Today I want to tell you why focusing on investing to get income is a flawed strategy and why a total return strategy will lead to a more reliable outcome.
Investors often desire cash-flow from their investments. There are blogs, books, newsletters and youtube channels dedicated to income investing.
Income investing means building a portfolio of dividend-paying common stocks, preferred stocks, and bonds to generate sufficient income to maintain your desired lifestyle.
The idea is that if you have enough income paying securities in your portfolio you are insulated from market turbulence and can comfortably spend your income and coupon payments regardless of the changing value of your portfolio.
There is a perception that if you never touch your principal you won’t run out of money. It seems like a foolproof retirement plan, but is it Really?
In what follows I will tell you why income investing won’t give you more income.
Let me start by saying that there is no evidence that dividend-paying stocks are inherently better investments than non-paying dividend stocks.
5 factors can explain the majority of stock returns. Dividends are not one of those.
For example, we know that if you gather all the small-cap stocks in the market, they will have better returns than all the large-cap stocks in the market. Based on this, company size is one of the factors that explain stock returns. The same evidence does not exist for dividend-paying stocks. If they aren’t inherently better investments, why do people like them so much?
Some potential explanations for investors preference for dividends:
“If they have poor self-control, and are unable to control spending, then a cash flow approach creates a spending limit — they will only spend income and not touch the capital.” — Explaining Investor Preference for Cash Dividend.
Another explanation in the paper is that people suffer from loss aversion. If their stocks have gone down in value they will feel uncomfortable selling them to generate income. On the other hand, they will happily spend their dividend, regardless of the value of the share.
But there is a problem. As much as a dividend may seem like free money, the reality of it is that the payment of a dividend decreases the value of your stock. If a company pays $20.000.000 to its shareholders as a dividend, the value of the company has to decrease by $20.000.000.
The investor is not better or worse off whether the company pays the dividend or not. This is known as the Dividend Irrelevance Theory which was originated in 1961.
I have just told you that whether returns come from dividends or growth does not make a difference to the investor. However, it is an important detail for taxable investors.
There is no difference whether returns come from dividends or growth on a Pre-Tax Basis. On an After-Tax Basis, the investor without the dividends is in a better position because they can choose to defer their tax liability by not selling any shares if they do not need to cover any spending.
The dividend investor is paying tax whether they spend their dividend or not. This is a big problem for the investor who does not need any income at that time.
About 60% of US stocks and around 40% of international stocks don’t pay dividends at all. Investing only in dividend-paying stocks automatically reduces diversification.
Dividend investing can also lead to ignoring important parts of the market. There are plenty of great companies that do not pay dividends. Ignoring them because they do not pay a dividend, which now we understand is irrelevant to returns, is illogical.
A good example of this is small-cap stocks. An income focus investment strategy will almost certainly exclude small-cap stocks, few of which pay dividends.
Now, don’t get me wrong. Dividends are an extremely important part of investing.
$1 invested in the S&P/ TSX Composite Price Only Index (without including dividends) in 1969 would be worth $14.37 today. The same $1 invested in the S&P/ TSX Composite Index ( including dividends) would be worth $64.59 today.
Dividend-paying common stocks are an important part of your portfolio. But a dividend-focused portfolio leads to Tax Inefficiency for taxable investors, poor diversification, and missed opportunities.
A Total Return Approach accomplished by investing in a globally diversified portfolio of total market index-funds results in greater tax efficiency, better diversification, and the ability to capture the returns market has to offer.
The topic of dividend investing can get people very exciting. Dividend investing is almost more of a lifestyle philosophy than an investing philosophy.
This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions
