Debunking Dividend Myths: Part 5

This post is the fifth in a series exploring the myths and misunderstandings about dividend investing. The goal of the series is to argue that many investors following a dividend-focused strategy may be better off with broad-based index funds.

Dividend Myth #5: It’s easy to build a well diversified portfolio of Canadian dividend stocks.

One of the most appealing aspects of dividend investing is the tax advantage: dividends from Canadian companies are eligible for a significant tax credit. This credit does not apply to US or international stocks, however—indeed, foreign dividends are taxed as regular income and are subject to withholding taxes. That’s why many dividend-focused investors hold only Canadian stocks in their portfolios.

Income from Canadian dividends is an important part of most retirement plans. But if you’re staking your whole future on a small number of domestic stocks, you should be aware that your investment strategy may be a lot riskier than you think.

Understanding risk

First, a little financial theory. All equity investors face systematic risk, which is simply the risk associated with the market as a whole. Systematic risk cannot be diversified away: even people who own index funds with thousands of stocks are not immune to a market crash.

A second type of risk is called is unsystematic risk: it applies only to investors who hold individual stocks. For example, a company’s share price will fall if it declares lower-than-expected earnings, but such an announcement will have virtually no effect on the broad market.

The important point is that investors are rewarded for taking systematic risk: it is the reason stocks have the highest long-term returns of any asset class. However, investors are not compensated for taking unsystematic risk. Holding a small number of stocks in a portfolio offers the possibility of dramatically beating the market, but this potential is outweighed by the much higher downside risk.

That’s why investors should try to eliminate unsystematic risk altogether. They can do this by diversifying their holdings across many stocks, so that no single company can torpedo their portfolio.

How many stocks do you need?

So how many stocks do you need in your portfolio to eliminate single-company risk? A commonly held belief is that 15 to 30 stocks are enough, so long as they are spread across several sectors. However, recent research suggest that number should be much higher.

An analysis in The Journal of Investing in 2000 found that “even 60-stock portfolios achieve less than 90% of full diversification.” A 2008 paper from Dimensional Fund Advisors argued that a 50-stock portfolio would need to beat the market by 10 basis points per month to reward the investor for the additional risk.

In his review of the research on diversification,  William Bernstein puts it this way: “To be blunt, if you think that you can do an adequate job of minimizing portfolio risk with 15 or 30 stocks, then you are imperiling your financial future and the future of those who depend on you.”

A narrow slice of a narrow slice

Even if you could properly diversify a portfolio with 30 holdings, there’s still the matter of spreading these across all sectors of the economy. And if you’re picking only from a menu of Canadian dividend-paying stocks, that is virtually impossible.

The makeup of the Claymore and iShares dividend ETFs bear this out. Claymore’s CDZ includes companies that have raised their dividends for at least five years: there are fewer than 40 of these, and about 30% are in the energy sector. Its iShares competitor, XDV, includes the 30 highest yielding stocks in the country, and it’s 52% financial services companies. The broad Canadian market is already poorly diversified, and focusing on dividend stocks just compounds the problem.

Canadians who select individual stocks rather than using ETFs have more freedom, but they can’t avoid sector concentration altogether. They can pick a few telecoms, utilities, REITs, and a railroad or two. But the technology, health care and consumer retail sectors (which make up about 45% of the S&P 500) are all but absent from the mix.

No one cares about diversification when their concentrated bets are working well. But what happens if Canadian banks suffer a crisis like US banks did in 2008–09? We dodged that bullet, but do we really think our financial institutions are immune from something similar? What happens when oil prices fall, as they have many times in the past? Or if foreign competition changes the Canadian telecom space?

Why expose your whole portfolio to idiosyncratic risks like this, when you’re not likely to be rewarded for doing so?

Seeking diversification abroad

It’s not just dividend investors who face risks from Canada’s small, narrowly focused stock market. Even Couch Potatoes who hold the entire S&P/TSX Composite have 70% of their money in three sectors (financials, energy, and materials). That’s why all Canadian investors should give serious thought to addressing their home bias.

If you have a significant portion of your investments in Canadian dividend stocks in a taxable account, consider taking a broader view with your RRSP. A diversified mix of index funds or ETFs (bonds, US and international stocks, and other asset classes) can dramatically reduce the risk of your overall portfolio. Canada is a wonderful place to invest, but there’s a big world out there beyond banks and energy.

Other posts in this series:

Dividend Myth #1: Companies that pay dividends are inherently better investments than those that don’t.

Dividend Myth #2: Dividend investors are successful because they select excellent companies and buy them when they are attractively priced.

Dividend Myth #3: Dividend-paying stocks are a substitute for bonds in an income-oriented portfolio.

Dividend Myth #4: You can beat the market with common sense: just focus on blue-chip companies with a competitive advantage and a history of paying dividends.

Dividend Myth #6: Investors who follow a dividend growth strategy will eventually beat the market on yield alone.

20 Responses to Debunking Dividend Myths: Part 5

  1. 0xcc January 31, 2011 at 9:11 am #

    I think that the witholding tax is dependent on the country the income was generated in (although I’m not exactly sure how ADRs (American Depositary Reciepts) work). It just happens that right now the US tax on dividends is 15% which is why there is a 15% witholding tax on income from US companies if held in a non-registered account (and for the purposes of witholding tax discussions a TFSA is a non-registered account).

  2. The Dividend Ninja January 31, 2011 at 12:32 pm #

    Dan, again another well researched and well written article! I’m sure we will be reading this series in the next issue of Money Sense? :) Congratulations on all your hard work, and for challenging investor’s ideas. You bring up excellent points here about diversification, sector allocation, and investment strategies in general.

    You bring up global diversification, yet I see what is happening in Europe and the US over the last few years, the long term effects of deflation in Japan, and I am quite happy to be holding primarily Canadian investments. I’ve just eliminated 97% of my risk by not diversifying globally! I’m sure that is flawed, but investing in China Brazil or India or even in Europe right now has a lot of potential risk as well – I’m just not ready to go there. Let us indeed hope our banking system is indeed in sound shape – otherwise index investors will be hit just as hard as well. An Index won’t provide a safety net in that scenario either – yet only 10% of my dividend portfolio is exposed to banks.

    Sector allocation is vital and it certainly is an issue, since the stocks I own (in my non-potato portfolio) are around 10% of my holdings, though I have done my best to diversify across sectors and have a US stock. It’s not perfect but it’s still diversified. And there are a couple of European multi-nationals on my watch list as well. Ultimately if one of those companies went under, yes it would have an impact on my portfolio, I cannot deny that. Of course buying an Index ETF eliminates that risk by the sheer volume of stocks in that ETF, but then again I’m not exposed to the Nortel’s (to use the trite example) or sector bias in the TSE (Resource and Financials).

    Again the combination of Passive Index Investing and Dividend Investing gives me the diversification I am looking for, slowly I will add US stocks and perhaps look into Asian and European equities in the future as well. Keep up the good work Dan, these are the best articles I have seen written in a long time! Do I see a Dividend Investing book in the works?

  3. Canadian Couch Potato January 31, 2011 at 12:45 pm #

    Thanks for the kind words, Ninja, and for adding your thoughts. I encourage people to remember that after the 1980s everyone was saying Japan was the place to invest. Then Japan went into the toilet. At the end of 1990s, the US was blowing everyone out of the water, including Canada. Then the US had a terrible decade. Canada went on to trounce both US and overseas markets in the 2000s. What are the chances they’ll be the only back-to-back champions?

    A dividend investing book in the works? Not from me! :)

  4. Echo January 31, 2011 at 2:38 pm #

    Hi Dan, I would argue that global diversification did not protect investors from the latest market crash. Concentrating your holdings to a strong commodity based economy with a sound financial sector shouldn’t be all that risky. Were technology and health care stocks immune from the latest crash? I think all sectors were hit pretty hard across the board, so how does spreading the risk help you?

    I’m not worried about chasing the next emerging market, I couldn’t care less if Japan or the U.S. markets trounce the TSX in the next decade. My retirement is a few decades away. It’s the growing income that dividend investors are after, so when the entire global market crashes again, dividends will likely be the only returns that any market provides.

  5. Think Dividends January 31, 2011 at 3:47 pm #

    Dividend Investors plant “money trees” whereas Couch Potatoes grow “nest eggs”.

    Dividend income is more reliable than counting on capital gains to fund retirement.

  6. The Passive Income Earner January 31, 2011 at 4:51 pm #

    Diversification is definitely a must regardless of the investment strategy. I personally like strong international companies with foothold in North America since I better understand the politics and economics here than elsewhere.

  7. My Own Advisor January 31, 2011 at 9:08 pm #

    Good post Dan.

    “Income from Canadian dividends is an important part of most retirement plans. But if you’re staking your whole future on a small number of domestic stocks, you should be aware that your investment strategy may be a lot riskier than you think.”

    How many investors really do that? Bet their whole future on a small number of companies? I would think that’s a small minority of DIY investors. Most folks are in mutual funds anyhow. Regardless, that’s why I don’t go “all-in” with only stocks, let alone just Canadian dividend-paying stocks. Canada, for the foreseeable future, will never be fully diversified. Never has been from what I recall. It has always been a land of fruitful financials, utilities, telcos and energy companies, with a sprinkle of tech stocks that have had some glory days. (I avoid the latter but that’s a decision other investors may not share with me, owning RIM or before that, Nortel for example.)

    A fair statement “if you’re picking only from a menu of Canadian dividend-paying stocks, that (prudent level of diversification) is virtually impossible.” However, the prudent dividend investor will own more than just Canadian dividend-payers if they want to be diversified. JNJ, KO, PG, PEP, XOM, IBM and MSFT and a few other companies immediately come to mind in the U.S. You instantly obtain international exposure with these businesses since they sell more to the world than they do domestically in the States. Check out the biggest holdings of VTI – half of those I mentioned above. I know you already know that :)

    Like Echo, I’m not worried about chasing the next emerging market nor if foreign or U.S. markets trounce the TSX in the next decade. My retirement is many years away as well. What I am after is the growing passive income. Think Dividends said it well.

    Canadian markets have never been and will likely never be the “be all, end all”. That’s true for Canadian indexed products and stocks alike.

    Going forward, I think dividend stocks (including Canadian ones) have a strong place in an investor’s retirement plan. They will provide an investor with steady income in “down” markets, providing a softer cushion when things get rough (and they will again eventually, maybe soon.) This makes dividend stocks a defensive and somewhat secure play, since dividends never lie and a company can either afford them or they can’t.

  8. Canadian Couch Potato February 1, 2011 at 1:37 am #

    @MyOwnAdvisor: Thanks for your comments. Having talked with financial professionals about this, I can tell you there are indeed investors whose entire portfolios (or at least the lion’s share) are made up of fewer than 20 Canadian stocks.

    I guess I’ve never understood the idea that, “It doesn’t matter if my returns lag the global markets over the next decade, as long as my dividends grow.” But this has been the impasse all along. I’ve been trying to argue that investors in the accumulation phase should focus on total returns and be indifferent to whether these come from dividends or capital gains. Clearly many people disagree with that.

  9. Paul G February 1, 2011 at 10:29 pm #

    I think people just don’t like the idea of tapping into their capital, and potentially having to pay capital gains…. which also makes the idea of selling off assets to get revenue-generating assets also scares people for that same reason. (those last points being irrelevant in registered accounts though)

    But most people think in terms of revenue and capital, and mental accounting seems to work that way. I’ve had to fiddle a lot on Excel spreadsheets to slowly figure out that capital growth + dividends is usually equal to play capital growth, elsewhere.

    I know I’m sometimes tempted to look for investments with NO dividends, to simplify portfolio management as well as taxes.

  10. Andrew Hallam February 2, 2011 at 9:14 am #

    Hey Dan,

    Another excellent article. With my portfolio, when I bought my international stock index, I actually looked for one that paid low dividends (VEA). I pay taxes on dividends, but not on capital gains.

    I do know that even some stock pickers go for low dividend paying companies if they can. I certainly used to. I bought some great dividend payers, but I never bought them for their dividends. There were other reasons. And from what I’ve read about Buffett, he thinks on the same lines (OK, I stole the ideas from him).

    If a company pays a high dividend, but it has proven to consistently earn high returns on total capital, then the dividend can be consider a bit of a waste, which is taxed twice: at the corporate level and at the individual level. In a tax advantaged plan, there’s an argument against that, but if Canadian stats are anything like American stats, most invested money is in taxable accounts, not tax deferred accounts. Prolific investors run out of room quickly in tax deferred accounts.

    I do like (and very much respect) both sides of the discussion that has emerged.

  11. Canadian Couch Potato February 2, 2011 at 9:25 am #

    @Andrew: Thanks for adding a new twist to the debate. I have spoken with professional money mangers who also make attempts to avoid dividends in taxable accounts for clients who do not need the current income. DRIP investors, for example, get taxed on dividends that they reinvest, whereas a company that reinvests its earnings accomplished much the same thing with no immediate tax consequences.

  12. daniel February 2, 2011 at 10:28 pm #

    I’m no expert,but I own 94 stocks,all Canadian.I think I”m fairly diversified but probably accidently so. My portfolio increased 37% in the last 12 months. I’m probably just lucky. I’m 76 years old and have been in the market for 45 years. Daniel.

  13. Canadian Couch Potato February 2, 2011 at 10:32 pm #

    @Daniel: I’m not going to argue with 45 years of experience. Cheers!

  14. My Own Advisor February 3, 2011 at 12:22 pm #

    @Daniel – WOW. You need to run a blog.

  15. Dave February 3, 2011 at 1:57 pm #

    It never ceases to amaze me how quick people are to jump on a hobby horse (dividend portfolios or anything else) and ride it to death. I find your comments on diversification and the relative merits of dividend and non-dividend stocks very useful, but suspect those who could most use it are the ones who focus on individual stocks to the exclusion of broader etfs.

    While I can’t prove it, it seems to me that it is possible to create a reasonably diversified range of high quality (read blue chip) dividend stocks, a la Rob Carrick’s Two Minute portfolio, and supplement it with a broad market blue chip fund and a complementary completion fund. Sure you will get some duplication with a TSX60 fund, but nothing is perfect.

    Leaving aside fixed-income investments at this point, it seems to me the more adventurous can throw in modest sector plays based on a good day-to-day knowledge of economic developments, e.g. agricultural funds, materials funds or whatever that reflect broad economic trends. The secret, it seems to me, is to limit positions as a way of controlling over-complexity and damage due to downturns.

    To me one of the foremost risks is the dependency on self-proclaimed experts most of whose long-term success and personal interests are a mystery. While I find discussion of narrow issues, such as this one, very useful, I despair of ever seeing overall portfolio analysis, as if that is something that only professionals in the field can handle. Considering the very low success rate of portfolio managers relative to the indexes, they are no better at doing this than anyone else.

    I’m beginning to ramble a bit here, but my point is that I strongly believe that it is quite possible for a reasonably committed non-professional to craft an investment strategy encompassing all his various portfolios (RSP, non-registered, TFSA, etc.) that exceeds the output of a significant proportion professional advisors by at least as much as the fees they charge. Thanks much for your forum and the opportunity to respond.

  16. Canadian Couch Potato February 3, 2011 at 2:02 pm #

    @Dave: Thanks for stopping by and adding your comment.

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