It’s been almost two years since I made the switch from dividend investing to a passive, two-fund ETF solution. I sold a portfolio of 24 Canadian dividend-paying stocks and REITs and bought Vanguard ETFs VCN (Canadian stocks) and VXC (U.S. and International stocks).
I started buying individual stocks in 2009, just after the stock market had reached its nadir from the financial crisis. Dividend investing was gaining popularity and I went along with the herd – following the likes of Tom Connolly and John Heinzl – believing that companies that paid a dividend produced better returns than those that didn’t pay a dividend.
Over the next five years, as the stock market soared to new heights, my portfolio of dividend growers actually outperformed the market. The strategy was working!
So what happened? Here’s why my thinking about dividend investing changed and what triggered a switch to passive investing.
1. Dividends aren’t magic
Dividend investors don’t get to have their cake and eat it too. If the expected annual return of an average stock is eight percent, that means a non-dividend paying stock will appreciate by eight percent, while a stock that pays a three percent dividend will see capital gains of only five percent.
Too many investors believe they’ll get eight percent growth from their dividend stocks, PLUS another three or four percent in dividends. That’s simply not true.
In a recent article titled, “The Irrelevance of Dividends”, author Larry Swedroe says that stocks with the same exposure to important factors such as beta, size, value, and momentum, have the same expected return regardless of the dividend policy.
“Any screen for dividend stocks results in portfolios that are far less diversified than they could be if dividends were not included in the portfolio design. Less diversified portfolios are less efficient, as they have a higher potential dispersion of returns without any compensation in the form of higher expected returns (assuming exposures to the factors are the same).”
2. Investing for growth, not income
As a 37-year-old investor with an investing time horizon in the decades, it’s not a priority to generate dividend income from my retirement portfolio. I should be looking to maximize growth in the most diversified and efficient way possible.
Sure, it was exciting to watch dividend income grow from just a few hundred dollars into thousands of dollars a year. Every time a company in my portfolio increased its dividend was cause for celebration.
But as fun as it was to get a bump in dividend income in reality the increase was meaningless for my investment strategy – I didn’t need the income so I’d reinvest the cash into more stock.
Now I own two ETFs that together hold 8,381 stocks from around the entire world and celebrate in the success of global capitalism and economic advancement.
Related: Is my two-ETF portfolio too simple?
3. Becoming a more rational investor
Switching from dividend growth to a total-return approach meant facing some inherent behavioural biases – mostly about how to withdraw income from an index-based portfolio.
Generating retirement income from a total-return approach means using a self-created dividend (i.e. selling shares). What took me a while to realize is that there’s no difference between a cash dividend and the sale of an equal amount of stock.
Back in 1984, behavioural finance experts Hersh Shefrin and Meir Statman wrote a paper that tried to explain investors’ preference for cash dividends.
One explanation for this preference is called prospect theory, or loss aversion, which states that investors will base decisions on perceived gains rather than perceived losses.
This explains why retirees, for example, prefer taking dividends instead of selling stock to generate income.
“Because taking dividends doesn’t involve the sale of stock, it’s preferred to a total-return approach that may require self-created dividends through sales. Sales might involve the realization of losses, which are too painful for people to accept (they exhibit loss aversion).”
4. Getting over the fear of regret
It’s hard to sell stock. I should know – I sold my entire portfolio and felt like a part of me died. So it’s easy to see why retired investors prefer cash dividends to a self-created dividend made by selling shares.
Shefrin and Statman call this risk avoidance and illustrate it with the following example:
1) You take $600 received as dividends and use it to buy a television set.
2) You sell $600 worth of stock and use it to buy a television set.
After the purchase, the price of the stock increases significantly. Would you feel more regret in case one or in case two? Since cash dividends and self-dividends are substitutes for each other, you should feel no more regret in the second case than in the first case. However, evidence from studies on behaviour demonstrates that, for many people, the sale of stock causes more regret. Thus, investors who exhibit aversion to regret have a preference for cash dividends.
That same fear of regret explains why dipping into capital is such a sacred cow for investors.
What I came to understand is that it’s irrational to spend only from my portfolio’s cash flow while never touching the principal. Unless I plan on leaving a large inheritance, it makes no difference whether I spend cash dividends or generate my own homemade dividend by selling shares.
Math doesn’t always trump behaviour. That’s why I still understand the appeal of dividend investing. Incoming dividends are comforting when markets fall, and rising dividend payments can help protect retired investors from inflation.
However, I’ve also learned that a portfolio limited to dividend-paying stocks is not optimal when it comes to diversification or efficiency.
I’ve learned there’s no rational reason to avoid stocks that don’t pay a dividend; or to avoid creating a homemade dividend by selling shares; or to avoid dipping into capital to generate retirement income.
Dividends aren’t magic, they’re certainly not optimal in the accumulation years, and while they may provide comfort to some retired investors to help control spending, they’re not necessary to create retirement income.