Who wouldn’t want a steady stream of income, whether the stock market is up or down? Who wouldn’t want a sure thing, when others are scared about stagnant returns this year?
The Answer: This golden goose doesn’t exist.
What is Dividend Growth Investing?
- Investing only in companies that pay Dividends (i.e. annual/semi-annual distributions to its investors) and will slowly grow with the economy.
- Most dividend-paying companies are mature, being some of the largest companies in their market segment. Think AT&T, ADP, The Coca-Cola Co., Chevron Corp, etc. They will still grow, but slowly with the greater economy since they already have such a large market share. While some of their profits are reinvested, the profits they cannot use wisely are distributed as dividends to shareholders.
- Dividend Aristocrats are the best of the best, some of the biggest companies in the USA increasing their dividends for over 25 years straight.
The problem is…
…Dividend Growth Investing stocks have the same risks as other stocks. Remember, stocks are part-ownership of a company vying for market share in a changing economy. They can and do see negative stock returns or even fail, just like non-dividend paying companies.
- 2008-2009, 2020- : Dividends can and will be reduced or suspended. But only during bad economic times, not when the sun is shining. If you need the income, you now have to sell likely strong companies when their stock is down 30%.
- Cash: We should all have some cash to weather the storms, dividends stocks or no. Shouldn’t the rest of your portfolio be invested broadly in stocks with higher returns? You can and should control the volatility and a buffer with your cash/stock/bond percentages.
- Tax Liability: Uncle Sam always gets his due. With dividends, you take what you’re given and cannot control your tax liability. With stock sales, you are in control of what year you will be taxed in and at what rate. And what if you don’t need the income and want to re-invest?
- Smoother Ride with LOWER long-term Returns: There is no free lunch. By investing in more established companies with less growth potential, you are borrowing from your returns in 20-40 years for some cash now.
- Retirement Accounts: Some of these negatives are reduced by holding your investments in a 401k, IRA, or other retirement account. But then, you are investing for decades from now instead of immediate income, so what benefit would dividend stocks have?
In a horrible economic climate, stocks and dividends will fall and you would have to sell at a loss if you need cash now.
And if times are good, other stocks will have higher returns.
So a dividend stock is mainly useful during poor, but not bad, economic times. I don’t know about you, but my crystal ball isn’t all that clear. You would either have to hold onto Dividend stocks during great times, seeing lower overall returns, or buy the Dividend stocks during poor times, when they are already priced as desirable stocks to own.
So What Should I Do?
When companies have net income, they have a finite set of options. A CEO, CFO, and Board will spend that cash on whatever gives the best return.
- Re-invest in the business and its products to grow further
- Pay off debt and/or buy back shares
- Hold cash to buy deals when they become available and weather economic storms
- And if there is no better use, distribute cash via dividends to investors
Ultimately, you want to invest in companies who have found and can capitalize on further growth, instead of companies that have climaxed, given the investment risk is essentially the same.
The good news is you don’t have to choose to invest in Dividend Stocks or not. Buy a S&P 500 index fund, or better yet, Total Stock Market index fund such as VTSAX. You will own some dividend-paying stocks by default, but have greater control over your tax liability, re-investment plan, and ultimately see greater returns long-term.
- The S&P 500 has an average dividend yield of roughly 2%
- VTSAX is around 2% but has been much lower
- For comparison, the best Dividend Growth stocks are in the 3-5% range