Dividend investing is a popular, but flawed investing approach promoted by popular blogs like wallethacks.com, thedividendguy.com, dividendearner.com, and countless others. This approach, which favors investing in dividend stocks, implicitly excludes non dividend paying stocks from an investment portfolio. While there are valid reasons to invest in dividend stocks, excluding non-dividend paying stocks from a portfolio will lead to lower returns and higher risk for the investor.
When companies make profits, managers can reinvest the profits, or return cash to shareholders through dividends, buybacks, or both. Since profits are finite, one dollar returned to shareholders is one dollar not reinvested. Because of this dynamic, companies typically only start returning money to shareholders when they are mature and stable.
Dividend investing inherently focuses on mature companies and limits diversification
While both dividends and buybacks are discretionary, buybacks are more flexible. If financial conditions deteriorate, buybacks are often slowed, reduced, or stopped. In contrast, paying dividends requires management to commit to returning cash in predictable intervals and amounts. When management reduces or halts dividend payments, the stock price of the company often drops as it signals lower confidence in the company’s future prospects. As a result, dividend paying companies are even likely to be more mature, consistently profitable, and predictable than companies that only buy back shares.
Lack of exposure to strong performing companies and emerging industries hurts portfolios
However, non dividend paying companies can also be mature, consistently profitable, and stable. In addition, fast growing companies and companies in emerging industries like cloud computing, cannabis, e-commerce rarely pay dividends. As a result, investors following the dividend investing approach excludes many mature and profitable companies, most fast growing companies, and entire emerging industries from their portfolios. This lack of diversification led to higher risk and lower returns in the last ten years: as many of the best performing companies were excluded from investment consideration.
For example, as of July 2020 the stock price of the five largest stocks in the S&P500 (Apple, Microsoft, Amazon, Facebook, and Alphabet) rose 58.1% in the past 12 months, compared to 0.6% for the rest of S&P500. Out of these five companies, Facebook, Alphabet, and Amazon do not pay dividends. Other companies such as Fastly, Shopify, Twilio that grew fast and performed even better do not pay dividends either. On a more macro level, both high yield dividend investing and dividend growth investing were suboptimal, as Vanguard’s S&P500 high dividend yield ETF and S&P500 dividend aristocrats ETF both underperformed the S&P500 and NASDAQ in all periods (year to date, one year, five year, and ten year) as of October 15th, 2020.
Capital gains income is more flexible and tax friendly
Tax implication of dividends must also be considered. Unlike share buybacks and reinvesting profits, dividend payments are taxable events, which leads to reduced returns and lower flexibility for investors. Capital gains on the other hand, are only taxed when investors sell shares and realize gains. This allows investors to compound gains pre-tax, pay capital gains tax on their own schedule, and use losses to offset capital gains, ultimately reducing their tax burden improving after tax returns.
What to do instead: have a clear investment plan
This is not to say investors should pick non dividend stocks over dividend stocks or vice versa. Instead, investors should construct a portfolio that reflect their investment objectives, such as risk, return, required income, and time horizon. Then, evaluate each investment opportunity against such objectives. Since dividends are paid at a regular interval and in predictable amounts, dividend paying stocks can contribute to income objectives. If there is sufficient income for a portfolio, or if income is not a consideration, then whether a company pays dividends become less relevant.
Constructing a portfolio is tedious work, and in most cases, investors are better off with a low cost S&P500 index fund, which performs better than dividend investing and requires almost no work. However, for investors who rather manage their own investments, defining investment objectives clearly, researching investments comprehensively, and learning from mistakes earnestly, will help provide a better chance of achieving the desired result.
Some common, but invalid arguments
Argument 1: Dividends paying stocks are likely to have sound finances and are safer to invest in
Why it is invalid: While many financially sound companies pay dividends, paying dividends does not guarantee that a company’s finances are healthy. Conversely, many companies with excellent financial health don’t pay dividends. Whether a company pays a dividend should not be used as a shortcut to determine the financial health of a company. To assess a company as a potential investment, investors should understand the financial statements, business model, industry trends, and more.
Argument 2: Dividend paying stocks provide better returns, with the specific points below
- Dividend paying companies benefits from both capital appreciation and dividends
- Dividend announcements impact stock returns
- Grow yield on cost by buying low & investing in companies that grow their dividends
- Dividends compound growth when you reinvest back into the company
Why it is invalid: Every dollar not paid as dividends, is reinvested into the company or returned through buybacks; this is reflected in the stock price. All things equal, when companies go ex-dividend, the stock price often drops to reflect the dividend to be paid. This is because dividend payments are paper transactions: a company you invested in transfers its cash to your personal account. And while stock prices go down or up when companies reduce, stop, or raise dividends, this is due to the signal it provides. Management signals confidence about the company’s future when initiating or raising dividends. Inversely, reducing or suspending dividends often signals the opposite.
Argument 3: Dividends provide passive Income like bonds, but are less sensitive to interest rate movement
Why it is invalid: The risk and return profile of bonds and stocks differ. While companies are obligated to pay coupons and repay the principal on their bonds, there is no obligation to pay stockholders. In addition, all assets are valued against the interest rate. Stocks, dividend paying or not, are no exception. When central banks increase or decrease interest rates, the value of assets moves in the inverse direction. And while dividend income is more predictable, it is not exactly passive: investors should evaluate if the dividend of a stock is safe or not on an ongoing basis. This work is no harder than the work required when investing in a non dividend paying stock. Selling stocks to realize capital gains income is also no more strenuous than receiving dividend income.
Argument 4: Prices of dividend paying stock are less volatile and safer during bear markets
Why it is invalid: While most people don’t enjoy seeing their portfolio value decrease, it should not matter for long term investors. Instead, investors should view it as an opportunity to accumulate more shares. Furthermore, dividend stocks are not safer during downturns, as the performance shown in the article includes the COVID19 downturn. Safety is driven by diversification, company fundamentals, and liquidity.