During periods of low yields and market volatility, more than a few experts recommend dividend stocks and funds. This may sound like good advice, but unfortunately, it is often based on misconceptions and anecdotal evidence.
It is time to take a closer look at the six most common reasons why advisors and other experts recommend dividends and why, based on these reasons, such recommendations are often unsound advice.
Misconception No. 1: Dividends are a good income-producing alternative when money market yields are low.
Taking cash and buying dividend stocks isn't consistent with being a conservative investor, regardless of what money markets are yielding. Additionally, there is no evidence that money market yields signal the right time to invest in dividend-focused mutual funds. In fact, money market yields were anemic throughout 2009, a year that is also one of the worst periods for dividend-focused funds in history.
Many advisors also call dividends a good complement to other investments during times of high volatility and low bank yields. In an October 22, 2009 article, financial guru Suze Orman recommended the following dividend funds: iShares Dow Jones Select Dividend Index DVY-N, WisdomTree Total Dividend DTD-N and Vanguard High Dividend Yield Index VYM-N.
Reality Check:
The 12-month performance after Orman's recommendation was DVY (up 7.86 per cent), DTD (up 21.91 per cent), VYM (up 17.72 per cent). These returns seem pretty good - until you realize you could have just held on to the S&P 500, which was up 26.36 per cent over the same period.
Misconception No.2: Dividend companies are more stable and better managed.
It is generally believed that companies that raise their dividends over a long period have solid market positions and strong cash flow. As a result, the stocks' total return is likely to outpace other stocks.
It's also common to hear the argument that dividends tend to hold companies to a certain standard of financial discipline and that, as a result, these companies budget more carefully and avoid wasteful projects out of fear that shareholders will punish the stock if it fails to return profits to its investors.
Reality Check:
It's easy to pick a "solid" stock in retrospect but it is impossible to pick a company today that will meet this statement moving forward. Sure, if you had purchased Coke in 1962…but what about today? In 2007 we would have said that General Electric GE-N and AIG AIG-N were stable and well-managed dividend companies. Would we say the same in 2009? What about in the future?
The notion that dividend-paying companies are held to higher standards does not bear out. Look no further than the financial industry. In September 2008, AIG had a $4.40 (U.S.) dividend - almost a 4 per cent dividend yield. By 2009, it was clear that AIG and others such as Freddie Mac, Fannie Mae, Bank of America, Bear Stearns and Citigroup were far from being financially disciplined companies, despite that fact that they were all long-time dividend-paying companies. As it turns out, dividends aren't much of an indicator of the financial discipline or the quality of a company's management.
Misconception No.3: You can count on dividends from solid companies.
Many people believe that it's rare for a solid company to suddenly reduce or rescind its dividend payment.
Reality Check:
"Solid" companies like Bank of America BAC-N, General Motors, Pfizer PFE-N and GE, have either suspended or cut their dividends. Unfortunately, it is a lot easier to identify companies that had a solid record than to identify companies that will have a solid record going forward. It is impossible to predict which "solid" companies today are going to be on shaky ground tomorrow. There is no certainty or stability in future dividends.
The idea that dividends allow you to get paid to wait doesn't make sense. It is the total return of your portfolio that matters, not the current yield. Throughout 2008 and 2009, companies were cutting or suspending their dividend payments at record levels, proving that there is no guarantee for those who buy in to these companies. Just ask anyone holding Freddie Mac since June 12, 2008, which was when Freddie Mac last distributed a dividend and traded at $23.01 a share. At that time, Freddie Mac had a dividend yield of 4.34 per cent. By October of 2009, the stock was down over 90 per cent and hope for future dividends had all but evaporated.
