Don’t Concentrate Your Portfolio in Dividend Paying Stocks

Not all stocks that pay dividends are good investments.

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Most individual investors engage in some form of active management, where their broker attempts to beat the markets. In order to justify their expertise, brokers have various strategies they believe will help them achieve this goal. These range from investing in commodities to overweighting your portfolio in a particular asset class, like large cap stocks or emerging market stocks. A popular strategy is investing in companies that pay dividends.

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Proponents of this strategy tout its benefits: The receipt of regular dividend payments effectively lowers the price you paid for the shares. Dividends are paid during both bull and bear markets. Management of dividend paying companies is also supposed to be more prudent because of the need to have cash available to pay the dividends.

Unfortunately, no active management strategy has peer review data to back it up. Overweighting your portfolio in dividend paying stocks fares no better. By limiting your portfolio to stocks that pay dividends, you deprive yourself of the returns associated with companies that paid no dividends at one time, but do so now, according to an analysis by Weston Wellington, a vice president of Dimensional Fund Advisors. Wellington looked at the initial offering price of five stocks that originally paid no dividends:

Cisco (CSCO)

Kohl's (KSS)

Oracle (ORCL)

St. Jude Medical (STJ)

Starbucks (SBUX)

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Each of these companies had huge appreciation in value from the date of their initial public offering until the present. For example, the purchase of 100 shares of St. Jude Medical on Feb. 9, 1977 at $3.50 per share was worth over $1 million on April 8, 2011. Each of these companies now pays a dividend, which further rewards those who invested in them prior to the start of dividend payments and had the patience to stick with them. St. Jude did not pay its initial dividend until March 29, 2011, almost 34 years after its initial public offering.

Conversely, just because a stock pays a dividend, doesn’t mean it’s a good investment. Wellington noted that Eastman Kodak has paid dividends since 1902, Kmart since 1913, and Dana Corp since 1936. The stocks of these three companies were singled out for special praise in the book, In Search of Excellence—Lessons from America's Best-Run Companies, by Thomas Peters and Robert Waterman Jr. Neither the dividends nor the high praise helped investors. Kmart and Dana filed for bankruptcy. Kodak eliminated its cash dividends in 2009 and its share price has declined by over 90 percent since the end of 1990.

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Brokers take advantage of your lack of knowledge of the data when they propose their active management strategies. It’s a rare investor who will insist on seeing long-term, peer reviewed academic data prior to making an investment decision. If your broker is recommending anything other than investing in a globally diversified portfolio of low management fee index funds in an asset allocation suitable for you, ask for the underlying data. Be sure to compare this data with the long-term data showing the returns of a comparable index based portfolio. Chances are you will see a quick retreat.

Dan Solin is a senior vice president of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, and The Smartest Retirement Book You'll Ever Read. His new book, The Smartest Portfolio You'll Ever Own, will be released in September, 2011.