This article is part of the Retirement Financial Life Equation (RFLE) series.
I need to confess: In retirement, I’m what I call a “growth and income” investor, not a pure total-return investor. I suspect that’s true for many retirees, especially those in their 70s and beyond.
What I mean is that as a retiree, I strongly prefer receiving a dollar from stock dividends or bond interest over a dollar generated from selling appreciated shares. I know this preference runs counter to modern portfolio theory. I know dividends don’t create “free money.” I know that when a company pays a $1 dividend, the stock price drops by roughly $1. I am aware of all the academic arguments against focusing on dividends.
Nevertheless, I still allocate about a third of my stock portfolio to dividend-paying stock funds.
This puts me at odds with much of the financial planning establishment, which correctly points out that from a purely mathematical perspective, dividends and capital gains are economically equivalent. Whether you receive $1,000 in dividends or sell $1,000 worth of appreciated stock, you end up with $1,000 in cash either way.
But here’s what eight years of actual retirement have taught me: Retirement is about simplicity. It’s also experienced in real time, with real emotions, during real market crashes. And during those crashes, the psychological difference between receiving dividends and selling shares feels enormous, even if the math says it shouldn’t.
Let me explain why I invest the way I do, acknowledge the legitimate arguments against my approach, and help you decide whether dividend-focused investing makes sense for your retirement.
The academic case against dividend investing
Before I defend my preference for dividends (and I really don’t have much of onee—it is more about preference), let’s honestly examine what financial theory says about them. The critics make valid points worth understanding.
Dividend irrelevance theory
In 1961, economists Merton Miller and Franco Modigliani published their groundbreaking paper “Dividend Policy, Growth, and the Valuation of Shares,” which established the dividend irrelevance theory. Their argument, simplified: dividend policy should be irrelevant to stock returns.
Here’s why: When a company pays a $2 dividend per share, the stock price immediately drops by approximately $2 per share. If you owned a $100 stock that pays a $2 dividend, you now have a $98 stock plus $2 in cash—still worth $100 total. You haven’t gained anything you didn’t already have. The dividend merely converted some of your stock value into cash.
This is mathematically correct. The dividend didn’t create value; it redistributed existing value from the company to your pocket.
The “free dividend fallacy”
University of Chicago finance professor Samuel Hartzmark describes what he calls the “free dividend fallacy,” the mistaken belief that dividends constitute independent returns distinct from stock appreciation. Many investors, he argues, mentally categorize dividends as “income” and stock price changes as “principal,” treating them differently even though they’re economically identical.
This mental accounting leads investors to perceive dividends as similar to bond interest, which is incorrect. When a $10,000 bond pays $400 in interest, you still own a $10,000 bond. When $10,000 of stock pays $400 in dividends, your stock is now worth $9,600. The situations are fundamentally different.
The tax inefficiency problem
From a tax perspective, dividends are actually worse than capital gains in most situations:
Qualified dividends are taxed when received (even if you don’t need the money). The amount of tax they pay varies with their total income. You have no control over the timing; you must pay taxes in the year dividends are received. Nor do you have any ability to offset gains with losses.
Capital gains are only taxed when you sell (complete timing control) and may be taxed at more attractive rates. (You can defer taxes indefinitely by not selling.) You can do what’s called “tax loss harvesting” to offset gains. And you can choose which tax lots to sell for optimal tax efficiency.
Warren Buffett has famously argued that Berkshire Hathaway’s refusal to pay dividends actually benefits shareholders. He suggests that investors can “create their own dividends” by selling shares when needed, which is more tax-efficient than receiving forced dividend distributions.
He makes a good point.
Sector concentration risk
Modern dividend-paying stocks are concentrated in more conservative (stable) areas of the economy, such as utilities, real estate, consumer staples, telecommunications, and energy.
Meanwhile, high-growth technology companies—which have dominated market returns over the past decade—typically pay little or no dividends. By loading up on dividend stocks, you’re inadvertently making a sector bet that may reduce your diversification and potentially lower your returns.
Recent performance data
In addition to some stock index funds, including the S&P 500, I also own two dividend funds: Fidelity High Dividend ETF (FDVV) and Schwab U.S. Dividend Equity (SCHD).
Over the past 5-10 years, most dividend-focused funds have underperformed the S&P 500. For example, from 2015 to 2023:
- S&P 500 total return: ~297%
- Fidelity High Dividend Yield (FDVV) ~209%
- Schwab U.S. Dividend Equity (SCHD)
- Vanguard High Dividend Yield (VYM): ~140%
- SPDR S&P Dividend (SDY): ~120%
- iShares Select Dividend (DVY): ~95%
My funds have outperformed some others, but the underperformance versus the S&P 500 isn’t trivial. In some cases, dividend funds returned half what the broad market delivered. (More on this in a bit.)
Why do I still like receiving dividends?
Given these legitimate and highly persuasive arguments against dividend investing, why do I tilt my portfolio toward dividend payers? I can give you three good reasons: psychological comfort, behavior management, and practical cash flow.
Psychological comfort during crashes
Here’s what academic theory misses: how it feels to live through a bear market as a retiree.
During the 2022 market decline, the S&P 500 dropped 18%. My stock allocation fell by roughly the same amount. However, throughout that decline, my dividend-paying stocks continued to send quarterly distributions to my account.
Even as my portfolio value declined on paper, I received dividend income that year. That income didn’t stop. It fell slightly but didn’t decline proportionally with stock prices. It just kept coming.
Compare this with the alternative of selling shares during the decline to generate cash. Theoretically equivalent, but psychologically? Worlds apart.
Dividends are more stable than stock prices
The data on dividend stability versus price volatility is striking. During the Great Depression—the worst market crash in American history—stock prices declined nearly 90% from peak to trough, but dividends were cut by less than 50%.
Let that sink in: Even in the most catastrophic market collapse ever, dividends proved far more stable than prices.
More recent data confirms this pattern:
- 2008 Financial Crisis: S&P 500 declined 56.5%, dividends declined ~21%
- 2020 COVID Crash: S&P 500 declined 34%, dividends declined ~2%
- 2022 Inflation Crisis: S&P 500 declined 18%, dividends increased 10%
This stability matters enormously for retirees. When you’re living on portfolio withdrawals, having income sources that decline far less than prices provides crucial stability.
Dividends help prevent panic selling
The most important reason I prefer dividends has nothing to do with returns and everything to do with behavior management, or more informally, what I call the “sleep at night factor.”
During bear markets, many retirees panic and sell at the bottom. This destroys wealth and ruins retirement plans. However, here’s what I’ve observed about dividend investors: they tend to hold through volatility better than total-return investors.
Why? Because they’re receiving tangible, spendable income even as prices fall. As long as the dividends keep coming, they can tell themselves: “My stocks are still working. They’re still paying me. I don’t need to sell.”
This is behavioral finance at its finest. Yes, they could sell shares to create the same income. But most don’t. The mental accounting that academics criticize—treating dividends as “income” and share sales as “depleting principal”—actually prevents destructive behavior during crashes.
Dividends as a “bond substitute”
In August 2020, Burton Malkiel—author of the influential classic, A Random Walk Down Wall Street (a book I heartily recommend, by the way)—made a controversial suggestion while promoting the 12th edition of his book. On Morningstar’s The Long View podcast, he described the then-prevailing low-interest-rate environment as “financial repression”. He recommended that retirees consider reducing bond allocations in favor of what he termed “bond substitutes”: preferred stocks and high-dividend equities.
As noted earlier, in addition to a total market index fund, an S&P 500 index fund, and an international stock fund (primarily for growth, with some dividends), I also own two dividend funds: Fidelity High Dividend ETF (FDVV) and Schwab (SCHD). I don’t hold these as “bond substitutes” but rather for “growth and income” that may exceed that of bonds over the long term, with lower risk than growth stock funds.
So, I was curious about how these funds have performed compared to alternatives since 2020.
As shown in the chart, my “bond substitutes” (although I don’t really think of them that way) outperformed bonds, with high-dividend equities substantially outperforming bonds and providing better downside protection during the 2022 inflation crisis than traditional bonds. FDVV and SCHD both lost approximately 4% in 2022, while bonds declined 13% and the S&P 500 fell 18%.
My “bond substitutes” prevailed, though not uniformly. High-dividend equities outperformed preferred stocks, which delivered more modest returns. But the blended approach—combining stability-oriented preferred shares with growth-oriented dividend equities—accomplished exactly what Malkiel suggested: providing income while preserving and growing purchasing power in ways that traditional bonds couldn’t match during this period.
The 2020-2025 period of initially suppressed rates, followed by rapid inflation, and then normalization exposed the limitations of conventional fixed-income investing.
But that doesn’t mean every retiree should have dumped bonds for dividend stocks in 2020. However, it suggests that quality dividend-paying equities warrant consideration as part of the income-generating toolkit, particularly when bond yields are artificially suppressed or when inflation threatens to erode the purchasing power of fixed income.
Practical cash flow
There’s also a simple, practical advantage, which is the main reason I prefer receiving dividends: dividend funds, similar to bond funds, automate cash flow.
With a dividend-focused portfolio yielding 3.5% on $500,000, the portfolio will pay quarterly dividends of $4,375. These payments will arrive automatically and don’t require any specific action on my part regarding how many shares to sell and when.
The dividend approach eliminates decision fatigue. Money arrives, and I spend it as income. Simple.
After eight years of retirement, I’ve learned that simplicity has enormous value. Anything that reduces the number of monthly financial decisions is worth considering, even if it costs a few basis points in returns.
Who should (and shouldn’t) consider dividend investing
Based on eight years of actual retirement experience, here’s my assessment:
Dividend investing makes sense if you:
Have a portfolio that is large enough to generate enough yield to give you the income you need. This is important: with a smaller portfolio, a total-return strategy will likely perform better over the long run.
Value the “sleep at night factor” over maximum returns: If seeing regular deposits hit your account helps you sleep better and prevents panic selling, dividends are worth the potential return drag.
Are in retirement or near-retirement: The stability and predictable income matter more than they did during the accumulation phase.
Have lower risk tolerance: If market volatility keeps you up at night, dividend stability helps.
Want to simplify cash flow: Automatic quarterly income beats monthly selling decisions.
Are in a lower tax bracket in retirement: Tax-efficiency concerns are minimal at these rates.
Understand that you’re making a behavioral choice, not necessarily a return-maximizing choice: This is key. Don’t fool yourself into thinking dividends will outperform. They might not. You’re choosing stability and psychology over potential returns.
Avoid dividend focus if you:
Are in accumulation phase (under 55): You don’t need income now; you need growth. Total market funds make more sense.
Are in high tax brackets (27%+ federal): The tax inefficiency of dividends versus deferred capital gains becomes costly.
Are maximizing returns over a 20+ year horizon: Younger retirees (60s) with long time horizons may benefit more from a total market approach.
Cannot tolerate sector concentration: Dividend stocks tend to skew toward specific sectors, reducing diversification.
Panic sell during crashes anyway: If you’ll panic regardless of dividend income, don’t bother—the psychological benefit won’t help you.
Are investing in tax-deferred accounts: No tax advantage to dividends in IRAs/401(k)s, so just own total market funds.
Theory vs. reality
Academic theory is correct: dividends don’t create value. They’re economically equivalent to selling shares. From a pure mathematics perspective, dividend investing is suboptimal.
But retirement isn’t lived in theory.
After eight years of retirement, including the 2020 COVID crash and 2022 inflation crisis, I can confirm: receiving dividends during volatility feels completely different from selling shares during volatility, even though the math says it shouldn’t.
(Now I admit that holding some cash in reserve can prevent having to sell shares for income during a down market, but many retirees who need to make a small stock portfolio last as long as possible don’t have the luxury of maintaining a large cash stash.)
That psychological difference translates to a behavioral difference. I held through both crashes without panic selling. I maintained my allocation. I stayed the course. The regular dividend deposits helped me do that.
Would I have behaved as well if I had had to sell $2,000- $ 3,000 worth of shares each month during those crashes? Honestly, I don’t know. Maybe. But the dividends made it easier.
My approach sacrifices some potential return for:
- Psychological comfort
- Behavioral stability
- Simplified cash flow
- Inflation protection (dividend growth)
- Sleep-at-night factor
Is this optimal? No.
Does it work for me? Yes.
Will it work for you? That depends on whether you value behavioral stability over maximum theoretical returns.
Bottom line
Dividend investing in retirement comes down to honest self-assessment:
If you can emotionally handle selling 3-4% of your portfolio annually during bear markets without panic, stress, or sleepless nights, then total return investing is theoretically superior. You’ll likely get better tax efficiency and higher long-term returns.
If the idea of selling shares during a 30% decline makes you anxious, or if you value the psychological comfort of automated income, then dividend investing makes sense despite being theoretically suboptimal.
I’m in the second camp. I know the theory. I understand the math. I acknowledge the tax inefficiency. And I still prefer dividends.
Why? Because I’m not optimizing for theoretical maximum returns. I’m optimizing for the highest probability that I’ll remain invested through the inevitable crashes that will occur over my 25-30-year retirement.
Dividends help me do that. The regular deposits remind me that my investments are still working even when prices are down. That’s worth something, even if it doesn’t show up in a Sharpe ratio.
You have to decide what you’re optimizing for: maximum returns or maximum behavioral stability. Both are valid. Neither is wrong. But you can’t optimize for both simultaneously.
I’ve chosen behavioral stability. If that costs me 0.5-1% annually in returns, it’s a price I’m willing to pay for the confidence to hold through volatility without panic.
That’s the real dividend.