Debunking the Myths of Dividend Investing

DDQRegular readers know I’m not a big fan of dividend-focused investing.

While I like the concept of “mailbox money” and passive income from dividend-producing stocks, I don’t like being forced to accept cash back when I don’t need it and the tax consequences that go along with those dividends.

For a more complete explanation of my rationale for investing for total return and my preference for no-dividend stocks, see my previous posts on the topics:

 

Today, I’d like to share a rebuttal from someone who admittedly has significantly more experience in the world of investment management than I do. I’ve spend my career in anesthesia, whereas he’s spent his in private equity and investment banking.

Please enjoy this guest post from the Minnesota-based dividend-loving travel rewards enthusiast who blogs at Millionaire Mob.

 

Debunking the Myths of Dividend Investing

 

It was I was recently on the Reddit Financial Independence subreddit asking if anyone had been living solely off of dividends from building a dividend income portfolio… I recently wrote a piece about how I constructed a plan on how to live off dividends forever.

I was completely laughed out of the financial independence community room that I couldn’t possibly ever beat the trends of index investing nor are Dividend Aristocrats truly outperforming the markets due to selection bias.

Well, I wanted to write a piece that was near and dear to my heart… Something that I was passionate about and hoped you’d consider as well… Dividend investing, and the commonly viewed myths associated with it.

 

Background with investing

 

As a finance professional that formerly worked in investment banking and now works in private equity, I had to get to the bottom of this. I couldn’t let people disregard such an awesome opportunity to invest in businesses not bet on stocks.

I grew up reading a number of different financial books on investing, fundamental analysis and more. There has to be a better way for high incomers like me to invest solely on their own without paying large fees for managers to build a portfolio on their own.

 

 

Myths of Dividend Investing

 

Let’s get down to the myths regarding dividend investing. Here are the most important myths that are simply not true.

 

Myth #1: You Can Never Beat the Stock Market

 

Component A: You Are Investing in Businesses Not Betting on Stocks

 

Beating the stock market over the extreme long-term is difficult, but it is not out of the question. However, what if you didn’t have to beat the market for 20 years? You only need to beat it for a 10-year cycle. This is more likely than 20 years. But, what if you found the exact criteria for overperformance by screening for high quality dividend stocks at extremely attractive prices.

My formula for screening for dividend stocks is quite simple. My quantitative analysis includes using a stock screener by inputting the following criteria.

 

  1. Invest in stocks that have a dividend yield greater than 0%. We only want stocks that pay a dividend.
  2. Find companies with a market Capitalization of over $10bln. I only want companies with scale and a size advantage.
  3. Invest in stocks with a P/E ratio less than 20x.
  4. I want to invest in companies that are growing their Earnings Per Share (“EPS”), so screen for EPS growth next year of greater than 5%.
  5. Long-term growth is important, so filter companies that are growing their EPS over the long-term.
  6. Don’t overpay for growth, so screen for companies with a Price to Earnings Growth (“PEG”) of less than 1.
  7. Finally, I want dividend safety over the long-term. Screen for companies with a payout ratio of less than 50%. This gives us a margin of safety. If EPS doesn’t grow, there is still sufficient dividend coverage.

 

From there I have my list of dividend stocks that I’d like to screen further, which includes the following criteria:

lucidity

  1. Is the company shareholder friendly?
  2. Does the Company have a modest dividend payout ratio? (Yes or No)
  3. Is the company known to hire internally? Has the team been there awhile?
  4. Do they have a track record of revenue and earnings growth? Has the company provided a long-term growth plan?
  5. Do you understand the business model and how they make money?

 

Institutional investors love dividend stocks, which in turn provides significant downside protections. Large institutional investors are always the first to invest in outstanding businesses at attractive valuations.

If the stock price decreases modestly without any significant news, institutional investors usually gobble up more shares quickly. This helps protect your downside too.

 

Component B: Not Every Stock In Your Portfolio Has to Beat the Market to Beat the Market!

 

Portfolio allocations is critical in dividend investing, which is why I built an infographic on how to build a dividend portfolio. In a portfolio of 10 stocks, you can actually do quite well if only 5 beat the market, 3 track or slight underperform the market and 2 underperform the market.

Follow the smart money. It doesn’t take a genius to find and understand a great business at attractive valuations.

Last time I checked there wasn’t lines of institutional capital looking to buy indices. Why?

 

 

Myth #2: Index Investing is Completely Worry Free

 

So, why don’t true investors just invest in indices? One could argue that they are being paid to invest and their investors wouldn’t like that… Yes, true! That is a part of it, but it is not the most important point. The most important part is…

Allocation of capital. By choosing an approach of building your own portfolio, you can allocate your capital to industries that have sounds businesses but are just not valued properly. For example, the Amazon craze has opened up doors of opportunity for investing in strong, proven retail stocks that meet my above criteria. I invested in Target when everyone thought the retail world is ending. I recently went to Target and they look to be doing just fine to me now. Retail-apocalypse? I think not.

 

worry free beach

a couple of worry free index fund investors

 

Another example includes right after the Great Recession, financial stocks were priced below book value (balance sheet equity) meaning you could invest at a price below the value of the business in a liquidation scenario. You are literally buying $1 for $0.50!

What about index investing then? Well, you have zero discretion on where your capital is allocated in terms of sectors. Currently, the S&P 500 is heavily weighted towards technology (i.e., Facebook, Netflix, Amazon, etc.). Those valuations are lofty and I expect valuations to correct, which doesn’t bode well for your overall asset allocation. How is that heavy allocation of technology stocks going to look in 5 years from now? I’ll let you be the judge.

With index investing, you don’t have the discretion to allocate your capital to opportunistic industries.

With the explosion of Exchange Traded Funds (ETFs) and roboadvisors, there is legitimate concern regarding stock market valuations and overvalued considerations for key components of the indexes. The rise of ETFs and robo-advisors has bid up the prices of some of the largest components of the indices…

Most retail investors have been enamored with the fact that they continue to throw money into these vehicles completely worry free. By being worry free within the approach of index investing, investors will be caught in a vicious cycle once the market turns.

 

Myth #3: Dividends Are Completely Tax Inefficient!

 

Yes, that might be true for those on this site. However, what about when you retire? Your retirement income becomes your dividend income. Your future effective tax rate is now substantially lower than your current tax rate.

With dividend investing, our goal is to invest in outstanding businesses at attractive valuations. Therefore, we should never have to sell shares and we are locked into long-term capital gains. We only want to continue buying shares in these businesses over time.

Consider my dividend calculator to help you develop a plan on what it will take for you to live completely off dividends forever.

 

Myth #4: Dividend Investing Takes Significant Time

 

Within my dividend investing approach, I invest in core businesses that simply have limited risk at further downside due to the attractive nature of the valuations, management teams and balance sheet. To find these outstanding businesses, it simply isn’t that difficult to do anymore. Why?

We live in the information age. We can have any piece of information pushed to us in real-time. I use several different resources

What is your excuse?

 

Conclusion on Dividend Investing

 

PoF stated in his prior post about Selling Shares Beats Collecting Dividends that in his portfolio, he sees a tax drag of about 0.6% of the portfolio annually with taxes on dividends of about 30% on a 2% dividend. However, I’d like to consider in my above points that the small tax drag is drastically trumped by the following considerations:

  1. The constant reinvesting of dividend income enables outstanding compound interest that add up dramatically over time. Even the smallest of dips in a stock will result in massive gains down the road when you are reinvesting all dividend income back into your portfolio.
  2. Investing in sectors or companies at attractive valuations can extract abnormal returns. This trumps a 6-7% average annual return over time by a wide margin.

 

Author Bio: Millionaire Mob is where people come together to find the best travel deals and financial advice. We specialize in dividend growth investing, passive income and travel hacking. Our advice has helped thousands of people travel the world and achieve financial freedom. Millionaire Mob will provide you the best advice to help you learn and grow along the way. Follow us on Instagram, Twitter and/or Facebook for all the latest updates.

[PoF: We could go back and forth all day on some of the finer points (kind of like I did with DGI in the comments of the selling shares post, but in reality, we’d be arguing over whether or not 50 or 60 basis points of tax drag on a portion of your portfolio is going to make or break your investing plan. Hint: it’s not.

Like my argument that the backdoor Roth gives you marginal gains for what might be a lot of effort, what you do with dividends (or whether or not you backdoor Roth) isn’t going to determine whether or not you’re successful. Saving diligently, investing sensibly, and remaining consistent are keys to an investing plan.

I’ll push back against point #1 just above — constantly reinvesting dividends isn’t going to make you any wealthier than not receiving a dividend. If a $100 stock gives me a $2 dividend, I’ll have a $98 stock and $2. Reinvesting the dividend gets me back to $100 or exactly where I would have been if I hadn’t received the dividend.

Yes, day-to-day fluctuations in stock prices make my example not precisely how things work, but that is essentially what happens when you receive a dividend. The share price is adjusted downward, reflecting the company giving up some cash to the shareholders.]

 


Track your investments for free with Personal Capital. That's how I track the PoF portfolio.  

 

Do you invest for dividends? What criteria do you use? Or are you like me and focused on the total return with a preference for a low dividend yield? Let’s discuss in the comments below!

 

 

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17 comments

  • Dances With Fire

    Thank you. Thank you. Thank you.

    I DO believe in a total return approach. That said, I have been an investor with Vanguard Wellington fund for almost three decades now. When I started investing dividend investing was popular and low P/E ratio stocks made good sense. Jack Bogle, John Neff, Ben Graham, Ed Owens ( Vanguard Health Care funds former manager), and even Buffet all believed in value investing.

    I am not trying to beat the market, only trying to come as close to those returns with the lowest amount of risk that is right for me, keeping a “margin for error.” As well as instant diversification, constant re-balancing (no need to sell and re-balance myself) and keeping things as simple as possible for my heirs.

    Reinvesting of dividends over 25+ years has allowed us to build shares (and wealth ) even on a modest income.

    As always, YMMV…

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  • I always love articles that give a counter point view to the view I currently have. If you get information from both sides you basically can make your own decision, much like informed consent is supposed to do for patients about to undergo a procedure.

    I do get some of the risks of index investing. Even a total market index fund is heavily weighted towards the larger companies just because of market capitalization. For instance the Vanguard 500 fund and the vanguard total stock fund are nearly identical (and I use that as my tax loss harvesting exchange equivalent) because the top 500 companies dominate the market cap so much that it skews the total index to have very similar holdings.

    I remember when I got my free analysis from Personal Capital they warned me of being overweighted in particular sectors (like Millionaire Mob said, Tech heavy). Their counter was to do sector investing and try to spread the same allocation over the 10-12 sectors in the market. I have done this manually using Vanguard sector funds myself when I feel underweighted in a particular sector).

    Index funds typically give a high 1% to low 2% yield. I am curious what the yield is you typically get when you solely focus on dividend investing.

    • Sam

      I can’t speak for the author, but I invest a portion of my money in dividend paying stocks. That portion of my investments generates about a 3% yield and the dividends increase at an annual rate of nearly 7%. I think you could easily generate 4% if you desired while still maintaining good diversity and low risk. I know of people who try to push 5%, but they have to get a little too heavy into REITs, telecoms, and utilities in my opinion. My yield of 3% is a little low because I have several stocks with a low yield that I believe have significant opportunity for future growth (example Disney yielding 1.54% and Visa yielding 0.71%)

      Kindest,

  • Drop it into MD

    2 words:

    Uncompensated risk.

  • ReFinDoc

    I am also confused about the concept of “compounding” in reference to dividend payouts. Dividends are simply returning a part of your investment to you, maybe when you don’t want it.
    Isn’t investing in large cap/dividend paying Stocks dangerously undiversified?
    If these Stocks are so highly sought after, isn’t this reflected in a higher price?
    Are dividend pay outs always the best use of capital by the company?

    Most of the desire for dividends is behavioral. The buyer feels he/she is constantly being “rewarded” for buying the Stock.

  • Thanks POF for posting this post. Thanks Millionaire Mob for your view. It’s always great to see multiple sides of the story and various interpretation on investing. Love it.
    And since I can’t decided what I like best, we still have Index Funds, dividends shares and real estate 😉

  • Henry

    “I recently went to Target and they look to be doing just fine to me now. Retail-apocalypse? I think not.”

    Equals

    It’s snowing now so global warming is a lie.

    I’m not saying that there is not a reasonable, evidence based, argument to be made for dividend investing, but this guy seems to just have more hot air (or ink as it were) than anything else.

  • I am looking to have my dividend portfolio replace at least one paycheck per month as part of my overall FIRE plan. With $300k in, I am more than halfway to my goal. Develop a plan that works for you and then stick to it, it is too easy to try and chase returns. Disciplined dividend investing is the sign of mature FIRE!

  • I love dividend investing and I engage in it on a very small scale relative to the bulk of my net worth. One problem with almost every dividend investing methodology I’ve encountered (including dividend growth investing): What happens when, during a market downturn, one or more of the components of your income portfolio cut their dividend? Are you stuck losing a portion of your income stream, having to sell into a capital loss, AND having to come up with more investible assets in order to replace the lost income? Because it seems like that’s the major achilles heel of every dividend investing style on the planet. I don’t care how great your selection techniques are or how advanced you feel like your skills as a stock picker have become, you’re vulnerable – and we’re in an era where even the most vaunted and venerable managers are failing to keep up with the indexes whether we’re in the midst of a major bull market swing to the upside like in 2017, or we’re in the throes of a volatility spike like we have been through the last two months.

    Of course, mutual fund managers charge administrative costs reflected in the fund’s expense ratio. If you’re going it alone, these expenses are better reflected in time, effort and worry.

    The tax treatment of dividends depends on whether you are investing in securities that pay qualified or unqualified dividends. The vast majority of dividend equities pay qualified dividends, which means you’re taxed at the long-term capital gains tax rate – the same tax rate you’d be taxed at if you sold a few shares of an index fund to create portfolio cash flow yourself.

    Let’s accept the Ibbotson research suggesting that 90% of a portfolio’s returns come from asset allocation alone – which can be achieved using indexes and low-cost products across various asset classes.

    How much time, effort and worry do you want to invest in that remaining 10 %? How much is maximizing that 10% really worth to you?

    Those are questions that MUST be answered before one becomes a dividend investor or any kind of investor more active than a simple, market-based index fund investor.

  • I may be asking a dumb question but one reason index funds are popular is that many studies have shown they beat actively managed funds most of the time. It isn’t really arguable because the data is public. So can’t the dividend stock debate be settled the same way? Just compare the average dividend fund performance to the index fund performance? It would stand to reason that dividend fund managers would know even more about how to screen stocks than you since you are a private equity guy now and they pick dividend stocks for a living. So if dividend stocks outperform when total return is measured and if normal investors are going to never match a paid professional then it ought to be duck soup for actively managed dividend funds to slaughter index funds over time. And maybe they have. I searched Google and could not find a single comparison of actively managed dividend funds versus index funds. I think that might add some insight to the debate, have you seen any comparisons like that?

  • Personally, I love dividends. They are right up there with rental income on my favorites list.
    I don’t write about it often because I get tired of all the arguing. I see that there are pros and cons. To me, there are a lot of benefits. Some of which you mentioned.

    I know retirees who have done this and they don’t fear running out of money.
    High dividend yields often indicate value stocks which outperform in the long run.
    It allows a higher percentage of equity investing without much stress over volatility.
    I don’t cook the goose. I enjoy the golden eggs it drops.
    I don’t have to decide when to sell shares. The dividend checks just come to me.
    I don’t have to sell after a market decline and subject myself to SoR risk.
    Dividends and dividend yields don’t drop as much as the overall market – even in recessions.
    Dividends and the underlying stocks tend to increase over time and produce more cash flow.
    I could live off all the dividends that I get right now. People can argue with that all they like.
    For now, I’m off to the bank to deposit a dividend check. Literally.

  • Gasem

    1. Actively managed “funds” are not dividend paying “stocks”. Actively managed funds have charges come rain or come shine and therefore drag the return.

    2. The idea you can’t beat the market is silly. If you bought AMZN and S&P 500 in 1998 S&P 500 is up 300%, AMZN is up 8000% This is known as a beat. If you bought BRK.B in 1996 it’s up 1000% S&P500 is up 420% since 1996 aka BEAT.

    If you own S&P 500 you own a dividend paying stock equivalent . S&P had paid 2% in dividends since Dec 1999. S&P growth has only been 3.4%/yr since Dec 1999 ex dividends till Dec 2018. S&P 500 with dividends reinvested has returned 5.4%/yr since Dec 1999. I use that time frame since it covers the last two market peaks and 2 recessions. Bonds have returned 3.9%/yr since Dec 1999.

    I look at dividend stocks as a kind of diversity. S&P paid 1.9 to 2% return every year regardless of asset price. At market peak in 2007 to market trough in 2009 the S&P dropped 59% of it’s value but still paid about 2%. If reinvested that’s “buy low” automatically implemented. It turns out for a couple years the S&P returns have not been broad based. about 100 of those stocks were in a bear market even when the index was roaring and another 100 were under water but not bear market. The FANGS and about 30 other stocks made up the difference. So dividend investing has it’s place. What I don’t like about dividend investing is people get too cute with dividend paying stocks and always go for the gold which tends to concentrate sectors.

    There is a trading strategy that has beat the market by 100% since 1999 that’s called Dogs of the Dow. The strategy only buys the 5 cheapest highest yielding stocks in the dow and holds them for a year so you are ranking on price and yield and it’s a value play on a specific universe of stocks namely the DOW. The DOW are the best run companies in the world and when they stop being best run they get kicked out. That’s a form of risk management. It is not expensive since you make a $5 trade on 5 or so stocks once a year. Sometimes you keep the same stock fore 2 years so you don’t trade just reinvest the dividends. I did an analysis and found 40% of the return was due to dividends and dividend reinvestment. Stick that in your bogglehead index investing pipe and smoke it. There are a lot of relatively safe ways to make money beside the “three fund” bogglehead approach. You want to control your risk even more set up a 60/40 DotD/bonds portfolio. The 5 stocks 12% each adding up to 60% and VBMFX at 40% gives an expected 10% return at 9% risk. For a bogglehead 3 you can expect 6.2% return at 13% risk.

  • Sam

    I love dividends, and I do have a portion of my stock investments allocated to dividend stocks. I don’t have the time, desire, or personality to directly own real estate, but I do enjoy researching stocks . While I’m far from an expert, I have become a more disciplined and focused investor because of all the research I have done.

    There are a few reasons that appeal to me personally that haven’t already been discussed. First, I like the fact that most of the dividend paying stocks increase their dividends at a rate faster than inflation (6-7% annual increases for what I currently own). I hope to be able to have a substantial income one day from dividends, and the fact that I should be able to increase my purchasing power every year is very appealing to me.

    Second, I don’t need to live on the dividends currently, so I pool the dividends and purchase stocks that I feel are undervalued based on historically low PE ratios and historically high yields (I use additional screens as well but those are a good starting point). This gives me that opportunity to be buying ever increasing numbers of shares of undervalued stocks that will, hopefully, “revert to the mean” at some point in the future.

    Third, I can focus on my income instead of the stock price. Dividends tend to be relatively stable while stock prices can fluctuate wildly. I, literally, have no worries about a drop in stock price because the underlying income is unchanged. In fact, I find myself actually hoping that the stock price drops, so I can have the opportunity to buy the stock at a higher yield.

    Lastly, dividend investing seems to provide some insulation against “sequence of return risks” that can happen immediately after retiring. Since I can have a stable income without selling the stock, a drop in the stock market early in retirement doesn’t worry me as much. My income would be unaffected, and the money generating stocks underneath would still be intact. At least, that’s my impression. Again, I’m not an expert, so if you think that’s an incorrect assumption, I’m happy to learn from this community.

    Of course, as with any style if investing there is risk. My goal is to mitigate that risk by buying stocks in different sectors and not having more than 5% of my dividend income coming from any single stock. Although my goal is to hold a stock forever once purchased, I also have a very few reasons why I would sell a stock that will hopefully protect against downside risks.

    Just my thoughts on this…

  • M

    Does anyone know of a good site that is able to show a stock or fund with total return (ie, dividend reinvestment) vs just the nominal price over time?

  • Mike H

    Good article. I’ve been dividend growth investing since 2014 and plough in fresh capital on top of dividend reinvestment and dividend raises. I’m on track to break $100k if dividend income this year, and this is in addition to rental income and working a day job. My total dividend payment growth rate has averaged 18% a year and I’ve had a bad year with 5% growth due to several dividend cuts in energy but that was offset with two years at 22% and 23% growth. This is in an after tax portfolio. I have another $7-8 k per year in dividend income in a pretax portfolio.

    You don’t have to do the same as that leaves less competition. I prefer buying my shares at a lower price.

    Drowning in income is actually fun and I don’t mind paying taxes at the low rate it is charged. I’m in my mid 40’s so as I get up there in years more of this cash flow stream will go towards charitable endeavors.

    -Mike

  • Grant

    Dividend investing is really just value investing. The problem is only about 40% of stocks pay dividends, so you are missing out on all the non dividend paying value stocks. If you want to invest in value stocks (with higher expected return relative to the broad market) it makes more sense to buy a value ETF. Ignoring non dividend payers results in a less diversified portfolio, which is therefore riskier than a more broadly diversified portfolio, not to mention less tax efficient due to the higher yield. The other issue currently with dividend payers is that because of low interest rates there has been a reach for yield which has driven up the price of dividend paying stocks so much that they now have valuations higher than the broad market, so therefore have lower expected returns going forward.

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