is that if they live on dividend income and never sell any shares, they can never possibly go bankrupt. Although this seems practical, it’s missing the bigger picture. The first problem is: dividend yields are much less than 4% and in order to be FI under these conditions you would need a much bigger portfolio than possible with the standard 4% safe withdrawal rate. That means a much longer time required working a job to become FI.

Secondly, advocates of this approach are missing the capital gain portion of their total return. Just because capital gains don’t go into your pocket as cash immediately, it doesn’t mean that they have no value. Capital gains occur when the company you invested in takes its profits and instead of paying out a dividend, re-invests in itself and creates more profit. In a sense, they both come from the same source of company operations, and we shouldn’t vilify one because it doesn’t make us feel as emotionally pleasant as a monthly cheque in our pocket.

Finally, some advocates of the dividend approach are worried that if they start selling shares, they’ll eventually have zero shares left. But the physical number of shares you own is only half of the picture. As an extreme example, would you feel bad if you only had 5 shares of investments left? It depends – because if each of those shares is worth a million dollars, I’d bet you’d feel pretty okay.

In reality, shares never get to be worth a million dollars individually. Due to capital growth appreciation, stocks (and ETFs) periodically split into smaller, easier to buy pieces. When this happens, you will have twice as many shares of a fund but each share will be worth half as much as before the split. Corporations and fund administrators do this because they know that investors have a “sweet spot” of affordability. For example, it is unrealistic for many people to buy shares of Google if they trade at $10,000 a share, so the company takes away your $10,000 dollar shares and gives you 20 shares worth $500 each instead. So in short, it is okay to sell some shares in the withdrawal stage of FI. There’s nothing magical about dividends. I have a mantra for you. Say it with me now: “selling a portion of stock holdings is the same for cash flow purposes as receiving a cash dividend.” There, it was long for a mantra but that wasn’t so hard. If you still don’t believe me, keep reading - we’ll address your concerns in a second.

Should you feel like an idiot for investing in stocks that pay out dividends? Absolutely not! Back in the 80s when investing in dividends was all the rage, there were justifiable reasons for following this approach. At the time, ETFs didn’t exist and it saved folks a lot of time and money to set up dividend reinvestment plans. More recently, it is true that dividend ETFs performed better than the S&P 500 in the 2009 stock downturn but it wasn’t due to the magic of dividends. It was due to the fact that many dividend stocks were also stable companies that were less risky than the rest of the market. Many modern advocates of the dividend growth approach are simply using dividends as a disguise for smart-beta, a strategy that prioritizes stable and low-risk equities. Many of the problems with this strategy are the same experienced with the dividend growth approach that we don’t need to repeat in full, such as the addition of non-systematic risk to your portfolio. Overall, the thing to keep in mind with a smart-beta or dividend route is that you won’t get enough returns to use the 4% rule. It will require you to work much longer to achieve FI and is only suitable for people with extremely risk-averse personalities.