One of the justifications that dividend investors use to justify their belief that they will beat market indexes is the fact that dividend income is more stable than capital gains. Dividend Growth Investor recently explained this line of argument. Dividends do tend to be more stable than capital gains, but this doesn’t mean that dividend investors will beat the market over the long run.
Dividend Growth Investor says that “Investors who sell stocks to fund their retirement face the risk of selling off stocks at low prices during bear markets, which could result in asset depletion.” The implication here is that this is not a problem if you own dividend-paying companies.
However, the reason why dividends are more stable is that companies do what they can to avoid cutting dividends. Even when it is painful to pay dividends, companies tend to pay them anyway. Even if the money is better reinvested in the business, or better used for an acquisition, or the company is forced to increase debt, it often pays dividends anyway.
The paying of dividends can be as damaging to businesses during bear markets as the selling of stock is damaging to portfolios. Dividend Growth Investor offers a common answer to this: “I try to select companies that regularly pay and increase dividends, and also have the potential to increase profits over time.” Choosing better dividend stocks avoids those businesses that would be hurt the most by having to pay dividends during bear markets.
Now we’re getting to what is really behind dividend investors’ hopes of beating market indexes: stock selection. They hope to pick superior stocks just like any other active stock picker. However, there is no guarantee that great dividend-paying businesses of the past will continue to be great businesses in the future.
The best justification for dividend investing that I’ve heard is that it helps some investors stay invested when they get nervous during bear markets. The steady stream of dividends helps them stay calm and stay invested. As long as they’re adequately diversified, this makes some sense. However, I’m very doubtful of the typical investor’s ability to outperform the market over the long run with dividend stocks. A more realistic goal is to roughly match the market’s total return over time while using the comfort of steady dividends as a way to stay invested.