Today I’m going to cover a listener question about dividend investing. I'll talk about five problems with dividend investing and also a better investment strategy. Check this out before deciding to add more companies to your portfolio that make regular cash payments to their investors.
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Over time, dividend investing has gone in and out of favor, and it seems to be in vogue yet again. Investors, and particularly retiree investors, mistakenly believe they need the income from the dividends to live on in this low-rate environment. This is not the case!
Some investors and advisors love dividend investing; indeed, some may have built their entire firms around the concept.
But there can be a few problems with the concept.
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5 Problems with Dividend Investing
First, what is “dividend investing?” Basically, dividend investing is investing in companies that make regular cash payments to their investors or owners.
Dividend investing is not the foolproof retirement answer it is sometimes made out to be. Below are 5 problems with dividend investing.
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, but they should simply be a portion of a portfolio constructed for you, based off your goals.
More times than not, a portfolio of a dozen or so of dividend stocks will not give you the “bang” for your buck.
2. Lack of diversification (or 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!
Studies have shown that most professionals, even with their ivory towers and fancy offices and millions of dollars of resources can’t beat index funds over the long run and if most professionals can’t do it, individual investors should think twice before making the attempt.
When you focus your investments on dividend stocks, you’re concentrating your investments into one type of company. This typically makes your investments riskier.
Many dividend investors are retirees. When you’re in retirement, you certainly don’t want to inflict unnecessary risks on your investments. After all, risk management, is a key tenet (probably THE key tenet), to investing.
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, with rates relatively low today, many are in search of high-yielding alternatives.
But here is the problem, and it isn’t a small one: 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?
Every once in a while, a friend, colleague or client may recommend a stock that has a high yield of 8 or 10% or even higher. There’s a reason for this! It is usually because the company is under duress and there is a strong possibility the dividend will be cut.
Take GE for example: GE has been around for over 100 years and was once one of the most revered and valuable companies on the planet. It is now merely a shadow of its former self selling at under $9 with a dividend they’ve cut all the way down to 1 cent per quarter.
You might say, why bother with paying 1 cent per quarter? Well, this is to keep the stock in the “dividend” type funds or ETFs that can only hold stocks that pay a dividend. Obviously not much of a positive for a company.
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.
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 time.
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 a tax bill.
5. Higher costs
One last thing to consider is the cost of a dividend-based investment mutual or ETF fund. The costs can be wide ranging, but any type of 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.
The Bottom Line: Invest in What Works, Not What’s “Sexy”
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. Often that hinders or shrinks their main goal of producing an income stream based on 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.
So, don’t focus on themes like dividend investing. Focus on a low-cost, well diversified portfolio, especially if you’re in or close to retirement.