5 Problems with Dividend Investing
Tim covers 5 problems with dividend investing and what he believes to be a superior long-term investment strategy.
"Tim, how would you invest my money at your firm? Should we invest in dividend stocks?"
Over time, dividend investing has gone in and out of favor, and investors, particularly retired investors, mistakenly believe they need the income from the dividends to live on. This is not the case!
First, what is “dividend investing?” Basically, dividend investing is investing in companies that make regular cash payments to their investors, or owners.
Some investors and/or advisors love dividend investing, and some may have built their entire firms around this concept. But it is not the foolproof retirement answer it is sometimes made out to be, and here are 5 reasons why:
1. Historical Performance is Misunderstood
Dividend investors often point to historical data that show dividend-paying stocks have outperformed over time. Historically, when this outperformance occurred, it was more than likely due to the fact that dividend-paying stocks were actually undervalued at the time, and over time, undervalued stocks generally outperform. So, while they may have had the returns they wanted, the reason for those returns was miscalculated. Now, I’m not saying to avoid dividend stocks, (we own many of them), but they should simply be a portion of a portfolio constructed for you, to best meet your goals. More times than not, a portfolio of a dozen or so of dividend stocks will not give you the best “bang” for your buck.
2. Lack of Diversification (also known as ‘Focused Investment Risk’)
Focused investing may have its place for some growth investors, but holding a portfolio of dividend stocks in or before retirement involves taking more single stock risk or focused portfolio risk than most should, especially if they are taking monthly withdrawals from their investments for living expenses! When you’re in retirement, you certainly don’t want to inflict unnecessary risks on your investments. And risk management is a key tenet (probably THE key tenet), to investing.
And when you retire, you will want to focus on return of your money as much as return on your money.
3. Lack of Focus on Total Return
A main problem with dividend investing is the focus on the dividends, yield, or income of an investment rather than the more important total return. For instance, retirees often search for high-yielding investments, but here’s the problem: if you see a stock with a dividend that works out to a 5% yield, and you purchase it based on that 5% yield, and then the stock drops 5, 10, 15, 20% or more, well the 5% yield doesn’t mean much anymore, does it?
Occasionally, a friend, colleague or client may recommend a stock that has a high yield of 8 or 10% or even higher. Well, this usually happens because the company is under duress and there is a strong possibility the dividend will be cut.
We stress focusing on total returns that will include stocks that pay dividends, along with stocks that will increase in value.
4. Dividends are Not Tax Efficient
Even if you’re holding your dividend-paying investments longer than one year to get better tax treatment, every time you receive a dividend, you get a tax bill. This can hurt your investment returns if you aren’t paying attention to your tax liabilities. Many investors, and advisors for that matter, fail to take taxes into account and the amounts that can be saved with proper tax planning and investing. It can add up to tens, hundreds, or even millions of dollars over time.
When stocks increase in value, you have more money, or at least more valuable stocks. But this money isn’t immediately taxed like dividends are. Instead, that money is only taxed when you decide to sell the stocks. With dividend investing, you’re taxed whether you need cash or not.
Warren Buffett's Berkshire-Hathaway has never paid a dividend. He has always preferred to reinvest the money Berkshire has made, and this has greatly benefited his shareholders over the long haul.
If no dividends are distributed, then investors decide when to pay the taxes on their investments by selling shares. If no income is needed, then you don’t sell, and you don’t have an extra tax bill.
5. Higher Costs
One last thing to consider if you are investing in a dividend-based mutual fund or ETF, is the cost. Fund costs can be wide ranging, and typically a specialty fund like a dividend fund or dividend focused ETF will almost always be more expensive than a more-diversified fund.
Again, this may not be a huge issue if it is part of a broader, diversified portfolio allocation for your investments, but you will want to ensure you’re getting good value for what you’re paying.
The Bottom Line:
Invest in what works, not in what is “popular at the moment.”
Focus on total-return investing, not just dividends or yields. People use a dividend investing strategy because they think they need the income that comes from dividends. But they don’t. Often this can hinder or impede their main goal of producing a maximized income stream, from their investments.
While dividend investing may go in and out of favor, we invest for total returns and build income streams for retirees based on well-diversified strategies where we own equity (aka, stocks) and bonds of the best companies in the world believing they will continue to offer solid, risk-adjusted returns, over the long-haul.
So, don’t focus on themes like dividend investing. Focus on a low-cost, diversified portfolio, especially if you’re in or close to retirement.
A CERTIFIED financial planner™ professional can help you plan for your retirement. Schedule a call today so we can talk about your situation.