During the 20+ years I’ve been a financial advisor, I’ve noticed how often the market keeps playing the same devilish tricks, each time in a guise that differs just enough to fool us all over again. Today’s “Stop Doing” post exposes one of these more common tricks of the trade: investors who are seeking a reliable income stream for retirement should STOP building their investment strategy around chasing dividend-paying stocks (or higher-interest-yielding bonds) in isolation, without considering them in the context of their total wealth management.
Speaking of devilish acts, let’s revisit The Wall Street Journal columnist Jason Zweig’s “The Devil’s Financial Dictionary” (emphasis is ours):
DIVIDEND YIELD, n. A company’s annual DIVIDEND divided by its current share price. “You buy a cow for its milk and a stock for its yield,” says an old Wall Street proverb. But when a company gets into financial trouble and has to cut its dividend to hoard cash for its own survival, the yield will shrink or disappear. Investors who buy a stock only for its yield may suddenly find themselves owning a cow that gives no milk and is too scrawny to butcher for the meat.
Clearly, I am not alone in my skepticism when I see investors investing in a stock because “it pays a good dividend.”
What Is a Dividend?
Sweep away all the complexities about corporate profits, and you’re left with this truth: When a public corporation makes a profit, it has two choices on what to do with that cash:
- Re-invest it back into the business, or
- Return it to shareholders through cash dividends or share repurchase plans.
These concepts aren’t new. Nobel laureate Merton Miller and Franco Modigliani published a paper back in the 1960s, explaining why profits are profits, whether they’re “packaged” as dividends or share value. So, let’s take a look at why chasing dividends may not be all it’s cracked up to be.
Source – Companies intend to pay dividends from their profits. But what happens when they’re not profitable? Then the dividend comes out of capital. When that happens, you are essentially receiving back your own invested money. You’re getting back a piece of your proverbial cow.
Other Uses – Even when a company is profitable, it could have kept those profits instead, investing them back into the business and potentially increasing your share value as much or more as if you had taken a dividend.
Tax Ramifications – Don’t forget taxes, one of the greatest drags on end returns. It’s more beneficial for a taxable investor if a company uses share re-purchase plans instead of dividends. The monetary benefit is identical either way, but dividends are taxable in the year they are received, while share repurchase plans benefit from more tax-advantaged deferred capital gains.
Bottom line, long-run stock values are driven by corporate profitability. Whether a company decides to pay those profits as dividends or increased share value really should not matter to investors.
Instead of Chasing Dividends
In our opinion, there is a better way than chasing dividends for investing in and for retirement. It’s called total-return investing. Instead of considering your retirement income in isolation, total-return investing considers a more meaningful question:
What will optimize your ability to generate a reliable retirement cash flow today AND maintain or increase the value of your investments for future goals?
So, for example, instead of fussing over the relatively irrelevant detail of whether a company distributes its profits as dividends or share value, we focus on the role that stocks and bonds play in your overall portfolio. We consider ideal asset location for generating liquid cash flow as well as minimizing the taxes involved. We balance the tradeoffs between having cash available for your spending needs versus investing it to achieve your accumulation/growth goals. Do you have legacy or philanthropic goals? These too should be managed as part of your cohesive plan.
In this context, the precise source of your retirement income plays its proper role as one factor (albeit an important one) in the sum total of your financial goals.
As we touched on at the beginning, chasing higher-interest-rate bonds is another way we often see investors sacrifice their total-return considerations on the altar of isolated advantages. We’ll take on this subject in a future “Stop Doing” post.