Canadian dividend stocks are often considered as a safe and reliable source of income for investors, especially in times of market volatility and low interest rates. However, some experts suggest that dividend stocks may not be the best choice for long-term investors, as they may offer lower returns, higher taxes, and less diversification than other alternatives.
The drawbacks of dividend stocks
One of the drawbacks of dividend stocks is that they may offer lower returns than growth stocks, which are stocks that reinvest their earnings to expand their business and increase their share price. According to a study by MSCI, growth stocks outperformed dividend stocks by an annualized rate of 5.4% in Canada, and by 3.9% globally, over the past 20 years.
Another drawback of dividend stocks is that they may incur higher taxes than capital gains, which are profits from selling stocks at a higher price than the purchase price. In Canada, dividends are taxed at a higher rate than capital gains, depending on the investor’s income and the type of dividend. For example, in 2023, the marginal tax rate on eligible dividends was 29.65% for an investor with a taxable income of $100,000, while the marginal tax rate on capital gains was 21.7%.
A third drawback of dividend stocks is that they may offer less diversification than other types of stocks, as they tend to be concentrated in certain sectors, such as financials, utilities, and energy. These sectors may be more exposed to cyclical and regulatory risks, and may not capture the growth potential of emerging sectors, such as technology, health care, and consumer discretionary. According to the S&P/TSX Composite Index, the top three sectors by weight in 2023 were financials (32.6%), energy (19.2%), and materials (12.4%), while the bottom three sectors were health care (1.2%), consumer discretionary (4.3%), and information technology (5.1%).
The alternatives to dividend stocks
Given the drawbacks of dividend stocks, some experts suggest that long-term investors may be better off with other alternatives, such as growth stocks, exchange-traded funds (ETFs), or dividend reinvestment plans (DRIPs).
Growth stocks are stocks that have the potential to increase their earnings and share price faster than the average market, as they invest in innovation, expansion, and acquisition. Growth stocks may offer higher returns, lower taxes, and more diversification than dividend stocks, as they span across various sectors, industries, and regions. However, growth stocks may also entail higher risks, volatility, and uncertainty, as they depend on the future performance and prospects of the company.
ETFs are funds that track the performance of a basket of stocks, bonds, commodities, or other assets, and trade on a stock exchange like a stock. ETFs may offer lower costs, higher liquidity, and more diversification than dividend stocks, as they allow investors to access a wide range of markets, sectors, and strategies with a single purchase. However, ETFs may also have some disadvantages, such as tracking errors, management fees, and currency fluctuations.
DRIPs are plans that allow investors to reinvest their dividends to buy more shares of the same company, instead of receiving cash payments. DRIPs may offer lower commissions, higher compounding, and more flexibility than dividend stocks, as they enable investors to accumulate more shares over time, without paying brokerage fees, and to adjust their reinvestment rate according to their needs. However, DRIPs may also have some drawbacks, such as tax implications, price fluctuations, and limited choices.
The bottom line
Canadian dividend stocks are not necessarily a bad investment, as they can provide a steady and stable income for investors, especially in times of low interest rates and market volatility. However, dividend stocks may not be the best choice for long-term investors, as they may offer lower returns, higher taxes, and less diversification than other alternatives, such as growth stocks, ETFs, or DRIPs. Therefore, investors should consider their goals, risk tolerance, and time horizon, and diversify their portfolio with a mix of different types of stocks and assets.