I’ve received an uptick in emails and comments from investors about dividends and so I thought I’d address some common misconceptions around dividend investing.
One reader in particular wanted to know if he should take the commuted value of his pension ($750,000) and put it all in Enbridge stock because it was yielding around 6.5%. That reminds me of the reader who, several years ago, asked if he should borrow money at 4% to buy Canadian Oil Sands stock that was paying an 8% dividend yield.
I shouldn’t have to tell you why it’s not sensible to put your entire retirement savings into one stock – dividend payer or not.
Most comments were much more sensible and reflected what I perceive to be some misguided thinking about dividend investing.
Dividends + Price Growth = Magic?
Some companies pay a dividend to shareholders. Some do not. Investors shouldn’t have a preference either way.
Amazon doesn’t pay a dividend, focusing instead on reinvesting their profits back into their business for more growth opportunities.
Apple, on the other hand, is awash in cash thanks to the tremendous success of the iPhone and decided to start paying a dividend in 2012. It likely cannot reinvest or grow fast enough to keep up with its cash flow and so it returns some of that cash to shareholders.
Investors shouldn’t prefer Apple to Amazon just because of Apple’s dividend policy.
But what happens when a dividend is paid? The value of the company decreases by the amount of the dividend. That must be true, since the dividend didn’t just appear out of thin air – it came from the company’s earnings.
Company A and Company B are worth $10 each. Company A pays out a $1 dividend, while Company B does not.
Company A is now worth $9, and its shareholders received $1. Company B is still worth $10 and its shareholders received $0.
But some investors do seem to think the dividend comes from thin air and that it does not reduce the value of the dividend paying company.
Consider this example: Let’s say expected stock returns are 8% per year. The average dividend yield from all stocks (both non-dividend payers and dividend payers) is around 2%. That leaves 6% to come from the increase in share prices or capital gains.
Shopify doesn’t pay a dividend. You could consider its expected annual return to be 8% (ignoring the extreme dispersion of possible outcomes for a single stock), but all 8% would come from increases to its share price.
Enbridge has a dividend yield of 6.5%. Should we expect its price to also increase by 8%? Of course not. It would be more reasonable to expect price growth of 1.5% (again, ignoring the extreme dispersion of possible outcomes).
Here’s a more diversified example featuring Vanguard’s VCN (Canadian equities, represented by the yellow line) versus iShares’ CDZ (Canadian dividend aristocrats, in blue):
Teasing out the high dividend paying stocks (CDZ) did not lead to higher returns over the last five years. In fact, this portfolio lagged the overall Canadian equity market by a fairly wide margin.
High yield stocks payout most if not all of their earnings to shareholders, leaving little to no cash for growth and acquisitions.
The bottom line: Dividends aren’t magic. Dividend investors don’t get to have their cake (high capital gains) and eat it too (high dividends).
Yield on Cost
Some dividend investors use a useless metric called yield on cost to track their growing dividends over time.
An example is that you buy a dividend stock for $10,000 and it yields 4%. Over time the company increases its dividend, which increases the yield on your original investment. Some dividend investors claim to be receiving double-digit yields on their original investment.
But this isn’t how investing works. The stock doesn’t care what price you paid for it in the past. All that matters today is the current yield.
Replacement for Bonds
One concerning trend is the notion that dividends are somehow a safe replacement for bonds. I get it, we’re in a low interest rate environment where bond yields have fallen well below 2%. But the idea of replacing bonds with stocks, even stocks that pay dividends, is incredibly risky.
Bonds do still play an important role in your portfolio. They’re the ballast that reduces the volatility of stocks. They tend to hold value during periods of falling stock prices, which is essential for rebalancing. And, they do offer a source of return.
Now, we can argue about the merits of holding long-term bonds in this environment. Perhaps a blend of short-term government bonds and high yield corporate bonds could be appropriate for your fixed income needs.
But all you need to do is look at the above chart and see how sharply CDZ fell during the March 2020 crash to understand why dividend stocks are not even close to being a suitable replacement for bonds in your portfolio.
Avoid Spending Capital
Many investors dream about having a portfolio so large they could simply live off the dividends and never touch the capital. But in reality we can see that this is impossible to do in an RRSP, and it’s impractical in other accounts. Here’s why:
You must convert your RRSP to a RRIF at the end of the year in which you turn 71. The RRIF minimum mandatory withdrawal schedule forces you to take out ever increasing amounts, starting at 5.40% in your age 72 year.
Good luck finding stocks that pay dividends (consistently) at that high of a rate – and, no, your yield on cost still doesn’t count.
It’s more realistic to just spend the dividends in your taxable account. But this poses two problems:
One, you’ll likely need to save a lot more money than you think in order to generate enough dividend income to meet your spending needs (i.e. a $200,000 portfolio would only reasonably yield $8,000 per year).
Two, unless you plan on leaving a sizeable inheritance there will eventually come a point when you need to dip into the capital. Meanwhile, you may have missed out on spending during your good, healthy retirement years.
Retirees who take a total return approach can create their own dividend simply by selling shares (or ETF units) to generate their desired income.
Dividend Tax Credit
This one might be the most misunderstood reason to invest in dividend stocks. The allure of dividend investing might come from the stories we’ve heard about investors living off extremely tax friendly Canadian dividends – even earning up to $50,000 in tax-free dividends.
But how realistic is it that you can enjoy a life of tax-free dividend income?
You can’t have any other sources of income, like from a job or a pension or from a rental property. And you’d need a large non-registered investment portfolio (think $1M or more) filled with Canadian dividend paying stocks.
In the article above, the example investor retired in his 40s and has been living off his non-registered dividends tax-free. A fun scenario to dream about, but extremely rare in reality.
Finally, most retirees start collecting other (taxable) income streams in their 60s, such as CPP and OAS, which start to erode the tax benefits of Canadian dividends.
I was a dividend investor for many years before switching to index investing. I understand all of the behavioural arguments in favour of dividend investing. But there is still a lot of misguided thinking around dividend investing.
I hope this article helped dispel some of these myths and also showed you that investors shouldn’t have a preference for dividend paying companies over non-dividend payers, and that dividends are no substitute for bonds.
Dividends aren’t magic – they’re part of a stock’s total return. If you’re attracted to a high dividend yield then consider what you might be giving up in capital appreciation.
And please don’t dump your life savings into one individual stock!