The Hidden Dangers Of Dividend Investing

I was scrolling through my Twitter feed the other day when I stumbled a tweet extolling the virtues of dividend investing – and 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.

I had just come off a client board call where we debated the various liquidity measures to help the company weather the current bear market.  Well, guess what – one of the measures we discussed was suspending the company’s long-standing dividend.

It was clearly going to be a massive hit to both the institutional and retail investors on their register. We literally spent hours debating every other possible liquidity solution.  In situations like these, there’s never an easy answer.

The bottom line is that oversimplifying dividend investing to the extent most people do is dangerous – to a degree where it can have dire consequences for investors’ portfolios.

This is why.

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 the 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. 

Stock Market Investing - Price vs. Total Return

Because the payment of a dividend causes the share price to decline by an equivalent amount, you haven’t found 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.  In particular, some energy stocks are currently 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% in the past 6 months, 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.

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.

Large-cap fund performance

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.  And I can assure you there’s more pain to come as more and more companies consider a (or in the case of European banks, are forced to) cut to their dividends as a way to preserve liquidity in the current bear market.

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 (i.e. an ISA, pension or a 401(k)), 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 where your income is otherwise low.

With dividend-paying stocks, you have zero control here.  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.

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.

As many people are about to find out, 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 a London-based 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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16 Comments

  1. Very interesting, thanks. I’m just sticking with index funds, but have read about dividend investing before. Better than random stock picking I guess – but still inferior to an index tracker over the long run.

    • The reality is that if you are investing in an index like the S&P 500 you own all the dividend aristocrats anyway. Once you start focusing on 10-15 specific stocks based on their dividend policy, you lose a big part of diversification – and we know that diversification is the only free lunch in finance.

  2. Thanks for another insightful article. Everything you’ve said makes sense, but a small part of me wonders if firms that pay big dividends have better operational financial discipline as a necessary consequence?

    • That’s a great point – nothing like a regular dividend payout to keep management’s financial discipline in check.

      Same applies to leverage by the way – it helps boost equity returns by utilizing lower-cost debt financing and incremental discipline that comes through making regular interest / principal payments.

      That being said, I’d argue there are tons of very well run companies where management teams are sufficiently on the ball even without the extra “incentive” of having to make dividend payments.

      The broader point isn’t that dividend investing is bad. It’s just that it isn’t as risk-free and straightforward as some people represent it to be.

  3. It fills me with dread each time that I read a FIRE blogger that seems to think that dividend investment is the only way to go. I think because it has actual money out- they seem to love it, oh look, I got £50 this month. Only 20x more and then I can retire forever. Without, as you point out, knowing that companies can stop their dividends whenever they want. Growth companies (within indexes of course) are surely the way to go, especially when you aren’t anywhere near retirement.

    • Precisely. There are many different ways to get to the same goal so to say that dividend investing is THE way is unhelpful at least, harmful at worst.

      Another problem as you correctly point out is that if you only focus on dividend-paying companies, you are missing out on some of the fastest-growing businesses out there (i.e. Amazon or Facebook)

  4. Being a cash flow investor myself, I try to stick to preferred shares and MLPs which have yields 7-10% easily and often don’t have the same volatility that regular companies do. It takes a decade for regular dividend aristocrats to come up to the same yield-on-cost basis. Click my name for a direct link to preferred discussion.

    • Thanks Ryan. It’s a well-written and informative article.

      As an investment banker I’ve always wondered why companies would want to have these pref instruments in their capital structure to begin with, certainly in the current environment.

      They are expensive and as far as I know don’t provide any rating agency benefit given the quasi-mandatory nature of the dividend.

      My first advice to a client would be to take them out and refinance with low-cost debt which most investment-grade companies can raise at sub 3% these days).

      • Thanks for the kind words!
        Since you have a front row seat to the show, is there ever any discussions between you and the company on the capital structure, or are you not a part of these types of discussions? I wasn’t sure if you have given that advice or if it was a “would” situation. I’m curious how they respond to the suggestions.
        Because you are right, the yield on these can be very high when it seems they could get cheaper financing with regular debt. I understand why banks do it because the divs are always un-cumulative so it basically “doesn’t count” against their BASEL leverage requirements.
        The odd thing is that it doesn’t seem like regular investors really even know about them and they trade an iota of the volume of the commons.

        • So the caveat here is that for a number of reasons, preferred shares aren’t really prevalent in the industry I specialize in. That makes it a theoretical conversation from my perspective, though I am sure that some of my colleagues in the more “traditional” industries (i.e. basic industries, financial institutions) come across prefs much more often.

          That being said, we discuss ways to optimize capital structures with our clients pretty much all the time. In a world of 15+ P/E ratios, shaving off even a few million dollars/pounds from the interest expense line translates into a considerable uplift to shareholder value. So we spend a lot of time thinking about replacing more expensive debt with cheaper instruments, putting zero-coupon converts in place etc etc

  5. Hey BOF, I agree that from an accumulation perspective, postponing taxes for as long as possible will be the best strategy. However, I truly understand the allure of dividend investing, as it has a sweet psychological effect, seeing them dimes trickle in every now and then 😉

    I don’t see why it couldn’t be part of a strategy to FIRE, but I agree that having it as THE ONE and only, sole strategy might be a bit misplaced.
    When you’re done accumulating though, dividends make perfect sense, I think.

    • I do agree with you. My broader point is that it’s not a magic wand people sometimes represent it to be and you’ve got to be very mindful of the risks that go with stock picking and assuming the dividend is “safe and will be growing into eternity”.

      Separately, the dividend payout is reflected in a (broadly equivalent with some variations) offset in price. So it’s really down to the individual preference in terms of seeing a cash payout vs a higher-priced stock in your brokerage account.

      PS: Nice blog you’ve got there!

  6. Nice summary and I do agree. Dividend investing seems to be an easy thing to blog about (there’s always another dividend or share purchase!) which makes it a great default choice for FIRE bloggers.

    I did have a slightly different take on the allure of watching income hit your account and rising over time – if you really find income motivating enough that it’s a positive force for making good choices, why not invest in Income versions of funds? It’s only a little less efficient than Accumulation units if you manually reinvest anyway, and is far more optimal (in my opinion) than purchasing individual shares.

    Even those using Accumulation versions like me can work out what the dividend *would* have been, and I do honestly find it a nice way of putting my account balance into context.

    • Yes, good point. I never looked at dividend investing through the prism of motivation by watching the stream of income, but a few people have pointed it out to me since I published this post.

      That being said, accepting potentially lower returns over long periods of time is an expensive price to pay for motivation. As you say, there are other ways around it.

      I just take my “stash”, multiply by 4% and voila!

  7. I do love receiving dividends but am actually quite glad of the recent dividend cuts which have shown me first hand what can happen to such income when companies need to shore up their finances during the bad times.

    I sometimes get asked why I have some investments which pay income and why not just stick to the acc versions? It’s because it is a great motivator, plus I wanted to see the income being paid – or not as the case is right now!

    Better to experience this now while I’m still accumulating, rather than when I’m retired and trying to scrape a living on decimated dividends!

    Dividend investing is part of my overall investing strategy – I hope I’m being realistic when I say that my dividend income is only intended to cover some of my basic costs in the future – the other costs will be covered by selling off investments in the usual manner.

    • I think the psychological effect is important. I’m just slightly exasperated when dividend investing is represented as a risk-free investment strategy that somehow has a superior return profile.

      As you correctly point it, it can turn on a dime and one better be prepared for it.

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