Wednesday, July 3, 2013

Dividends More Stable Than Capital Gains

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.

17 comments:

  1. Since long-term dividend investing is so different from the focus of most market participants, I can see the preferred dividend-paying stocks occasionally being priced very cheaply. That could lead to a good return on those stock purchases. However it's questionable whether the total return on capital is that good since you would earn a much lower return on your cash while waiting for those buying opportunities.

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    1. @Value Indexer: These stocks can sometimes be expensive as well. As you observe, dividend investing has some of the same troubles with trying to beat the index as other types of stock picking have.

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    2. MJ,

      Why are you focusing so much on "beating the market" over time? This is why you missed the point of the article I had written.

      If you are retired/FI/living off investments, your goal is to stay retired/FI/living off investments.

      Your goal is to generate income that is sustainable, stable, reliable.

      By having a stable source of income to pay for your expenses, it is much more likely to remain retired.

      I need to eat every day, and not have to worry if markets are in a bear market or in a bull market.

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    3. @Dividend Growth Investor: It is precisely because you don't seem to understand that your investing strategy is based on trying to beat the market that I point this out. If the broader market matches your dividend stocks, then you can just as easily live off capital gains. Dividend investing has its virtues, but expecting to beat the market is unrealistic for most investors. Sadly, too many dividend investors are poorly divdersified and will likely trail a good blend of Canadian, US, and foreign stock indexes over time.

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  2. I read in the latest MoneySense magazine that a bunch of monkeys beat the index :)

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    1. @Robb: I know you meant this is jest, but it brings up a serious issue that so many investors miss. A monkey can beat the index by luck, particularly over short periods of time. Monkeys even have a small chance of beating the index over a decade. But they never have an expectation of beating the index.

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    2. I don't have the article in front of me but I think it mentioned a dozen investing strategies beat the index over quite a long period of time. The problem, as Dan noted, is that the average investor is unlikely to stay the course and stick with one strategy forever.

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    3. @Robb: There are many investing strategies that beat the market for a long time. A bigger problem than sticking with a strategy is that once enough people have heard of it, it stops beating the market. At one time I was very tempted to try the "Dogs of the DOW" strategy that had a very long and strong run. Fortunately, I decided against it because it stopped working just as it's popularity was exploding. Not coincidentally, it was this explosion of popularity that caused me to consider it.

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    4. @Michael James - I disagree that the 'popularity' of a strategy is a bigger problem than our natural tendency to chase performance.

      I suspect you still would have done quite well using the Dogs of the Dow approach.

      http://www.dogsofthedow.com/dogyrs.htm

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    5. @Robb: I guess that's a matter of taste. We have a chance to do something to curb our natural but destructive tendencies. However, it's hard to do much about a strategy that no longer works.

      I'd like to know which version of the Dogs of the Dow these return figures are based on. Back when this investing strategy became most popular and then stopped working, people came up with dozens of variations. Each variation back-tested well, but didn't fare well in the following several years. I lost interest after watching yet another variation that looked promising but later failed to outperform.

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    6. I'd love to continue this debate over a beer at CPFC13. See you there!

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  3. Before I became more enlightened shall we say...I used to think dividends were the be all, end all.

    Now, I've matured my thinking and it comes down to exactly what you wrote Michael: dividend investing helps me stick to my investment plan. I see the money coming in, good markets, bad markets or indifferent. When prices drop, I buy. Even if prices flatline, I tend to buy. I try to avoid buying on the way up. That's my recipe. Rinse and repeat.

    I suspect as far as CDN stocks go, I'm a bit of a closet indexer. I've got 30 CDN companies now, over half of them DRIP every month or quarter. I'm sure you could name half my holdings without thinking about it. I'm getting close to owning a proxy for XIU. The steady stream of dividends helps me stay calm. I believe by buying and holding many of the same companies within XIU, I will, over time, considering XIU small fees be close to matching XIU returns. Because the U.S. market is far too huge, I do own a few hundred shares of VTI along with my U.S. stocks. Over time, I suspect I will continue to hold more VTI.

    Good read Michael, just go easy on the indexing talk with us dividend investors in Toronto this fall :)

    Mark

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    1. @Mark: Your approach sounds sensible to me as long as you aren't counting on beating the market over time. It could happen, but it's not something anyone should count on.

      I'm sure I'll be outnumbered at the conference.

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  4. Some supposed index ETFs could also be considered a dividend strategy - e.g. XIU, where every single constituent pays a dividend. It's not designed that way of course but it is not an accident that these companies do pay a dividend. Other interesting fact, at least in recent years - dividend payments on equity ETFs aka distributions also are just as stable as bond interest distributions but with one other hugely attractive difference - dividends/distributions rise over the long term (and at a rate faster than inflation). An equal lump sum investment a decade ago would now be paying out more in any of a variety of equity ETFs than the broad bond fund XBB - see a post I did on this http://howtoinvestonline.blogspot.ca/2013/06/surprise-equities-can-outdo-bonds-for.html. Put all the dividend paying stocks into a portfolio, then put the non-dividend payers into a portfolio, guess which will do better over almost any multi-year horizon?

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    1. @CanadianInvestor: Most dividend investors prefer a larger dividend than XIU pays, but I see your point. Measuring stability over only a few years doesn't mean much unless you have a time machine to go back and make different decisions. If a couple more European countries go into crisis, the current stability could end in a hurry. (That is not a prediction.) Dividend-paying stocks can look like bonds for a while and then suddenly stop looking like bonds in a sickening way.

      My guess is that the long term results of your two hypothetical portfolios (dividend payers vs. non-dividend payers) would follow the past trends for value/growth and small-cap/large-cap. But, who knows, maybe even these trends will fall away and all we'll be left with is the risk premium.

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    2. I am always tempted to make the switch off of my balanced index fund strategy but keep telling myself that most people don't beat the market. For those that do beat the market good for you!

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