On the surface, bulking up on stocks that are expected to deliver decent dividends may seem like a capital idea. Like savings and loan interest, stock dividends are relatively easy to see and measure, which can make them seem like reliable bets. Their popularity is further fueled by ongoing media coverage, touting dividend stocks’ ability to generate steady income, enhance your returns or both. The problem with favoring dividend stocks is that, while we’ve seen worse ideas, we’ve seen better ones too. When every penny of your life savings counts, why would you pursue a so-so strategy when more effective ones are readily available?
Dividend Dependability: More Like a Wash?
Perhaps a dividend-yielding stock’s greatest appeal comes from its reputation as a source for supposedly generating a steady stream of spendable income while leaving the value of the underlying stocks intact. The hope is that a sturdy dividend stock portfolio might replace or augment dependable, but low-yielding fixed income investments for one’s liquidity needs.
The ability to separate a stock’s dividend from its share value can make for nice mental accounting, but by understanding how dividends really work, it becomes easier to see what is really taking place, and why the appeal may dampen on closer inspection.
Dividends Are No Free Lunch
First, it’s helpful to know how a stock’s dividend gets paid. As described in “Dividend Facts You May Not Know“, when a company pays its shareholders a dividend, that money has to come from somewhere. That “somewhere” is the company’s retained earnings, which is listed under shareholder’s equity on the balance sheet. That means that your stock’s price is diminished by the dividend payment. Granted, the price dip may be essentially unnoticeable in the grand scheme of a stock’s overall activities, but it underscores the continued reality that dividends are not a free lunch or somehow “found money.”
Tilting your portfolio toward dividend stocks also distracts you from the sources of expected return that have been determined through rigorous academic inquiry, which makes it harder to most efficiently manage your portfolio’s overall risks and expected returns.
By heeding the academic evidence on how capital markets operate, we are informed that dividend stocks are NOT considered to be a distinct asset class; they do not share a common return factor that can only be pursued by investing in them.
For example, as a long-term investor, you can expect higher returns, but increased uncertainty by bulking up on small-company and value stocks. You can expect lower returns, but less volatility by instead embracing large-cap and growth stocks. In contrast, tilting toward or away from dividend-yielding stocks does not strongly inform you either way about what to expect in terms of stability or returns. (If anything, there is research indicating that pursuing high-dividend-paying stocks may be on the riskier side, since more of them may fall into the value asset class. This Financial Planning Association paper, for example, describes dividend stocks as “a value tilt in disguise.”)
Merton Miller, an American Economist and Nobel Prize winner theorized that dividend policy is irrelevant. This is known as the “dividend irrelevance theory” i.e. dividends have little to no impact on a a company’s capital structure or stock price. After winning his Nobel Prize in 1990, he was asked by media to explain his theorem simply – in ten seconds. Miller stated, “If you take money out of your left pocket and put it in your right pocket, you’re no richer.”
The Trouble with Taxes
Even after knowing all that, you may still prefer to receive some or all of your realized (by no means guaranteed) stock premiums in the form of a dividend instead of waiting for the share value to increase. There’s one more rub to be aware of. Dividends are taxed in the year that you receive them, whereas unrealized capital gains on appreciating stocks can be deferred until you actually sell them.
A Portfolio-Wide Approach
All in all, while it may be tempting to go for the tidy mental accounting that dividend investing affords, we prefer viewing the portfolio as a whole resource for addressing a family’s total wealth care. To balance the multiple, often conflicting goals of building, preserving and spending wealth, it’s best to focus first on the factors that offer us the greatest degree of control, including:
Diversified asset allocation according to one’s tolerance for market risks and need for market growth
Asset location to maximize tax efficiency across taxable and tax-sheltered accounts
Cash-flow planning integral to these larger factors rather than as a stand-alone activity
As such, dividend stocks may well end up playing a role in your portfolio’s holdings as you build and manage it for maximum effect. But we believe their role is more appropriately cast as supporting actor, rather than the star of the show.