When it comes to investing, there are usually detailed, seemingly murky, questions that often arise which require some digging into. For example: Should I be investing for dividend yield? Is it safer to invest in dividend stocks? Are dividend stocks good to own in retirement?
Abacus’ advisors have been fielding many of these questions lately about investing in dividend stocks. It’s not surprising. We often get inquiries about what investment approach has recently been hot – and 2022 favored dividend paying stocks.
Let’s explore and find some clarity.
What is Investing for Dividends?
First, let’s define what investing for dividends means. An investor’s total stock return is derived from two sources. One is capital appreciation, or an increase in the stock’s price. This is similar to your home increasing in value. You can’t spend the gain until you sell the house, but you are also not taxed until you sell.
The second source of stock returns is dividend yield, or payments made by companies to shareholders at regular intervals. This is like receiving rent for leasing your house. You are taxed every time you receive them. Together, capital appreciation and dividend yield comprise total stock return.
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How Dividend Investing Works in Practice
Let’s look at two very different examples of dividend paying stocks.
Apple pays a dividend that is 0.5% of its price (as of this writing). Apple’s shares also increased in value by 19% over the prior 12 months. For Apple, dividends have been, and are expected to, play a small role while capital appreciation has been, and will likely be, the main driver of its returns.
Johnson & Johnson pays a 2.8% dividend, more than five times greater than with Apple. Dividends are a far larger portion of its long-term expected returns. Investment funds that target dividend paying stocks focus more on companies like Johnson & Johnson and less on companies like Apple.
Most companies don’t pay a dividend at all. Over time, it has become much less common. 68% of US companies were paying dividends in 1927, while only 38% of firms paid in 2021.
How Dividend Paying Stocks Underperform
If you care about maximizing your income, focusing on dividend paying stocks has not been an effective strategy. Dividend paying stocks have underperformed stocks in general over the long term.
The Vanguard Dividend Growth mutual fund (SYMBOL: VDIGX) has been around since 1992 and made Morningstar’s list of The Best Dividend Funds in 2023. Here we will let it represent dividend stocks. And we will compare its performance to the SPDR S&P 500 ETF (SYMBOL: SPY), a fund which invests in the index that most people think of as ‘the stock market.’
As Exhibit 1 below illustrates, over 30 years and 7 months, the VDIGX underperformed SPY by 1.1%, on average, annually. Over this period, that lower return dented comparative total returns by 27%. And remember, this fund is one of the better performing dividend funds (as well as one of the oldest).
There are other reasons not to favor dividend stocks. A focus on dividend yield sacrifices sector diversification. High dividend yields tend to occur in companies concentrated in consumer staples, utilities, telecoms, energy, and real estate. This can expose an investor to significant sector-specific risks.
Why a Diversified Portfolio May Be a Better Choice
A diversified portfolio, on the other hand, spreads investments across all sectors, thereby mitigating the risks associated with any one sector’s poor performance.
Dividend focused funds tend to be highly concentrated in US stocks. The Vanguard Dividend Growth fund is allocated 91% to US equities which is typical of the dividend focused funds that Morningstar ranked highly in 2023. And not having an international exposure can be costly.
For example, US stocks had a negative 0.95% average annual return from 2000 to 2009. That is a decades-long cumulative loss of roughly 17%. Some refer to that period of time as the United States’ ‘Lost Decade’. Meanwhile, international stocks bested US stocks over the same period by an average of 2.99% annually. We don’t like our clients losing decades, especially in retirement.
Dividend focused funds tend to be highly concentrated in large stocks which are far more likely to pay dividends. At Abacus, we actually overrepresent small stocks in our client portfolios, because small company stocks have had a higher return historically. That return derives from their higher risk. Heightened expected risk has a heightened expected reward. Smallness in market capitalization is a source of higher expected returns that is not available when investing for dividends.
What are the Taxes for Dividend Investing?
Dividend yield is less tax efficient than capital appreciation. Qualified dividends and capital gains are taxed at the same rate (20% Federal). But dividends are taxed every time they are received, whereas capital appreciation is only taxed when you sell. Imagine a tree that grows 10 inches every year. And then every year, two inches are cut off. That is similar to how dividends are taxed. Capital appreciation is a tree you only trim when you need some wood.
In Exhibit 2 below, two investments have the same rate of return and taxation – the only difference is one is entirely dividends being taxed annually and the other entirely long-term capital gains being taxed at the very end. Long-term capital gains enjoyed a roughly 15% advantage in after-tax returns over 15 years. Time compounds this effect.
Other Dividend Investing Tips to Remember
People often fail to appreciate that dividends can be (and have been) cut. Companies sometimes decide to reduce or eliminate their dividends during difficult economic times or due to poor company performance. This could lead to significant declines in stock prices, as has happened to many financial and energy firms during economic downturns. In 2020, during the height of the pandemic, global dividends fell by $220 billion – or 12% of total global dividends.
Beyond their outperformance in 2022, dividend stocks are perennially popular despite evidence to the contrary. But why? Perhaps it is easier to conceptualize dividends than to think about selling shares. One can imagine people failing to realize that a stock’s price declines by the exact amount of the dividend that has just been paid. Comparing the two examples in Exhibit 3 below, you can see that whether via dividends or via a sale of shares, both paths are mathematically identical.
Staying the Investment Strategy Course
Always remember that the financial press is selling clicks. They don’t necessarily have your best interest at heart. Next time you read or hear anything from the media, take it with a grain of salt. They can hawk any idea that captures eyeballs without having to comply with government oversight or actually being accountable to a client.
There are any number of investment strategies you will read about over your lifetime. Whatever you do, don’t switch investment strategies repeatedly. Indecision can convert a suboptimal approach into an investment train-wreck.
At Abacus, we apply investment principles based on academic research. This research has a high degree of statistical confidence that, when maintained over long periods of time, is expected to be both increasingly dependable and provide a higher return than alternatives. Narrowing the range of outcomes over time is what makes our financial modeling so powerful. That is what allows you to be intentional about your life and financial choices.
Historical performance results for investment indices, benchmarks, and/or categories have been provided for general informational/comparison purposes only, and generally do not reflect the deduction of transaction and/or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of which would have the effect of decreasing historical performance results. It should not be assumed that your Abacus account holdings correspond directly to any comparative indices or categories.
Please Note: (1) performance results do not reflect the impact of taxes; (2) comparative benchmarks/indices may be more or less volatile than your Abacus accounts; and, (3) a description of each comparative benchmark/index is available upon request.
Please Also Note: This material is not intended to serve as personalized tax and/or investment advice since the availability and effectiveness of any strategy is dependent upon your individual facts and circumstances. Abacus Wealth Partners is not an accounting firm. Please consult with your tax professional regarding your specific tax situation when determining if any of the mentioned strategies are right for you.