Why My Thinking Changed Around Dividend Investing
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.
Related: Why indexing doesn’t mean settling for ‘average’ returns
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.
Final thoughts
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.
Thx for the article. It supports my recent personal discoveries. Tax optimization is part of my arguments. Good to see a second reason
After reading this article, I have some questions;
Who thinks that dividends are magic? I am interested in learning, because otherwise, the first point is a straw man argument.
The second comment does not make a lot of sense – a lot of growth companies pay and raise dividends. Capital allocation at the business is what should be studied.
On third – indexing does not automatically make you a rational investor. If you study the results of index fund investors as a group, you see them underperforming the indexes they track. You can have things like performance chasing with indexes as well.
On fourth – it depends. Let’s say that you bought 1000 shares of Nortel at $50/share, and sold them for 60 cents, you got $600. If you bought 100 shares of Altria for $15, and they now happen to generate $600 in dividend income every single quarter. You have $600 in hand in each scenario. But you would have to be a fool to select option one.
Here’s a few comments:
The amount and timing of dividends is more predictable than capital gains.
This makes dividends a helpful tool to live off in retirement. But the total returns of a diversified dividend portfolio (at least a diversified US one) should be relatively similar to that of US index portfolio. I know Canada is less diversified as a whole, so foreign stock ownership is encouragable.
Imagine a situation where stocks never pay dividends. The price is determined by other people, who get greedy and fearful. So your returns are dependent on the opinions of others. What if the stock market investments go flat for extended periods of time and investors have to “sell shares” at depressed values. The problem is not regret – the problem is eating your capital in retirement and running out of money.
When stock markets have been booming for a while, everyone is looking for total returns. When I started in 2007 – 2009, everyone was embracing the idea of dividends as cash in the hand. What does that speak for investor behavior? And if everyone is embracing indexing, isn’t that an example of herding ( a behavior problem)?
“Who thinks that dividends are magic?” You should start reading a few DGI blogs 🙂
More to the point, if you think stock markets couldn’t function without dividends isn’t that a bit of magic?
With stocks that never pay dividends there are two possibilities. Either they do have some cashflow in the end (such as being sold to another company) so investors can make rational decisions about those cashflows. Or there is no cashflow and it’s pure speculation on something that has no value at all.
A stock market made up of the first kind of stock could function well. It would be more volatile since there is a lot more uncertainty about the amount and timing of cashflows. Long-term investors would do about as well (possibly better if they buy on big drops).
In fact the US market is moving towards this as the average S&P 500 company has spent as much or more on stock buybacks as they have on dividends in recent years. Selling your shares back to the company is just another way to get a dividend (and also pay less taxes).
DGI, true, the amount and timing of dividends is more predictable than capital gains, but that doesn’t matter. In the withdrawal phase you have an allocation to cash or bonds, which you tap when markets crash, so you are not selling stocks. And, of course, when you take dividends during a market crash, that is exactly the same as selling a $ equivalent of your stocks. Dividends are not magic.
60% of US stocks do not pay a dividend, so a diversified dividend portfolio will certainly not be as diversified as the market, so will be higher risk without the compensation of higher expected returns.
If all stocks didn’t pay a dividend – no matter; during depressed markets live off your cash/bonds until the market rebounds as it always has.
Perhaps more people are embracing indexing now because the word is getting out there that the very wide and deep body of evidence on the subject indicates it is a more efficient strategy to follow?
Another way to look at it is that when you’re building a dividend-stock portfolio you normally take the dividends and re-invest them to buy more shares. It’s well-known that this is an important part of the long-term returns.
When you’re withdrawing and spending the dividends you can’t re-invest and buy more shares so you end up owning less shares than you would otherwise — the exact same situation as an index investor who sells shares for income.
I honestly don’t think it really matters which is better. When you look at the big picture, both indexers and dividend investors are investing and taking care of their retirement. That’s unfortunately the minority …
Instead of arguing a strategy, we should focus on how to get people to think about their retirement and capital accumulation.
The rich don’t worry about this, the money is flowing in …
I think dividend investing is a fine strategy, it’s just that some of the arguments used to support it don’t add up. From a behavioural point of view, if dividends help you sleep at night, keep you calm, and help control spending in retirement, then by all means keep going with that approach.
Some of the arguments against dividend investing do not pass the smell test either…
Thank you for sharing your views I enjoyed reading your article.
I started investing in ETFs just before my retirement. However, as a retiree with a steady pension I did the opposite to your approach. After reading lots of articles on investing I started to buy shares in individual companies. I enjoy trying to beat the market. My portfolio is comprised of 13 ETFs for about 80% of its value and shares in 15 companies for the rest of my investments.
I can’t claim any great success and it has been a hit and miss approach for me but I am having fun as I try increase my capital. “Investortainment” as I like to call it (not my original term).
Dave, “Investortainment”- that’s a good one! Although as Larry Swedroe says “if you are looking for having fun from investing, you should probably find a less expensive form of entertainment”
Great post! I went through much the same process. I wonder if it’s just a natural evolution of being a rational investor…
John, I’m not so sure about that. Many DGI investors will not change due to the behavioural reasons discussed here. And at the end of the day the best strategy for an individual is the strategy he/she is most comfortable with and will stick with for the long haul. When I discuss this with a DGI friend, I know she understands the issues, but she enjoys the research involved and “thrill of the chase” of DGI, and accepts the likely cost of sticking with her strategy. For those just starting out, though, it’s important to have all facts, so they can make an informed decision.
Excellent post and very clearly explained. Actually, even if you did plan to leave a large inheritance, you are better off with a total return approach, as you will likely end up with more money due to having a more efficient portfolio.
True, but that doesn’t fit with the whole “don’t spend the capital” narrative.
OK, you are 37, employed, and not seeking income. But what about a recent retiree looking for secure income? How can we find, e.g., the best dividend paying stocks to construct our income portfolio?
Hi randall, that’s a complicated question. If you have a non-registered account, and want to take advantage of the dividend tax credit, then it can make sense to invest in 15-20 Canadian blue-chip stocks (think banks, utilities, pipelines, telecos).
But I question using the word “secure” when it comes to stocks, as dividends can be reduced or eliminated altogether.
What I’m aiming for in retirement is to keep my two ETFs but also have about 3-5 years worth of annual expenses sitting in a high interest savings account. Let’s say that’s $90,000, for example. Every year, as I spend $30,000, I’ll sell $30,000 worth of stock to replace the cash. If the markets have a really bad year then I’ll just wait and spend another $30,000 from my cash, selling shares to replace that cash if markets recover the following year.
That is exactly what I do
Excellent Post – a good easy-to-understand explanation of a complex decision often based on cognitive bias.
I’m in those same Vanguard ETF’s and mostly retired so I am in agreement with your approach.
Great article, thanks. For me, a balance between both worlds works best.
Great article. Behavioural biases are so important to understand so that we are not blind-sided by our own thinking. I never considered selling stocks as a way of capturing income when it’s needed. But it’s so true. Thanks for this article, very valuable.
“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.”
One quibble. In an upcoming age of slower growth, I believe it’s important to own birds in hand (dividends) vs. two in the bush (capital gains). If I’m correct, dividend investing will be more beneficial.
Although I plan to live and invest for decades, I plan on part-time work in 7 years. If capital gains aren’t great then that’s a problem for me.
In the next market downturn, it will be interesting to see how my portfolio performs vs. the index. That’s the real test and so another 2008-2009 will be interesting to see how indexers and dividend investors handle it.
Otherwise, good balanced article. You avoided the indexing-is-the-greatest-and-nobody-should-ever-invest-any-differently-article.
🙂
Mark
Mark, I don’t think the return environment makes any difference. In a low return environment the total return is just less. If capital gains are less there will just be less capital gains there to take. The “bird in the hand” thing is part of the behavioural issue with dividend paying stocks. It doesn’t matter if you take money from your investment as dividends or capital gains. You are still reducing the value of your investment by x, whether you take x as a dividend or a slice of capital gains.
What does matter is your exposure to the factors that produce returns – value, size etc. Dividend paying stocks give you some exposure to the value factor, but not as much as portfolios that are screened by price/book etc. And a portfolio of dividend payers is much less diversified, so as in the article
“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).”
I think the return environment is always important. Growth is what investors are counting on…otherwise, why invest?
Let’s say the CDN market goes flat for one year. No growth. That means, for the most part, XIC or VCN or whatever broad-market ETF remains virtually flat in price. Same goes for a given stock. No price appreciation; no growth. Flat. Nothing.
Let’s say for sake of argument, you hold XIC. That yields 2.8%. Cost = ~ $23.50 per unit. No growth.
Over the same period of time, you hold BCE. That yields 4.4%.
Cost = ~ $62 per share. No growth.
I’m thinking $10,000 invested in BCE (about 161 shares) is going to deliver more cash into your pocket than XIC (about 425 units), without touching the capital in either case, in a no-growth environment, without any dividends increased.
With that money invested:
425 XIC units pays out about $72 per quarter in distributions.
161 BCE shares pays out about $109 per quarter in dividends.
Maybe I am missing something? Let me know!
Hey Mark, I think there are a couple of things going on there.
We know the stock does pay a dividend. It’s also fair to say that during the year the stock price will decrease by the amount of the dividend, plus any other market-driven changes. So if the stock price is exactly the same all year that means that investors consider it to have increased by the amount of the dividend and then decreased by the same amount.
But what are those market-driven changes? It’s entirely possible that a utility company is less volatile than the index (especially in Canada). So it might have less overall losses in a bad year and less overall growth in a good year.
If dividend stocks are a different type of stock than the average of the index then of course they have a different type of return. Given the limited selection in Canada this seems likely. An index with a similar type of stocks would have a similar total return.
I don’t know whether that would be a positive. Some believe that less volatile stocks have higher returns. On the downside, a dividend portfolio can be a lot less diversified — oil and pipeline companies are a great example.
I’m not saying the return environment is not important – just that it doesn’t make any difference to the efficacy or otherwise of dividend investing.
Your example of XIC and BCE – all you can say is a that year BCE has a better total return than XIC, and it happened to consist of no capital gain and all dividend. A total return approach looks at the two components together – it doesn’t matter if you take retained earnings from your investment as dividends or retained earnings, you are left with the same $ amount of your investment.
Thanks a great article that in the first paragraph answered a nagging question in the back of my head that had me questioning my all in move from 2 1/2 decades of MF’s to a couch potato index route for all my equity holdings.
Only a couple more years to go before I can move out of my locked in target fund to bond index’s and some GIC’s, and cut over $8000 a year in fees to a few $100, or looked at a better way, grow my portfolio by $8000 a year in my favour.
Thanks Rob
Hi Andy, thanks! It sounds like you’ve got things figured out!
While I’m also interested in going the ETF route I seem to recall that simplicity was one of your prime reasons for doing so originally: The ultimate buy and hold strategy. And that, combined with the fact that few of us are likely to consistently outperform the market, are the best reasons for going the ETF route.
The reasons you give above, on the other hand, aren’t so satisfying. While dividends aren’t magic, of course, it’s simply not true to generalize that a dividend stock’s price will be held back by its dividend. There are all sorts of catalysts that will drive a stock’s price higher, unexpectedly good quarterly results and a bright prognosis being chief among them, whether the stock in question pays a dividend or not. I’m not sure how you could prove that BCE’s price, for example, would be 4% higher every year if they didn’t pay a dividend. Or that CCL’s share price, which has gone from $112 to $250 in the last two years has been held back just a little by its small dividend. On the opposite end of the spectrum, Teck pays a dividend but that didn’t stop it from tumbling 90% over a few years. I believe that the market would like to be so rational but it fails because human behaviour drives it.
As for investing for growth, not dividends, I would suggest that the one advantage a value investor at your age would have by buying dividend stocks is the growth in the dividends. To stick with BCE, if you bought it today and its dividend were to double over the next 20 years, as it did over the past 20 years, while the stock price more than doubled, then you’d be earning 9% in your early retirement and your shares would be worth around $125. If your entire portfolio had a similar, conservative result that would help pay the hydro bill.
I’ve never understood why those who choose to invest in dividend stocks are assumed to want to live off the dividends alone. Why would they? While some folks are interested in leaving an estate, most of us, I think, would like to spend our last dollar a few minutes before our last breath. If you’re invested in dividend stocks, the logical plan would be to build a portfolio that allows you to live off both the dividends and the sale of those dividend stocks on a measured basis over the years you estimate you’re going to live in retirement (and taking into account your other sources of income).
I do believe that if you have two equal portfolios and one spins off $50,000 per year in dividend income and the other does not, that the dividend stock portfolio will last longer because you’ll only have to sell $25,000 worth of stock each year if you’re counting on your portfolio to generate $75,000 for you each year. The non-dividend portfolio will have to sell the full $75,000 worth of units each year. This aspect is particularly advantageous if you happen to retire during a major market tumble. You can hold onto more of your equities until things improve. I get it that you think the non-dividend paying equities in your ETFs will grow by so much more than a dividend stock portfolio that your portfolio will be sufficiently large to allow you to sell three times as much (in my example) of your ‘share dividends’ each year, but I’m not convinced.
I’m playing devil’s advocate here to some extent. I am serious about moving into a couch potato portfolio but I’m over 20 years older than you and buying into the index at these levels makes me nervous. So, I’m thinning and pruning and building a larger cash position for the time being.
Hi Jeff, thanks for your comment. There’s a lot to chew on here but I wanted to tackle your argument about buying BCE 20 years ago and earning 9% per year just on dividends alone. This is a common fallacy that I used to buy into, but have since come to realize is not true.
Let’s say you bought your shares of BCE 20 years ago and they grew and split over the last two decades so now you own 1000 shares. Those 1000 shares churn out $2,730 worth of cash dividends per year ($2.73 per share).
Now I come along and buy 1000 shares of BCE at today’s price ($61.35 per share). Like you, I’ll collect $2,730 in dividends from this investment.
The fact that your cost per share is much much lower than mine is completely irrelevant today. We will both collect the same amount of dividends and participate in the future earnings growth of the company, whatever that might be.
Your yield on cost might be 9% or more, but that doesn’t matter. The current yield is 4.43%.
I do understand what you’re saying and, to some degree, it’s a semantic argument. While there’s no doubt that my original $29 investment is now earning 9.4%, it’s also true that as a component of my current portfolio, or, for the sake of this example, as my entire portfolio, consisting, say, of just those 1000 shares of BCE purchased in 1996, I would indeed say that my $61,800 portfolio was earning me 4.4%.
BCE is actually a good example for your point. I just picked it out of thin air, never owned it myself, but it’s a bit of plodder, returning the sort of results you mentioned in your piece.
If we had bought Johnson and Johnson twenty years ago for $25 per share (ignoring currency differences) we’d not only be earning 12.8% on that original investment but our 1,000 shares would have increased to almost $120,000 (and yes, we’d be earning 2.9% on that $120,000 but we’d have lots more ‘share dividends’ to cash in). And that’s the rub: it comes down to the companies you invest in if you’re investing in individual companies.
Going the index fund route might look better compared to BCE but not so much if your portfolio is made up of J and J-like companies.
As I said in my original post, the biggest fallacy is that all those who invest in dividend paying companies want to live off only the dividends and not touch their capital. I’m sure there are people whose portfolios are large enough to make this a realistic proposition but, quite honestly, they’re also wealthy enough that they don’t need to spend time reading blogs like this.
For those of us living on wages, making ‘average’ salaries, though, the subject of making the most of our savings so that our retirements will be as comfortable as possible is of great interest. I think there’s every likelihood that a portfolio of dividend paying stocks can match the performance of your ETFs and, given that the DPS spin off cash every month or quarter, a same-sized portfolio of DPS should last longer, or allow me to spend more each year, than an ETF portfolio where I have to cash in my share dividends. But this is where the argument for the simplicity of the ETF portfolio comes to the fore.
There’s a million other strategies out there, too, but those of us who follow your blog are, I think, those who are dealing with the conflict you dealt with. You made the choice to go the simpler ETF route and we’re interested to see how it turns out.
Have you done an actual comparison? What would the total return be on the shares you sold versus the return on your ETFs to date? I know it’s not an entirely valid comparison because you might have traded some shares if you’d been actively managing your portfolio but it would be interesting nonetheless.
On the debate between dividends vs. total return, please take a look at your dividend payers on the day before the ex-dividend date and the morning of the ex-dividend date. All things being equal (no dramatic news overnight) the value of the stock will decline by precisely the amount of the upcoming dividend.
“A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts,” Burton Malkiel wrote in his 1973 classic, ‘A Random Walk Down Wall Street.’
http://www.bloomberg.com/news/articles/2016-09-06/it-s-been-another-terrible-year-for-anyone-looking-to-beat-the-market
That’s good reasoning, although for some it can be a little harder to “celebrate the progress of the global economy” than to celebrate receiving a large cheque 🙂
I can understand how you could start with a desire to protect your assets (which is what separates good investors from bad ones) and then see a strategy where you (hopefully) never have to sell any shares as a natural part of that. It comes from the right place and it’s certainly far better than GICs.
As you said either strategy is good, and while indexing may have a slight advantage it takes more abstract thinking to believe in that.
I find it hard to believe that many dividend investors accept the chance of lower returns from stock picking and choose to do it anyways because they enjoy it.
Based on everything we know about investor behavior it is much more likely that most of them secretly believe they will outperform the index. It’s easier to enjoy the idea of winning a bet than to enjoy reading financial reports. In fact that’s probably one of the reasons that I “enjoy” indexing.
One thing I think dividend lovers miss is how interest rates have pushed up the valuations of dividend stocks. As the return on GICs and whatnot have plunged to basically zero, people have adapted by investing in dividend stocks. Then, after 2009, people started valuing safety over everything else, which further pushed them into dividend-payers.
Add all that together and the result is pretty obvious. Dividend-paying stocks, especially the 100 dividend growers that are widely loved, are overvalued, and due for a correction.
Getting a 3% rising dividend is all fine and good, but how about if that comes with no capital appreciation for a decade?
Now, personally, I like getting dividends. But I’m primarily a value guy. If I believe a stock is undervalued, I’ll consider buying it. If that stock pays a dividend, all the better. But I don’t insist on dividends, and neither should anyone else. You miss out on too many opportunities that way.
I’ve heard about dividend investing and the appeal of my investments paying out a dividend is very appealing.
But for simplicity sake, I chose to put my money in ETFs instead. I understood it better and I like that it is passive.
Reading this article, I’m glad I made that choice.
Good article. The reservation I have about Canadian Market ETFs is the concentration. The long standing complaints about the TSX is that after Financials and Energy there is not much else. The TSX composite has 55.8% in those 2 sectors. The Vanguard ETF VCN has 56.1% in those 2 sectors. I am not sure how diversified that portfolio is in reality.
The advantage ETFs are supposed to enjoy is diversification and I am not sure that many Canadian Market ETFs will meet that test.