Published September 14th, 2017
This is a guest contribution from ModestMoney.
Investors are of all stripes. Some build portfolios around growth opportunity, others stake their wealth on mature businesses which will last for decades to come. These options are not mutually exclusive, though the average investor tends to heavily favor one or the other. Not mentioned yet is a third place that an investor might look for value: stocks that pay high dividends.
When you read the top finance blogs about dividend stocks, you’ll start to notice that there are great differences of opinion about their value (and of the intelligence of those who buy/avoid them). Those who love dividend stocks do so for their long term security and especially for the income they produce. Some investors use these dividends for income, while others save or reinvest it. However, there are many critics of this model, who claim that dividends underperform relative to more aggressive growth strategies.
When you learn about how these high-yielding stocks work, you’ll understand that there is no single criticism which applies across the board. Dividend stocks as a portfolio strategy can be effective and efficient, often more so than strategies that rely more on growth. A growth-based portfolio, or one highly diversified with Betterment investing, might better meet the goals of some. But dividend investing is the best possible strategy for others. Here are some of the most common arguments against a dividend-focused portfolio. We’ll debunk them one by one.
High Dividends = Lower Share Price
When a company has surplus revenue they can use to pay off debt, buy back stock, build their business, or pass it off to investors as a dividend. On paper, one could easily demonstrate that a company valued at $25 per share is inherently worth $24 if they pay out a $1 annual dividend. While this is true in a vacuum, it doesn’t always hold true in the real world.
The stock market is a voting machine. People who perceive a stock to be valuable will pay a premium for it, often without regard for its inherent value. In practice, high dividend stocks have all the growth potential of similarly valued companies who do not pay high dividends. Well-chosen high dividend stocks will yield solid per share growth, as well as dividend rates which usually increase over time. Think Apple as a good example of a company with great growth and great dividends.
Dividend Investors Are Victims of Mental Bias
A second common criticism of dividend focused investing is build upon the same foundation as the first. It goes like this: when a company pays a dividend, it is depleting its capital. When an investor receives a dividend, therefore, it represents depleted capital. That same investor would often be loathe to sell stocks to get the same money, even though it represents basically the same depletion of capital. This is due to a mental bias and generally confusion, the argument goes.
However, this is not the way most dividend investors think about this feature of the stocks they choose to hold. Dividends can be reinvested, but this is not the only way they can be used. They can be spent as income, or they can be used for a different investment entirely.
Oftentimes an investor is happy to have cash from dividends, but does not want to reduce the number of shares they own to get the same money. Maybe they believe in the long term potential of a dividend stock and don’t want to sacrifice the size of their position. Dividends represent a versatility of possibility, to re-invest, to save, to invest elsewhere. A traditional growth strategy might be simpler, but it doesn’t offer the same range of possibilities to the hands-on investor.
The Greatest Total Returns Come From Up-and-Comer
This is true. Small-cap stocks have shown the highest returns of any stock class over the past several decades. Larger companies that have not yet matured often pay out no dividends at all, because they can put their revenue to better use than simply giving it to shareholders. Doesn’t this mean that dividend stockholders just don’t know what’s what?
Not really. Greatest possible total returns is not the goal of every investor. The opportunity for high returns is always accompanied by higher risk. Risk/reward; you know the saying. Many investors don’t have the stomach to chase the highest possible returns, otherwise they’d all be investing in Bitcoin. Dividend and dividend growth strategy creates a much less volatile portfolio, one which still beats inflation and provides incomes/reinvestment potential all the while.
Investors who select this strategy may simply be conservative. It has been proven from market history, there are periods of multiple decades when no growth was achieved beginning to end. An investor might legitimately believe that this is a threat, selecting a dividend portfolio model to supply tangible income even if stocks don’t rise.
Another dividend investor might decide not to chase growth above all else because they couldn’t afford to lose value in the effort. Perhaps this investor plans to retire early in just a couple of years. Perhaps this investor is getting older and doesn’t want to risk losing portfolio value with not enough life left to get it back.
As you can see, for every common criticism of dividend investing, there is a valid reason why someone might still choose to invest this way. It’s a fallacy to claim that dividend investing is superior to growth investing in every respect, but that is also true when a cocky investor claims the reverse.
Dividend investing done right provides growth potential, income, and low volatility. Dividend investors who value any of those traits more than the other can fashion a portfolio that leans more to one or the other. A dividend-heavy strategy can also look an awful like growth investing. It’s all up to the needs and personalities of the investors involved. So the next time that someone on the internet makes some blanket statement about dividends, understand that this is a person looking for a simple answer to an issue that’s more complicated than they’re willing to handle. Dividends aren’t the only answer, but they’re a great opportunity for many.