Note: This post was first published in April 2020 and updated in May 2021.
I was scrolling through my Twitter feed the other day when I stumbled upon a tweet extolling the virtues of dividend investing.
It also had a less than veiled reference to the investing superpowers of dividend investors themselves.
I won’t quote it verbatim, but it had all the requisite components, such as:
- I LOVE dividend investing!
- My dividend aristocrats will generate $xxx in income for the rest of my life
- Not only that, but the amount will grow above the rate of inflation
- Hurray to me, for I have discovered the holy grail of investing
I don’t often get riled up on social media, but this comment really rubbed me the wrong way.
In my day job, I often work with clients who fall upon hard times – and need to explore various liquidity measures to help their businesses weather the tough stretches.
Well, guess what – if the company pays a dividend, the discussion ALWAYS involves the topic of either suspending the dividend – or cutting it altogether.
Yes, it’s a massive hit to both the institutional and retail investors on the register. Thus, such decisions are never taken lightly.
But in the end, survival takes a priority over everything else.
This is why oversimplifying dividend investing to the extent most people do is dangerous – to a degree where it can have dire consequences for investors’ portfolios.
Back To Basics
I’m not in the business of writing about things that are well-covered elsewhere, so as a starting point, I’ll direct you to this article about dividends.
Aside from the technicalities, the key points I will make are as follows:
1. Not All Companies Pay Dividends…
…and that’s okay.
A dividend, just like a share buyback, is an indication that the company hasn’t got a way to redeploy excess cash to grow its business.
As a result, it chooses to return that extra cash to shareholders.
2. Share Price Reaction Can Vary
This is where Investopedia hasn’t got it exactly right.
Sure, if a company is introducing a new dividend, it may well cause the share price to go up.
However, for companies already paying a dividend, the expectations of a payout are already built into the price.
Importantly, the share price typically declines by the amount of the dividend after it is paid.
It makes total sense – because the simple act of paying dividends creates zero economic value.
However, this is where many dividend investors get it wrong – which segways nicely into…
Dividend Investing Misconceptions
The biggest lie in dividend investing is that the dividend is somehow providing an extra return. It isn’t.
As I’ve written about here, when it comes to the stock market you need to focus on total returns.
Total returns are comprised of price appreciation AND any dividends paid along the way.
*Note: if you are wondering how share buybacks play into the equation, the answer is that they underpin price appreciation. Back to regular programming now.
Because the payment of a dividend causes the share price to decline by an equivalent amount, it’s wrong to represent it as a magical way to squeeze an extra return from the stock market.
But that’s not where it ends.
Some investors point to attractive dividend yields as the reason to buy dividend stocks.
As an example, for the majority of 2020, a number of energy stocks were trading at very appealing (i.e. in excess of 6%) dividend yields.
Put $100 to work, make $6 in dividends per year. Add price appreciation – what’s not to like?
But therein lies the issue.
The reason many of the high yielding stocks are so, well, high yielding is because they’ve suffered a dramatic decline in price.
For example, the oil sector has traded off almost 50% as a result of Covid, effectively doubling the dividend yield.
European telco stocks are another great example. There’s a bunch of names that are yielding well north of 5% at the moment.
The reason for that is they’ve got to make massive investments in fibre rollouts and 5G deployments.
As a result, investors are questioning where the cash will come from – and suspect part of the answer will come in the form of a dividend cut. So much for the “my dividends will keep growing and growing” investing thesis.
Alternatively, the cash may come from a highly dilutive capital raise.
Sure, it’s nice to get a dividend – but not when the share price declines by 30%!
But I Only Invest In Dividend Aristocrats!
Sure. Let me give you a couple of names that were on the dividend aristocrat list at some point.
Gannett. Comerica. Yellow Pages.
Any of these ring a bell? Feel free to look up their share price performance.
There are plenty of great companies on the current dividend aristocrat list.
However, the fundamental challenge with dividend investing is that you are essentially stock picking.
While we can sure keep going with the active vs. passive argument until the cows come home, the data doesn’t lie:
Over the long run, active investing is a losing proposition.
I am sure some people will bring up charts showing that dividend aristocrats have outperformed over the long run.
I’ve seen those as well – but they miss the point entirely.
Sure, companies that have been paying a consistent (and growing) dividend over the past 25 years will have done well.
But could you really pick them out of a line-up twenty-five years ago?
Thought so. Nothing like the good old hindsight bias.
A Word On Taxes
This is the last, but certainly not the least important item on the list.
Unless you are investing in your tax-sheltered accounts, your dividends will be taxed if and when they are paid.
Everyone’s tax circumstances differ and there’s often zero tax for the first few thousand of dividend income.
However, as you grow your portfolio and cross that threshold, you need to consider the tax implications of your investment strategy.
When it comes to capital gains, you have control over when you trigger them – and can ideally do so in tax years when your income is otherwise low.
With dividend-paying stocks, you have zero control.
This is especially important in your wealth accumulation phase, when you are likely to be in a higher tax bracket.
And The Verdict Is…
In my experience, boards and management teams are incredibly reluctant to cut or suspend their dividends.
Everyone knows – and appreciates the reason investors buy dividend stocks in the first place.
When cuts do happen, they tend to be temporary in nature.
Sometimes, however, they are not. Just ask all the newspaper publishers out there.
For full disclosure, the bank stocks I own do pay a dividend – and it sure feels nice to get a check for a few grand once a quarter.
I get it – dividend stocks (or funds) can be very additive to your portfolio, especially in retirement.
But as you contemplate investing for dividends, please don’t lose sight of the bigger picture.
Some bloggers are pretty transparent about the risks of dividend investing.
Many others would like you to believe it’s a magical solution that somehow defies the laws of finance.
As many people found out last year, dividend investing is not the stock market panacea some would like you to believe it is.
About Banker On Fire
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Banker On FIRE is an M&A (mergers and acquisitions) investment banker. I am passionate about capital markets, behavioural economics, financial independence, and living the best life possible.
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