In my last two videos I talked about high yield bonds and preferred shares. These are two alternative asset classes that investors venture into when they are seeking higher income yields. I told you why you might want to avoid those asset classes. Today I want to tell you why focusing on investing to generate income is a flawed strategy altogether, and why a total return approach to investing will lead to a more reliable outcome.
Investors often desire cash flow from their investments. There are blogs, books, newsletters, and YouTube channels dedicated to income investing. Income investing means building a portfolio of dividend paying common stocks, preferred stocks, and bonds in an effort to generate sufficient income to maintain a desired lifestyle. The idea is that if you have enough income-paying securities in your portfolio, you will be insulated from market turbulence and can comfortably spend your dividends and coupon payments regardless of the changing value of your portfolio.
There is a perception that if you never touch your principal, you won’t run out of money. It seems like a fool-proof retirement plan. But is it, really?
Let me start off by saying that there is no evidence that dividend paying stocks are inherently better investments than non-dividend paying stocks. There are five factors that explain the majority of stock returns. Dividends are not one of these factors. For example, we know that if you gather up all of the small cap stocks in the market, they will have had higher long-term returns than all of the large cap stocks. Based on this, company size is one of the factors that explains stock returns. The same evidence does not exist for dividend paying stocks.
If they aren’t better investments, why do people like them so much? In a 1984 paper, Meir Statman and Hersh Shefrin offered some potential explanations for investors’ preference for dividends. If they have poor self control, and are unable to control spending, then a cash flow approach creates a spending limit - they will only spend income and not touch capital. Another explanation offered in the paper is that people suffer from loss aversion. If their stocks have gone down in value they will feel uncomfortable selling to generate income. On the other hand, they will happily spend a dividend regardless of the value of their shares.
As much as a dividend may seem like free money, the reality is that the payment of a dividend decreases the value of your stock. If a company pays twenty million dollars to its shareholders as a dividend, the remaining value of the company has to decrease by twenty millions dollars. The investor is no better or worse off whether the company that they invest in pays a dividend or not. This is known as the dividend irrelevance theory, which originated in a 1961 paper by Merton Miller and Frank Modigliani.
I have just told you that whether returns come from dividends or growth does not make a difference to the investor, but there is an important detail for taxable investors. There is no difference whether returns come from dividends or growth on a pre-tax basis. On an after-tax basis, the investor without the dividend is in a better position because they could choose to defer their tax liability by not selling any shares if they don’t need to cover any spending. The dividend investor is paying tax whether they spend their dividend or not. This is a big problem for an investor who does not need any income at that time.
About 60% of US stocks and 40% of international stocks don’t pay dividends. Investing only in the stocks that do pay dividends automatically results in significantly reduced diversification. Dividend investing can also lead to ignoring important parts of the market. There are plenty of great companies that do not pay dividends. Ignoring them because they do not pay a dividend, which we now understand is irrelevant to returns, is not logical. A good example of this is small cap stocks. An income-focused investment strategy will almost certainly exclude small cap stocks, few of which pay dividends.
Now, don’t get me wrong, dividends are an extremely important part of investing. One dollar invested the S&P/TSX Composite Price Only Index, excluding dividends, in 1969 would be worth $14.37 today. The same dollar invested in the S&P/TSX Composite Index, including dividends, would be worth $64.59. If you are investing in Canadian dividend paying companies, you also receive favorable tax treatment on your dividend income. You should want dividends - they are an important part of stock returns. But you should not want to focus on buying only stocks that pay dividends.
Dividend paying common stocks are an important part of a portfolio, but a dividend-focused portfolio leads to tax-inefficiency for taxable investors, poor diversification, and missed opportunities. A total-return approach, accomplished by investing in a globally diversified portfolio of total market index funds, results in greater tax efficiency, better diversification, and the ability to capture the returns that the market has to offer.