Question e-mailed in by Globe reader Andrew: “I am a 22-year-old finance major interested in investing for income. Every month I invest a portion of my income into my tax-free savings account, which is invested in monthly dividend equities. Ideally, I would want to invest until I reach a position where I can live off my dividends before I can start looking into a mortgage. Is this a good idea?”
Answer from Benjamin Felix, a portfolio manager with PWL Capital in Ottawa, a wealth management firm that builds diversified portfolios for clients using exclusively low-cost index mutual funds and ETFs. PWL Capital does not recommend individual stocks.
Andrew, I think that the most important part of your question is your interest in investing for dividend income as opposed to investing in low-cost index funds.
In my opinion, investing for dividend income is one of the most romanticized ideas in personal finance. The thinking goes that if you can buy up enough stocks with stable and growing dividends, then you will have achieved financial independence – you can live off of your dividends regardless of market volatility.
Our brains like to treat cash differently from stocks. This bias, known as mental accounting, makes dividend income feel different from increases or decreases in stock prices. In reality, dividend investing does not have many quantifiable benefits, but it does have plenty of drawbacks.
I am not alone in this thinking. In his 2012 letter to Berkshire Hathaway shareholders, Warren Buffett, one of the greatest living investors, went to great length to walk readers through the reasons that dividends should not matter in identifying a good investment.
Let’s start by looking at some of the drawbacks I see when it comes to dividend investing.
Dividend investing leads to poor diversification. Restricting yourself to dividend-paying companies eliminates a huge portion of the stocks that are available for investment. According to a 2013 study by Dimensional Fund Advisors, close to 60 per cent of U.S. stocks and 40 per cent of international stocks don’t pay dividends. Knowing that dividends do not help us identify good investments, and the importance of diversification in capturing market returns, it should be obvious that eliminating half of the market simply for not paying dividends is harmful to your expected returns.
Picking dividend stocks is unlikely to lead to investing success. This is true for any stock – dividend payer or not. Most stocks do not beat the market over time, which is one of the reasons that index investing is so attractive. A 2014 study from JPMorgan showed that two-thirds of U.S. stocks that had been included in the Russell 3000 index from 1984 through 2014 underperformed the index over that period. If we take any stock at random, it is highly likely to underperform the market over the long term.
Now let’s have a look at some of the myths that supposedly make dividend investing a good strategy.
Dividends are an identifier for strong, stable companies. Corporations can use cash to invest in future projects, fund research and development, or fund mergers and acquisitions. If they do not believe that they can do any of these things profitably, then they will return capital to their shareholders. Dividends are one way that a company may return capital to shareholders. They could also buy shares back from their shareholders, known as a share repurchase. In both cases, the company has returned cash to shareholders. Why would we favour companies that return capital to shareholders as opposed to investing in profitable projects? Why would we favour dividend payers over share repurchasers?
Dividends are a guaranteed source of returns. False. Let’s break down the basics of a dividend. Say we have a company with a per-share value of $10. If it pays a per-share dividend of $2, it has now distributed $2 per share to its shareholders; the company has shed $2 of cash for every share on the market. When this happens, the value of each share must also decrease by the amount of the dividend that was paid. As the investor owning these shares, your total return from the dividend is zero per cent. You started with $10 in stock, and you ended with $8 in stock and $2 in cash. You gained nothing.
Dividends protect you in down markets. This one could hurt if you’re not ready for it. Dividend investors believe that collecting dividends in a bad market while their share price is low protects them from market volatility. As we saw above, a dividend decreases the value of a share. There is no difference between selling some shares to “create” a dividend, and receiving a cash dividend. I get that there is a psychological aspect here, but even if dividends make market volatility feel better, the reality is that in 2009, 14 per cent of firms worldwide cancelled their dividend, and 43 per cent reduced their dividend.
Companies that grow their dividends should beat the market. This is simply not true. The only way that a company will beat the market is if it exceeds the market’s current expectations. At any given time, the market prices a stock based on the available information, including the expectations for future growth. This is known as the Efficient Market Hypothesis. For a stock to beat the market going forward, it must exceed those expectations. If a stock only delivers on its expectations, we would expect it to earn something close to the market return. This is true whether a company pays a dividend or not.
Your goal of investing until you can live off of your portfolio is still an excellent goal – just keep in mind that you do not need dividends in order to spend from a portfolio. Indeed, I would argue that there is effectively no difference between receiving cash dividends and creating your own dividends by selling off some shares.
People who are looking for regular payments could find the idea of dividend investing attractive. But in my mind, Andrew, you will get a much more reliable result by diversifying across the whole stock market using low-cost index funds.
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