A few years ago, one of my friends asked me to meet with his father to discuss his portfolio. He’d been managing his own portfolio for the last 20 years or so, and wanted some advice.
He’s kindly agreed to me sharing his story for this article, but for the sake of privacy I’ve changed his name to David – for reasons which will become clear later.
David was long retired, but had done exceptionally well during his career, and his portfolio was valued in the tens of millions. During his working years he’d worked in an area of finance only tangentially related to investments, so he had some idea how investments worked, but was by no means an investment expert.
I invited him into the office, and asked him to send over a copy of his self-managed portfolio ahead of the meeting. After he arrived, we exchanged pleasantries and sat down to discuss his portfolio.
I remember the meeting well.
We kicked things off by going through his portfolio and discussing his method for selecting stocks. I had a suspicion of what was coming, as he’d agreed to send his portfolio over beforehand, and I’d noticed the numbers in the “yield” column were clearly high.
Unaware of the enormous red flag he was about to wave in front of my face, he then confirmed he was a dividend investor. He only bought stocks with high dividend yields.
Telling me that you’re a dividend investor is a bit like telling Donald Trump he’s got small hands, or telling Harrison Ford he shouldn’t do another Indiana Jones film. I just couldn’t resist.
So I pressed him on why he liked dividends so much.
“Well, I like the income. My portfolio yields about 5%, which I think is a very good return in this environment. Everyone’s telling me that returns are likely to be lower than in the past, so I think a 5% yield is pretty good going. How about you? What does your portfolio yield?”
“About 2%”, I replied.
“TWO PERCENT!!” he exploded, “Why should I invest in something which pays two percent when I can make five percent?! After taking off fees and inflation, I’m barely breaking even with two percent!”
I was expecting some pushback, but his voracity was still surprising. The guy really liked dividends.
But was David the Dividend Investor right?
Well, if he were, I wouldn’t be writing this post. I’d probably have to go back and rethink why I bothered with all that education if investing really was as simple as “buy high dividend stocks”.
So where’s he going wrong?
His example is a good one, because it raises two separate, but related points:
- He’s confusing yield with return,
- He thinks picking stocks with high dividends is a good strategy.
The points are clearly related, because the investor who confuses yield for return often extrapolates that logic into thinking high dividend paying stocks make for good investments.
So let’s explore these points, and try to correct his thinking about dividend investing.
The problems with dividend investing
I’m not sure exactly why dividend investing is still such a popular strategy.
From a classical finance theory perspective, a preference for dividends makes no sense. Dividend policy should be irrelevant to stock returns, and this has been known for decades. Back in 1961, Merton Miller and Franco Modigliani famously noted in their 1961 paper ‘Dividend Policy, Growth, and the Valuation of Shares’ that:
“Before frictions like trading costs and taxes, investors should be indifferent between $1 in the form of a dividend, which causes the stock price to drop by $1, and $1 received by selling some shares.”
This highlights one of the primary reasons I think dividend investing is so popular. It’s a general lack of understanding around one fundamental point:
When a stock pays a dividend, the share price falls by the amount paid out in dividends.
The dividend you receive is not ‘extra’.
You receive £1 in dividends; your stock price goes down by £1.
The cash you receive is paid out of the company’s bank accounts. By paying out all this cash in dividends, it reduces the value of the company by exactly the amount paid out. This reduces the value of the shares you hold.
As a result, a 5% dividend does not mean a 5% return.
It’s actually closer to meaning the opposite.
A 5% dividend means that at the end of each year, your holding will be worth 5% less, but you’ll have 5% more cash.
For example, a stock worth £100 with a 5% dividend yield will be worth £95 after the dividend is paid, and you’ll have £5 in cash from the dividend. You will not have £105.
You then have the choice of whether you reinvest that dividend and get back to your original position of having £100 invested in the stock. Or you can take the cash and spend it.
Unless you reinvest that £5, the value of your holding has decreased as a result of the dividend being paid.
Yield is not the same as return. It’s closer to the opposite.
A 5% yield means your holding goes from £100 to £95 after a year, with £5 in cash.
A 5% return means your holding goes from £100 to £105.
Thinking back to David the Dividend Investor, this is the first point where he’s going wrong. He’s making the classic mistake of confusing yield for return. Just because his strategy yields 5%, it doesn’t mean he’s generating a 5% return. It just means his portfolio will go down by 5% each year, and his cash will go up by 5%.
To bring home this point, I’m breaking out some of my famous graphic design skills. I’ve turned to the number-one graphic design program of choice for all world-class illustrators: Microsoft PowerPoint.
Let’s say we have two companies. They are exactly the same in every way but one – one company pays a 10% dividend at the end of each year, the other pays no dividend.
You own 100 shares of each company at the start of the year, and the share prices are both £10. The value of your holding in each company at the start of the year is therefore £1,000:
For simplicity’s sake, let’s assume that the share price doesn’t move all year. (If it did move, it wouldn’t make any difference to the conclusion – keeping the share price constant just makes the explanation clearer.)
At the end of the year, the dividend paying stock pays its 10% dividend. You choose to do nothing with your holding in the non dividend payer.
The dividend payment reduces the price of the dividend paying share by 10% – its price falls from £10 to £9 after paying the dividend. Because you still own 100 shares, but the share price is now £9, your shares are now worth £900. But you now also have £100 in cash from the dividend:
Note that the total value of your portfolio in both cases is still £1,000.
The value of the dividend paying portfolio is not £1,100. The £100 cash has been generated from a reduction in the company’s share price. It is a return of the capital you invested.
Now let’s say you want your non dividend payer to generate some income for you. In effect, you want to create your own dividend by selling some shares. At the end of the year, you choose to sell 10 shares in the company, which is 10% of your holding.
In doing so, the number of shares you hold falls from 100 to 90. Remember, the share price is still at £10 because the company hasn’t paid a dividend. The value of your shares at the end of the year is therefore £900 (90 shares at £10), and you have £100 in cash from selling your 10 shares:
You’re now in exactly the same position with both stocks: £900 in shares, and £100 in cash.
There was no advantage to holding the dividend payer.
(NB: for simplicity’s sake, I’ve deliberately avoided mentioning the mechanics of how dividends are paid and how the various dividend days work in this article. You’ll find no mention of things like the ‘ex-dividend date’, because it has no impact on the conclusion, and only serves to confuse things. Similarly, with transaction costs and taxes, which we’ll get to later.)
Why does everyone love dividends?
So why are dividends so popular?
Studies have shown that the irrational love of dividends may come from:
- Prospect theory. Investors prefer dividends because it doesn’t involve them having to sell a stock at a loss, or from
- Regret avoidance. Spending a dividend payment and then seeing the stock price increase significantly is behaviourally easier to deal with than selling shares and seeing the price rise, or from
- Investors rationally limiting their future spending by implementing a rule that they’ll only spend dividend income.
But I think the issue is more basic than any of those.
I think there are a few primary of culprits behind the love of dividends:
- Not understanding that a dividend reduces the share price (as we’ve seen)
- The unrealistic assumption of 100% immediate dividend reinvestment
- Not understanding that dividends have no impact on total return.
We’ve already gone through the first point, and will build on it later.
Now let’s look at the second point on dividend reinvestment.
All investors have at some point or another seen this chart, or some derivative of it:
Source: JP Morgan
It’s a pretty compelling chart. Why bother investing in assets which don’t pay a dividend if dividends are such a critical factor in total return? Some large investment companies have pointed out that dividends have accounted for as much as 99% of returns over the last 100 years (link here).
On the surface, it’s a good question. The data look pretty convincing in favour of dividends, but the facts are actually quite counter-intuitive.
The first problem with this line of thinking is that every single one of these charts and studies assumes 100% dividend reinvestment.
This is simply not practical. There are any number of factors, and often a combination of factors, which prevent full reinvestment of dividends. These include:
- The inability to reinvest in fractional shares
- Timing lags before reinvestment
- An investor’s decision to spend or save the dividend rather than reinvest it
All of these limit the investor’s ability to reinvest all their dividends immediately.
To show how various rates of reinvestment can dramatically affect long-term returns, the following chart shows the growth of £1 for a stock with a dividend yield of 3% and annual price appreciation rate of 7% at various rates of dividend reinvestment over time.
As you can see, anything less than full reinvestment results in a lower returns. As the dividend reinvestment rate reduces, price appreciation rather than dividends accounts for a larger and larger percentage of the results. If the investor chooses to reinvest nothing and instead chooses to consume the dividend, the only source of growth is price appreciation.
Charts which ostensibly demonstrate the power of dividends are often overstating an investor’s ability to reinvest.
Even investors who manage to reinvest 75% of their dividends immediately at every opportunity see their portfolio grow by 36x rather than 46x after 40 years. That’s a pretty big reduction given they’re only neglecting to reinvest a tiny portion of their portfolio each year.
In this example, the 3% dividend * 25% not reinvested = 0.75% of their portfolio value not being reinvested each year. It seems like a tiny amount, and would probably be ignored by most investors when looking at their valuations, but cumulatively it makes a huge difference.
Reinvesting as much of your dividend as you can is incredibly important if you’re a dividend investor looking to compound your wealth over time, and this is often simply not practical.
This brings us to the third, and most interesting, misunderstanding surrounding dividends.
Dividends are completely irrelevant for capital accumulation
In order for stocks to compound over time, dividends needs to be reinvested. This much is true.
If we think back to the previous sections, if we don’t reinvest the dividend, then we have less invested than when we started.
But by reinvesting the dividend, you’re simply getting back to the point you were at before the dividend was paid.
Looking back at those last two glorious PowerPoint pictures, you can see that the only way to maintain the same position in the dividend paying company is to reinvest the cash from the dividend.
So when portfolio increases in value, it’s not because you’ve received dividends. We’ve seen that this has no impact on the value of the portfolio. The only factor which increases the value of the portfolio is the price appreciation of the stocks held (assuming no cash inflows/outflows).
By reinvesting dividends as an investor, you’re not saying, “Thank you, dear company, for this extra cash, which I gratefully receive as an added bonus and will reinvest to increase my capital invested”.
You’re actually saying, “I wish this dividend hadn’t been paid. This is a reduction in the value of my investment through a return of a portion of my capital. I’m reinvesting my dividend as I’d rather have kept my invested capital unchanged”.
When a stock pays a dividend, the share price falls by the amount paid out in dividends.
The dividend you receive is not ‘extra’.
And we can now see:
All a dividend represents is the company returning a portion of your capital back to you.
Dividends are a return of capital. Not a return on capital.
This is a crucial difference.
By reinvesting all dividends, an investor is simply maintaining the amount of capital in the investment. Price appreciation is therefore the only driver of capital accumulation over time.
That’s right. Dividends don’t account for 99% of returns, as some would claim. In fact, they account for 0%.
The only driver of capital accumulation is price appreciation.
It sounds counter-intuitive, and it is. It goes against the feeling that dividends are extra. But as soon as you realise that dividends aren’t extra, and are just a return of your capital rather than a return on your capital, the more it makes sense.
Hopefully now when you see another one of those charts comparing the performance of an index ‘with dividends reinvested’ against ‘no dividends reinvested’, it’s now clear that it’s not an argument for buying dividend stocks. It’s merely an argument for reinvesting dividends, if you happen to own dividend stocks.
If you don’t reinvest your dividends (100% of your dividends, as assumed in those charts), then your capital will gradually erode by the amount you receive as dividend payments. This is what the ‘no dividends reinvested’ line represents.
If anything, that chart should discourage investors from investing in dividend-paying stocks, given that it’s almost impossible to continuously reinvest 100% of your dividends.
For those who are still in need of convincing, I highly recommend this paper by Michael Mauboussin, which dives into more detail. The paper is, predictably for something written by Mauboussin, an excellent read, and in fact formed the inspiration for much of this article.
Bond yields are not dividend yields
Adding to the confusion over how dividends work – and potentially another reason why dividend investing is so popular – is the idea that bonds also have a yield. And those coupon payments from the bond are extra.
After buying a bond for £100, when you receive a coupon payment of £5, you now have an extra £5. When you buy a bond, you know that you’ll eventually receive your capital back when the bond matures. Therefore, any cash received between now and then is ‘extra’ and increases your capital. If you were able to reinvest that £5 coupon back into the bond, you would have £105 capital.
This isn’t the case for equities. Because dividends on equities represent a reduction in capital, dividends on equities are not ‘extra’. They are merely a return on your capital, as we’ve seen. Reinvesting a £5 dividend on a £100 stock means staying at £100 capital.
Receiving the equivalent of an equity dividend on a bond would be akin to the bond investor being paid back portions of his original £100 invested capital, so receiving less at maturity.
Other disadvantages of dividend investing
We’ve already seen that dividends don’t increase total return, because:
- It’s almost impossible to continuously reinvest all the dividends
- Even if that were possible, dividends represent returned capital, so have no impact on total return
But even for investors who understand these facts, dividend investing has a number of other drawbacks.
Firstly, investors are giving up control over the timing and the size of the payout when they rely on company-issued dividends. It’s up to the companies when they return the investor’s capital, and when.
On the other hand, when an investor sells shares to create a dividend, it’s the investor who’s in control. They’re now the one determining how much the payout is, and when it’s received.
This is clearly a big benefit for choosing to sell shares over relying on dividends. Not only does it give you more flexibility over how much you can withdraw from your portfolio and when, this flexibility is hugely advantageous from a tax perspective, as we’ll see later.
Secondly, the average proportion of firms paying dividends in the US was about 52% between 1963 and 2019, meaning investors focusing only on those stocks are missing out on nearly half of investible companies.
By only investing in high dividend stocks, you’re severely restricting your investment universe. Given that only 1% of stocks have been responsible for creating 99% of global wealth, by restricting your universe to dividend paying stocks, you’re greatly reducing the chances that you’ll own those tiny number of stocks which are likely to produce the overwhelming majority of the gains.
The odds are simply not in your favour.
Thirdly, high dividend stocks also tend to be concentrated in specific sectors. Looking at the sector allocation of two of the largest global dividend ETFs and comparing them to the sector weights of the MSCI ACWI (as a proxy for the global equity market), we can see that dividend investing takes some heavy sector bets:
The dividend ETFs are both heavily overweight to financials, utilities, and real estate, and heavily underweight to technology, healthcare and industrials. The underweight to technology in favour of financials is particularly stark.
Dividend investors are taking on some significant active bets on the sectors they think will outperform.
Fourthly, a rising dividend can be caused by a falling stock price. As the dividend yield is calculated by taking the dividend per share and dividing it by the stock price, a rising yield can be caused by having a constant dividend per share, but a falling stock price. In this instance, the stock isn’t paying any extra dividends.
Even if it were – even if the stock increased its dividend yield by raising the amount paid out in dividends – it still doesn’t matter for capital accumulation. A stock with a high yield doesn’t provide any extra income over a stock with a low yield – it just returns more of your capital to you.
A stock with a dividend yield of 50% doesn’t provide any extra returns, or any extra capital, over a stock yielding 2%. It’s just returning more of your capital. After reinvesting the dividends, you’re back at where you started for both stocks.
And finally, we turn to the last disadvantage of dividend investing – tax.
Dividend investing and tax
First things first. I am NOT a tax adviser, tax expert, tax specialist, or any other form of authority on tax. None of this should be read as being advice, and you should always consult a professional tax adviser if you think this could impact your tax situation.
Tax will only be an issue for investments held outside a tax wrapper (like an ISA, occupational pension, or SIPP). Shares held in an ISA or pension account don’t suffer any tax on dividends or on any gains made from selling shares.
If you’re receiving dividend income outside a tax wrapper, however, you may have to pay tax on your dividend income. So it’s worth understanding how dividends are taxed.
Firstly, you don’t pay tax on any dividend income which falls within your Personal Allowance (the amount of income you can earn each year without paying tax).
On top of the personal allowance, you also have a dividend allowance each year. You only pay tax on any dividend income above the dividend allowance. For the 6 April 2020 to 5 April 2021 tax year, the dividend allowance is £2,000.
How much tax you pay on dividends above the dividend allowance depends on your income tax band.
If we compare the tax rates for dividends to the regular income tax rates, we can see that dividends are treated more favourably than regular income for tax purposes:
That’s great, dividend income is taxed more favourably than interest from bonds. But the real comparison for us here should be between tax rates for dividends versus selling shares.
The sale of shares incurs Capital Gains Tax (CGT).
If you’re a basic rate taxpayer, you’ll pay 10% tax on your gains, and if you’re a higher or additional rate taxpayer, you’ll pay 20% tax on your gains (source: gov.uk). The CGT rate is slightly higher than dividend tax rates for basic rate taxpayers, but considerably lower for higher and additional rate taxpayers.
You also don’t have to pay CGT if all your gains in a year are under your tax-free CGT allowance, which is currently £12,300. This is much higher than the £2,000 allowance for dividend income.
Another crucial benefit of selling shares over receiving dividend income is that when an investor sells shares, they’re only taxed on the gains they’ve made – not the amount of money received. With dividends, they’d be taxed on the full amount the investor receives.
As an example, let’s say we have two investors. One invests in a dividend paying company, the other invests in a non dividend paying company. Both companies are otherwise exactly the same.
During the year, the share prices of the two companies rise from £20 to £30. At the end of the year, the dividend payer pays its 10% dividend, and the investor in the non dividend payer sells 10% of his holding to create an equivalent dividend:
Number of shares
Price at purchase
Share price after 1 year
Value after 1 year
10% dividend paid
Sold 1,000 shares (10%)
Amount subject to tax
For the non dividend payer, each of the 1,000 shares he sold had gained £10 (£20 -> £30), meaning the total taxable gain is £10,000.
The non-dividend investor receives £30,000, but is only taxed on £10,000. The dividend investor receives £30,000, and is taxed on the full £30,000 as dividend income.
Given the higher CGT allowance (£12,300 for CGT, £2,000 for dividends), none of the non-dividend payer’s gain would suffer tax, as the £10,000 gain is covered by the £12,300 allowance. The non-dividend investor therefore pays no tax on any of the £30,000 receipt.
The dividend payer investor, on the other hand, would very likely have to pay tax on the £30,000, as only £2,000 is covered by the dividend allowance. The amount of tax paid would depend on his tax band.
A further benefit of choosing to sell shares over receiving dividends is that selling shares at a loss can be useful for reducing tax – both in the current tax year, and in future years.
Remember, selling shares at a loss is exactly the same as receiving a dividend from a share that’s below its cost.
Selling shares at a loss generates a capital loss. Capital losses can be offset against capital gains of the same tax year, or, if you have an unused capital loss, can be carried forward indefinitely against gains of future years.
If you need to take income from your portfolio, selling shares at a loss can be used tactically to reduce your tax bill, both in the current year and in future years.
Receiving dividend income on shares which are valued below cost – remember: this is the same as realising capital losses – offers no such benefit. Receiving dividends on shares below cost actually increases your tax bill (as the dividends will be taxed as dividend income), rather than reduces it.
Importantly, relying on dividend income provides no flexibility surrounding the amount or timing of the income. It’s up to the companies’ dividend policies how much cash an investor receives and when. Not only are capital gains taxed at lower rates and are more flexible in terms of utilising losses, but by selling shares rather than receiving dividend income, it’s the investor who’s in control of how much income is received – and therefore also how much tax is paid – and at what point.
Selling shares, either for a gain or loss, is therefore hugely more efficient from a tax perspective than receiving dividends. Given that receiving dividends and selling shares are equivalent, selling shares is almost always preferable to receiving dividends for tax.
Don’t high dividend stocks beat the market anyway?
This is a more interesting question.
It could be the case that, despite all the disadvantages of dividend investing, dividend stocks still manage to outperform the market.
Let’s assume that David the Dividend Investor understands that dividends are a return of capital, manages to reinvest 100% of his dividends immediately, suffers no tax, has no need to control the timing or amount of his income, and is allocating to a dividend strategy as part of an already-diversified portfolio.
Is he likely to outperform the market?
This could be a whole article in itself, so I’ll try and keep it brief.
(NB: I realise there are many dividend strategies out there. This section focuses on high dividend yield and dividend growth, as those are the most popular.)
To cut to the chase, high dividend yielding stocks and dividend growth stocks have historically outperformed the market. This has been confirmed by a large number of sources – a few examples of which are here, here, and here.
So if dividend strategies have historically outperformed, what’s the catch?
Research from Larry Swedroe came to the same conclusion as many other papers written on the subject. It’s not dividends causing the outperformance, but is instead dividend stocks’ exposure to underlying factors:
“As theory predicts, the performance of dividend strategies is explained to a large degree by exposure to a handful of equity factors: value and lower volatility for high-dividend-yielding equities, lower volatility and quality for dividend growth equities. Additionally, multifactor regressions showed very high explanatory power, 0.95 for high-dividend strategies and 0.89 for dividend growth strategies. Thus, we can conclude that the historical performance of these strategies can be largely explained by exposure to common factors.”
…and in a separate piece of research:
“The bottom line is that dividend growth strategies are basically quality strategies. The good news about the quality factor is that the premium (about 4.7% a year from 1958 through 2018, according to data from AQR Capital Management) has been persistent and pervasive around the globe.”
So dividend investing is a proxy for exposure to common risk factors.
But what’s more interesting is that, after adjusting for this factor exposure, dividend stocks actually detract from performance.
In ‘Dividend Investing: A Value Tilt in Disguise?’, Gregg Fisher found, as have many other papers, that high dividend yielders significantly outperform the broad market. However, when returns of the portfolio are decomposed into the factors that explain returns, value (price-to-book) and earnings yield (earnings-to-price) were significant contributors. After accounting for these factors, the contribution of dividend yield was actually negative.
Meb Faber came to a similar conclusion in his whitepaper, ‘Do You Pay Taxes? Then Avoid Dividends and Do this Instead’. He created portfolios to replicate the returns of dividend stocks, but without actually holding any dividend stocks. What he found is that such portfolios outperformed the dividend portfolio, even after accounting for taxes:
In his own words:
“I had started with a question: By avoiding dividends might we improve “dividend investing”? But by removing the dividend, it inadvertently refocused the selection methodology on pure value. My research turned out to be a backdoor way of reminding myself that value investing and dividend investing – while often confused as the same thing – are distinct strategies. And more times than not, value wins out. It turns out that the simple value strategy (which included avoiding high yield stocks) produced higher returns than the dividend strategy – not just similar returns. In other words, before we even get to the tax benefits, “value” had already trumped “dividends.” And after factoring in taxes? Even more outperformance.”
There are a number of reasons why dividends may be detracting from outperformance, including:
- High dividend yields may also imply poor growth prospects (i.e. the companies don’t have any better uses for the cash than to return it to shareholders)
- The strategy may avoid profitable companies that have temporarily suspended or reduced dividends
- High yielders are, on average, larger than their counterparts in value portfolios, creating a negative size effect
The bottom line for investors is that it’s not the dividends causing the outperformance. It’s the exposure to the value, low volatility, and quality factors. These factors are why dividend stocks have tended to outperform.
The existence of a dividend has actually been found to detract from performance. This means investors would have a better chance of outperforming by trying to more efficiently capture these investment factors than through picking dividend stocks.
So that brings us to the end of the flogging session for dividend investing.
We now understand the second reason why David the Dividend Investor was going wrong. Even if he understood that dividends were a return of capital, managed to reinvest 100% of his dividends immediately, suffered no tax, had no need to control the timing or amount of his income, and was allocating to a dividend strategy as part of an already-diversified portfolio, he still would have been better off in factor funds than picking dividend stocks.
Before concluding, let me make sure the horse is well and truly dead by finishing up with some dividend investing FAQs.
These are questions which I’ve either been asked more than once, have seen asked on forums more than once, or have seen seasoned investment professionals wrongly espousing as fact.
Dividend investing FAQs
Can I still benefit from compounding without investing in dividend stocks?
To be fair, I can see where the confusion comes from.
What the usual explanation of compounding being “interest on interest” (or, in a dividend investor’s case, “income on income”) fails to capture, is that compounding does not need reinvested income to work.
All that compounding needs to work is a positive growth rate, and time.
A gold bar which pays no dividends or interest, but increases in value by 3% every year will still benefit from the effects of compounding, because the 3% growth rate will be applied to an ever-increasing value.
Whether a stock pays a dividend or not is irrelevant. We’ve seen that dividends have no effect on total return. As long as your overall portfolio has a positive expected return, you’ll receive all the benefits of compounding regardless of the portfolio’s dividend yield.
Can I still get passive income/retirement income without investing in dividend stocks?
As we’ve seen, dividends you receive aren’t ‘extra’.
Dividends are a return of capital, not a return on capital.
If you want to take capital out of your portfolio as income, you can achieve exactly the same outcome by selling a portion of your shares.
A higher-yielding portfolio should not be viewed more favourably than any other, solely on account of its dividend yield. Its ability to produce income is no different than an identical portfolio which pays no dividend.
Is dividend investing bad because dividends can be cut?
As we’ve seen, dividends don’t provide any extra income, they’re merely a return of your capital. If a company stops paying its dividend, investors are still able to create their own equivalent dividend by selling that same portion of capital (glorious PowerPoint picture number 3).
Dividends are more stable than share prices, so isn’t dividend investing better in low return environments?
The statement “dividends are more stable than share prices” makes no sense. It confuses a return of your capital (a dividend), with capital appreciation (share prices).
Dividends are a return of capital, not a return on capital.
As a result, yield is not return.
In fact, it’s not even a component of return.
A 5% dividend yield doesn’t mean you’re more likely to receive a 5% ‘return’ in dividends than receive a 5% return in share price appreciation. Because a dividend payment is not extra.
A 5% dividend yield means a stock worth £100 will be worth £95 after the dividend is paid, and you’ll have £5 in cash from the dividend. You will not have £105.
Dividend yield shows how much of your capital is returned to you each year. If you’re focussed on maximising total return in a low return environment (or any return environment), it doesn’t matter how much of your capital is being paid back to you in dividends, because you’ll be reinvesting it anyway.
Dividends are more stable than share prices, so isn’t dividend investing lower risk?
Dividends are more stable than share prices, so isn’t dividend investing better during a falling market?
Receiving a 5% dividend during a falling market is equivalent to selling 5% of your holding during a falling market. Both reduce the value of your holding by 5%, regardless of what the market is doing.
You’re no better off investing in dividend stocks during a falling market than investing in equivalent stocks which don’t pay a dividend.
Doesn’t Warren Buffett like dividends?
No, not really.
Warren Buffett likes value stocks, not dividends. Value stocks often have high dividend yields, but as we’ve seen, dividends are a poor proxy for value.
He’s mentioned a specific dislike for dividends, on grounds that they destroy value if there’s a better use of the company’s capital elsewhere. As we’ve already seen, dividends are highly tax-inefficient. So, when compared with the other ways in which a company might use its free cash flow to generate greater value for investors (buying back shares, acquisitions, reducing debt, etc) dividends are hamstrung by tax.
His explanation for Berkshire Hathaway’s refusal to pay dividends and how it’s actually more efficient for both Berkshire and their shareholders if shareholders “create their own dividends” by selling shares is covered in detail in his 2012 annual letter.
It’s surprising that the preference for dividends has survived for so long, despite the preference being proved to be completely irrational all the way back in the 1960s.
And yet, during the writing of this post, I opened a copy of The Sunday Times, only to find an article written by their ‘stocks guy’ who talked about an “inflation-busting 5.3% yield on IBM”. Sigh. I could just imagine David the Dividend Investor nodding along sagely.
It seems dividends have some sort of timeless allure. But really, they shouldn’t.
We’ve covered a lot of ground in this article, and although there’s more than enough data to fill multiple books (let alone articles) on dividend investing, we have to draw the line somewhere.
One area which I haven’t given much attention to, but which is still worth investors paying attention to, is transaction costs. For those investors whose platform/broker charges a transaction cost for selling shares, this needs to be considered against the inefficiencies of receiving dividends. There is no one-size-fits all answer as each platform has a different charging structure. However, as fees fall across the industry, this will likely become less of a factor as time goes on.
To summarise the article, hopefully the points below distil the essence of why dividend investing isn’t as attractive as many investors believe.
- When a stock pays a dividend, the share price falls by the amount paid out in dividends.
- The dividend you receive is not ‘extra’.
- Dividends are a return of capital, not a return on capital.
- As a result, a 5% dividend does not mean a 5% return. It’s actually closer to meaning the opposite: it means you’ll have 5% less capital invested at the end of the year.
- A dividend represents is the company returning a portion of your capital back to you.
- By reinvesting all dividends, an investor is simply maintaining the amount of capital in the investment.
- Price appreciation is therefore the only driver of capital accumulation over time.
- The idea that “dividends are more stable than share prices” makes no sense. It confuses a return of your capital (a dividend), with capital appreciation (share prices).
Dividend strategies are likely popular because:
- Not all investors realise that dividend payments reduce the share price.
- As a result, many investors confuse yield with return.
- In addition, many investors think dividends contribute to capital accumulation. They don’t. Share price appreciation is the only driver of returns.
- As investors are extremely unlikely to be able to continuously reinvest 100% of their dividends immediately, returns from reinvested dividend strategies are likely overstated.
Dividend stocks are inefficient for taxable accounts in the UK because:
- The capital gains tax (CGT) rate is considerably lower for higher and additional rate taxpayers.
- The tax-free CGT allowance is currently much higher than the allowance for dividend income.
- Dividend investors are taxed on the full amount received as dividend income. Investors selling shares are only taxed on the gains.
- Selling shares at a loss can be used to reduce tax – both in the current tax year, and in future years. Receiving dividend income on shares which are valued below cost (equivalent to realising capital losses) offers no such benefit, and actually increases the tax bill, as the dividends will be taxed as dividend income.
- Relying on dividend income provides no flexibility surrounding the amount or timing of the income, as it relies on companies’ dividend policies. When selling shares, it’s the investor who’s in control of how much income is received – and therefore also how much tax is paid – and at what point.
Dividend stocks have outperformed the market because:
- They tend to have high exposure to the value, low volatility, and quality factors.
- The existence of a dividend has actually been found to detract from performance.
- This means investors would have a better chance of outperforming by trying to more efficiently capture these investment factors than through picking dividend stocks.
So, after all that, what happened to David the Dividend Investor?
After his initial eruption on how a 2% dividend yield strategy was laughably inferior compared to his 5% yield strategy, I proceeded to explain the contents of this article.
After we’d finished talking, I could tell he wasn’t convinced. And to be fair, I don’t blame him. It’s ingrained in many investors’ psyches that dividend payments are extra, and are a return on capital. So telling him that dividends actually reduce the share price, and so reduce his capital invested went contrary to his intuition and understanding.
At that point, I also hadn’t had the benefit of clarifying my thoughts through writing them down on paper, as I now have – years later. Perhaps I could have been more convincing.
Nonetheless, I’d hoped at least some of it had sunk in and given him pause for thought.
Then, about a week later, I received a phonecall from David.
“Thanks for sitting down with me and going through my portfolio options, I really appreciate it. I’m struggling to get my head round all the things we talked about, but a lot of what you said made sense.
Since we last met, I’ve asked around to find the best investment management company to take over management of the portfolio from me, and would like your advice. I’ve been sent a proposal, and am going through it at the moment.
The first thing I noticed was that the yield is only 3%.
What do you think?”