When Does a Dividend Strategy Make Sense?

January 17, 2011

My last couple of posts have dealt with stock picking and dividend-based indexes, and they’ve sparked some of spirited debate in the comments sections. Much of the feedback has come from dividend investors, and it’s prompted to me to finally write a series of posts that I’ve been researching for some time.

Dividend investing is perhaps more popular than it has ever been. There are two obvious reasons for its increased appeal. First, many people have lost faith in the growth prospects for equities and see dividend payouts as more reliable than share-price increases.  Second, the low rates on bonds and GICs have made dividend yields even more attractive to income investors. But if the emails and comments I’m receiving are any indication, many investors have flocked to dividend investing for the wrong reasons, without understanding the risk-reward trade-off.

When dividend investing may be best

Let me stress something before we go any further. I am not suggesting that building a portfolio of dividend stocks is a bad strategy. Many savvy investors have done so successfully for years, and it would be supremely arrogant for me or anyone else to tell them they’re wrong. Indeed, there are at least three situations in which focusing on Canadian dividend payers may well be superior to a global indexing strategy:

You rely on income from a non-registered portfolio. Dividends from Canadian companies can provide significant tax advantages. An Ontario resident with $65,000 in taxable income would pay only about 10% tax on eligible dividends, compared with more than 30% on interest income. If you’re making regular withdrawals from a non-registered account, the tax advantages of Canadian dividend stocks can make them superior to other types of investments.

You buy discounted shares directly from companies. Many investors have enjoyed great success using share-purchase plans (SPPs) and dividend reinvestment plans (DRIPs). SPPs allow investors to buy shares directly from the issuing company without brokerage fees, while DRIPs reinvest all dividends in new stock (including fractional shares), often at a significant discount. Investing this way is for the serious DIYer only. However, if you’re buying all of your shares at a discount and with no trading commissions, the rewards can be enormous over time.

You cannot imagine yourself as a passive investor. While the academic research is clear that indexing is likely to provide the highest returns, that assumes people have the discipline to stick to the strategy. Most people don’t: they either believe they can beat the market, or they accept the theory behind indexing but find it too hard emotionally. If you know you could never buy and hold index funds, but you’re prepared to be rigorously disciplined with a portfolio of dividend-paying stocks, then you should certainly do the latter. The best investment strategy is always the one you’ll stick to over the long term.

Dividends are not a free lunch

That said, I believe that many investors have bought into myths and misunderstandings about dividends. Many believe that choosing individual stocks based on their yields gives them a high probability of outperforming the broad equity markets. Others think that dividend stocks can take the place of bonds or GICs in a portfolio. Perhaps most alarming, some even refer to dividends as free money or a free lunch.

Dividends are an extremely important part of investment returns, but there is nothing magical about them. If you’re still in the accumulation phase of your life — that is, if you’re not drawing on your portfolio for income — then you should focus on total return, whether it comes from dividends, capital gains or interest. And the optimal vehicle for maximizing total returns is a globally diversified, passively managed portfolio, not one based around dividend funds or individual stocks.

I’ll kick off the series tomorrow with Dividend Myth #1: Companies that pay dividends are inherently better investments than those that don’t.

Congratulations to Michael and Echo, who won the draw for free copies of Meir Statman’s new book, What Investors Really Want. Thanks to everyone who entered by posting their thoughtful comments about their own behavioural biases.

{ 26 comments… read them below or add one }

Money Smarts Blog January 17, 2011 at 7:47 am

Looking forward to the series.

While I think dividend investing is a decent investment method, I’ve never understood the “magical qualities” of dividends.

I think that if you are going to be a dividend investor, you have to have confidence in your stock picking abilities (and measure it).

Mark January 17, 2011 at 9:01 am

“While the academic research is clear that indexing is likely to provide the highest returns”

This statement caught my interest. I am an index investor because of the easiness and hassle-free style of the strategy but I didn’t realize that index investing yields the highest returns. I thought it was the average return before fees and above/well above average returns after fees.

Canadian Couch Potato January 17, 2011 at 9:15 am

@Mark: It’s important to be clear about the term “average return.” There is a big difference between “market returns” (which is how you’re using the term, I think) and the returns of the average investor. Market returns are much higher than those earned by the average investor, as demonstrated by many years of evidence from DALBAR and others.

Indexing gives investors market returns, minus minimal fees. There is no investing strategy that has been shown to consistently beat the market over the long term.

Echo January 17, 2011 at 9:43 am

Hi Dan, I think your statement – “The best investment strategy is always the one you’ll stick to over the long term” is the key message to any investor.

I don’t believe that dividends are a free lunch by any means, but in order to build up a portfolio that will provide me with income in retirement without having to eat into my capital requires the following:

1. Patience – During the accumulating phase, those 5% and 10% dividend increases look small, however after 20 years with a solid company consistantly increasing their dividends, your yield on cost should be in the double digits – beating the market with yield alone.
2. Understanding of Valuation – Buying solid blue chip dividend paying companies is a sound strategy, but only when they are value priced. You can look at average yield, P/E ratio, Graham Number, etc to determine value.

Dividends are not magical, but they play an important part in the total returns of the market.

PS – Thanks for the book, and I’m looking forward to the series!

Canadian Couch Potato January 17, 2011 at 9:58 am

@Echo: Thanks for the comment. See, this is where there is a fundamental misunderstanding: “after 20 years … your yield on cost should be in the double digits – beating the market with yield alone.” You’re comparing the market return in the current year with the yield on cost you’re getting after 20 years of compounding. This makes no sense: you’re giving yourself a two-decade head start! The only fair comparison is to compare the 20-year total return on a dividend-focused portfolio to the 20-year total return of the broad market.

DM January 17, 2011 at 10:37 am

HI Dan, looking forward to the series. What would be interesting is to know what % of the total return on the TSX or, say, the S&P 500 has historically come from price appreciation of underlying equities vs. dividends. From what I’ve read, the vast majority of capital gains has come from price appreciation, not dividends. So over the long run, I believe a globally diversified portfolio should outperform a portfolio that is constrained to investing in companies with a high dividend yield. As you point out, the problem is that in the wake of the market meltdown of 2008, we are anchoring on blue chip companies as a “safe haven” where you get “paid to wait.”

Canadian Couch Potato January 17, 2011 at 10:46 am

@DM: I’ll have to rely on secondary sources for now, but Tom Connolly’s Dividend Growth website quotes the Globe and Mail as saying: “Over the 20 years ending January 2009, the TSX index grew 4.5% a year. If you include dividends, the total return of the TSX was 7.0%.” So 4.5% from price increases and 2.5% from dividends.

Norm Rothery’s Stingy Investor says: “From 1975 to 2009 the MSCI World Index (a measure of the performance of stocks across the world) provided an average total return, adjusted for inflation, of 6.9% per year. Of that total, dividends accounted for 2.9 percentage points and capital gains 4.0 percentage points.”

Echo January 17, 2011 at 11:25 am

@Cdn Couch Potato
I would love to see that comparison over the last twenty years. I did provide a link from RBC in the comments of your last article that suggested the total 20 year returns from dividend growth stocks was 11.9% vs. the S&P/TSX index which returned 7.5%. You’re right, they didn’t quote their sources in that marketing piece, so I’d be curious to find out how they reached those numbers. If it’s true, 4.4% is a HUGE difference over 20 years.

My issue with indexing is that it’s commonly referred to as passive investing when it is anything but that. You’ve said yourself that you have tinkered endlessly with your portfolio, switching in and out of ETF’s based on what you feel has a better representation.

How is that more passive than buying dividend paying stocks when they are value priced and holding them for the growing income? You can’t achieve market returns minus fees when you are constantly switching in and out of funds, can you? And if you are too passive, your portfolio will become out of balance with your original strategy. Look no further than the difference in returns between the Canadian Capitalist and Money Smarts Blog portfolios last year.

In the end both strategies come down to the individual investor. We are our own worst enemy when it comes to investing, and those who lag the market will be the ones whose portfolios are eaten away by fees and poor market timing.

Brian January 17, 2011 at 11:47 am

Thanks for shedding some light on the subject Dan! I’ve read a few books on dividend investing, Ultimate Dividend Playbook, and Single Best Investment.

Never been able to incorporate this into my investing approach because I don’t believe I can successfully pick stocks.

Canadian Couch Potato January 17, 2011 at 1:36 pm

@Echo: I’ll be dealing with all of these arguments in future posts. But for now I should say for the record that I don’t “tinker endlessly” with my portfolio. I made a number of changes in the first six months of my indexing life when I didn’t know what I was doing and didn’t understand the full range of products available. (For example, buying hedged ETFs before discovering Vanguard.) I have long since settled into Couch Potatohood.

Echo January 17, 2011 at 1:55 pm

@Cdn Couich Potato
Sorry, I said “have tinkered” as in “you did that in the past”…I’m aware that was in your initial set-up, which I was guilty of doing as well with my approach.

But what about the re-balancing? In your Uber-Tuber portfolio there are 11 funds. In the Yield Hungry Portfolio there are 9 funds. Re-balancing these more than once every year or two would get awfully expensive, yet they would likely become out of balance the day after you set it up. Again, hardly more passive than buying and holding dividend growers for the long term.

Anyways I don’t mean to high-jack your intro post, so I’ll be looking forward to your series on this subject.

The Passive Income Earner January 17, 2011 at 4:16 pm

I am looking forward to you post. I side with Echo and the dividends. Surely, compound growth of dividends in an explicit fashion can out-pace an index growth over time … It’s not easy to compare since every dividend investors are selective about their picks so no portfolio is the same … For me compound growth is the differentiating factor.

JS January 17, 2011 at 10:00 pm

Looking forward your series! I feel a little guilty about my previous post Saturday: I day write that i’d rather own XDV than GIC, but I do have 20% of my portfolio in XCB!

My (weird) logic can be summarize like this: I should allow a smaller proportion of my portfolio to fixed income by allowing more money to dividend ETF (32% in my case).

I must admit that you (and other readers) are making mw think twice about my strategy. I became a DIY investor by reading a lot on dividend investing. I guess I became a believer and the approach is still attractive to me even though I decided a couch potato approach would be better.

The asset allocation is still killling me! I’ll be looking forward your posts!

Paul January 17, 2011 at 10:44 pm

Am looking forward to why you think DRIPs are “for the serious DIYer only”, since that’s how I’m doing it, and I still see myself as a beginner (I’m realistic in my assessment and don’t expect to ever be an expert in any way, shape or form).

Steve in Oakville January 17, 2011 at 10:48 pm

I’m a fan of dividend growth investing as well, but I think the dilemma we face when looking at blanket statements like “the total 20 year returns from dividend growth stocks was 11.9% vs. the S&P/TSX index which returned 7.5%”, which, although possibly factual, is that any company who cut their dividends during that time (e.g., TRP in 2000, MFC more recently) would have been deleted from the dividend growth side of the equation. Obviously, that might end up inflating the dividend growth returns.

Basically, the issue is looking back vs. looking ahead, and it might be harder than we realize as dividend growth investors to find the companies that will continue to increase their dividends. I’m sure, 20 years from now, the subset of stocks that HAVE increased their dividends from 2010 to 2030 will outperform the broader markets, but maybe a few of those companies have only just started to pay dividends – how could I identify those companies now? – and can I successfully avoid the ones who halt or cut their payouts. How can I be sure, in other words, that I’m selecting the winners over the next 20 years.

I think it’s important to recognize the bias of hindsight in any of these types of comparisons.

The Dividend Ninja January 18, 2011 at 3:53 am

Hi Dan thanks for opening up this debate. I’ve noticed Index investors and Dividend investors are so polarized, but there is no need to be. It’s all apples and oranges here, and oddly enough everyone is right.

Of course beating the index is tough, and its also ludicrous to fixate on companies that ONLY raise their dividends. If a company has a reasonable yield, and is a good price then that is a sound investment. Why limit yourself to only growth without dividends? Why assume dividend paying stocks have no room for growth ? Many dividend stocks have much capital appreciation.

I would argue that combining BOTH Index Investing with Dividend Stocks is the key.

Here is why: You buy an index fund you are only betting on an index. If the market does well you make money, if it doesn’t you lose money and you have to rebalance at some point and top up the losing index fund with somehting else from your portfolio. If you buy an Index fund at the bottom of the market you will do well, if you buy near the top of the market then you won’t. Not that anyone knows where the tops and bottoms are so its just as much a gamble as picking stocks. Having said that, everyone should have index funds in their portfolio becuase you cannot second guess the market.

But if all you buy is index funds you are also missing out on BOTH the GROWTH and INCOME from dividend stocks. Personally I don’t care if a company raises their dividends or not. I don’t care if its an Aristocrat or not. If the company is solid, earns a decent yield and is not trading at 52 week highs (i.e. Canadian Banks, Rogers or Shaw for example) then its a buy.

The Canadian Banks for example did phenomenal since 2009, they are nearly double their share price and have excellent yields, but I didn’t see index funds with that kind of growth in 2009 and 2010. That’s why I believe a combination of Index Funds and Dividend Stocks will make more than investing in either one exclusively. Its a simple case of diversification :)

Canadian Couch Potato January 18, 2011 at 8:14 am

@Paul: Sorry, I should have been clearer. I meant that that enrolling in SPPs and DRIPs directly through companies is for serious DIYers only. It can be quite time consuming and involves calculating average costs yourself, etc. This is quite different from people who use DRIPs through their discount brokerage, which is effortless.

@Steve: I could not have said it better myself. More on this in a future post.

@Ninja: It’s never my goal to be polarizing, and it’s not my intention to tell committed dividend investors that they’re all wrong and should adopt a new strategy. However, many less experienced investors are being bombarded with misinformation. With all due respect, that includes claims like index investors “are missing out on the growth and income of dividend paying stocks” and that investors can consistently beat the indexes by selecting stocks based on yield or by timing their purchases. Much more to come, all in the spirit of friendly exchange.

The Dividend Ninja January 18, 2011 at 11:09 am

Hi Dan, yes all in the spirit of friendly exchange :)
Not claiming anyone can time the market, just saying if I buy a stock I like to buy near the 52 week lows and hold. And yes I get growth and income from that investment. I also think a core of index funds are vital to any portfolio as well. Keep up the good work, I’m looking forward to reading your articles further on this!

Mark January 19, 2011 at 7:38 am

@CCP
“Indexing gives investors market returns, minus minimal fees. There is no investing strategy that has been shown to consistently beat the market over the long term.”

That makes sense since any strategy that is known to beat the market consistently would have many bandwagon jumpers thus driving down the gains.

Invest It Wisely February 9, 2011 at 5:20 pm

@Mark
That’s what I was thinking, too. By the time everyone knows about a certain strategy it’s probably too late.

Daniel March 21, 2014 at 11:20 am

Hi everyone,

I have what it likely a very basic question, but as rookie investor your advice/feedback would be greatly appreciated.

I’m confused about the difference between investing in a CDN dividend ETF vs a broad based CDN Equity Fund (e.g. Vanguard Canadian All Cap ETF). It seems like the All Cap ETF would include many of the dividend paying stocks that would appear in Dividend ETFS, but is more broadly diversified. In fact, to my untrained eye, many of the funds seem the same, but they’re packaged as specifically dividend. When I scan through the sector allocation and holdings, they seem quite similar. Lots of financials and energy, and most of the same companies in each sector, e.g. the big banks. Am I missing something?

I would like to invest in my TFSA which the goal of growing my portfolio in order to have a downpayment for a house over the next 2-4 years. I do not require income for day to day purchases, will not be making withdrawals, etc.

Thanks!

Daniel

Canadian Couch Potato March 21, 2014 at 1:00 pm

@Daniel: You are generally dead-on with the first question: the Canadian market is dominated by banks and energy companies, which also happen to be good dividend payers, so a dividend-focused ETF will have many of the same holdings as a broad-based ETF. But overall it will be less diversified because of the fewer holdings and even greater concentration in those sectors.

Re: your second question, it’s very important to understand that equities are not an appropriate investment for the short term. They can easily lose money over 2 to 4 years. If you are saving for a house purchase, GICs or a simple savings account are far more appropriate:
http://canadiancouchpotato.com/2010/11/10/ready-willing-and-able-to-take-risk/
http://canadiancouchpotato.com/2011/08/09/do-you-have-the-right-asset-allocation/
http://canadiancouchpotato.com/2010/08/16/lunch-is-still-not-free-even-if-its-potatoes/

Daniel March 22, 2014 at 11:32 am

Hi!
Thanks for the reply, just purchased your book! Happy to hear I’m not totally confused about those funds.

I was a bit surprised about the no equities rule – is it not ok to be a little bit more aggressive if I can tolerate and afford the risk? Given that I’m still relatively young (32), with no debt/dependents and solid income, it seems that GICS or a simple saving account is rather conservative no? For example, if I had five thousand dollars of my maxed out TFSA in the Vanguard CDN all cap and the markets dropped 50% I would be okay with this. On the other hand, given that it’s an election year, maybe it’s not the time to use my house fund for U.S. Equities given the volatilty/uncertainty that comes with election years. Thanks!

Canadian Couch Potato March 22, 2014 at 11:43 am

@Daniel: The “no equities rule” applies only to short-term savings where you absolutely must have the money on a specified future date.

You said you wanted to use the money for a house purchase in 2 to 4 years. Let’s assume you need $20,000 for the down payment. If you invest that money in stocks, it could very easily be worth less than $20,000 two years from now (in 2008–09 you could have lost half in six months). If you have the ability to make up that shortfall with money from other sources, that’s fine. If you don’t, then you can’t buy a house.

The same is true for education savings. If I know you will need $50,000 to pay for a child’s education from 2015 through 2018, you can’t invest that money in stocks or you risk it turning into $30,000 (or less) and having to tell her you can’t pay for her schooling.

Daniel March 22, 2014 at 12:45 pm

Hey Dan,

Sound advice as ever, I think I was a bit dazzled by the index returns of 2013. Actually I have enough for a down payment, hoping to increase it to either afford more or pay less when I decide to purchase over the next while.

So let’s say that I need $50,000 for a downpayment and I currently have $60,000. I will put $50,000 into GICS and play with the extra cash – should I divide this extra cash in my TFSA the way I would elsewhere – eg into a mix of CDN equities and bonds? Currently my TFSA is a mix of cash, short term bonds (Vanguard) and an overpriced CDN Balanced mutual fund (70% equity, 30% mixed bonds). Based on your advice it sounds like I should sell most of this to be safe once the early redemption fees no longer apply.

Right, sounds like the way forward is to protect my savings and work harder to add to them! Thanks again for your time and expertise, really appreciate it. It’s nice to have someone helping the little guy.

D

The Passive Income Earner March 22, 2014 at 6:20 pm

Dan has given you some sound advice.

I would also avoid the ‘afford more’ unless you really need it and I would recommend to put more down on your place. It doesn’t take long for the ‘afford more’ to turn into a money pit …

I have also found the best way to grow a portfolio is to add money to it. There isn’t any magical investment multiplier and time does wander to the portfolio.

All the best!

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