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Dividends obsession distracts investors from big picture

Would you rather see your portfolio earn 3 per cent per year and provide monthly distributions of 5 per cent, or earn 5 per cent with irregular payments totalling 2 to 3 per cent?

It may seem like a ridiculous question, but it's reflective of the choices being made today. The focus on income and dividends is so intense that it's distracting investors from what they really need, which is attractive "total" returns. Indeed, the pursuit of convenient, tax efficient, GIC-beating yield is getting downright unhealthy.

Why do I say this? First of all, I hear it constantly from investors. "Do you offer a monthly income fund? How big is the distribution? This fund has been a dog, but I don't want to sell it and lose my 6 per cent."

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I also see this obsession revealed in where dollars are flowing. Income-oriented ETFs have grown many times over in the last few years. There's been a rash of new products touting high yields and fancy strategies, including the again-popular covered-call writing. Some income-oriented closed-end funds are trading at premiums to their net asset value. And I watch with interest as Kevin O'Leary builds a fund company and media career based on dividends, dividends, dividends.

Income is clearly important, particularly for older investors, so how can it be wrong to focus on it?

To answer that, we need to go back to basics. Interest and dividend payments come from corporations (government bonds excepted). To compensate bondholders and shareholders, businesses need to make a profit. Earning a return on invested capital is what's important. The dividend policy developed by the board of directors is the easy part.

It's similar for investors. Building a portfolio that will earn a total return of 5 to 6 per cent (3 to 4 per cent after inflation) from a combination of interest, dividends and capital appreciation is what's important. Figuring out how to extract a paycheque from the portfolio is a secondary consideration, and not a particularly difficult task.

So, while investors need income to live off of, pursuing investment strategies that focus solely on the tap (current yield) instead of the source of long-term return is, in my view, misguided. This is especially so when the income flow comes with a higher fee or has features that structurally inhibit long-term returns, such as guarantees (guaranteed income funds), caps (principal protected notes) or limited scope (financial services stocks only).

Now, before you sit down to send me a scorching e-mail, let me say that I fully appreciate the merits of dividends. I know they've accounted for 50 per cent of the S&P/TSX composite's return over the last 30 years. They're a good indicator of a business's quality and management's ability to allocate capital. They can grow over time to offset the ravages of inflation. And in the Canadian context, they're tax efficient. But hear me out.

Declining interest rates has been a constant tailwind for all types of income securities over the last 30 years, and high-dividend stocks, along with bonds, have been great vehicles to ride. Interest rate risk was amply rewarded. But with stocks like Enbridge now trading at over 20 times earnings and government bonds yielding 2 per cent, the wind is shifting.

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No longer can income investing be an excuse to not be diversified. A larger portion of investor returns needs to come from other types of risk – corporate bonds, a broad range of stocks (the other 50 per cent of the stock market return), and perhaps some illiquid investments and alternative approaches (arbitrage, short selling, derivative strategies).

If you're in the twilight of your investing career, withdrawing 5 to 6 per cent of your portfolio each year while earning a secure, sleep-easy return of 3 to 4 per cent makes sense. For longer-term investors, however, it's important to build a portfolio that can generate profits well in excess of inflation. One that takes advantage of all the opportunities that are out there, including dividend-paying and heaven forbid, non-dividend paying. And most importantly, a portfolio that clearly focuses on the source of wealth creation, not what's flowing from the tap.

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