The most common misconception among investors may be the value of investing in dividend-paying stocks. Almost every week, someone contacts me to extol the virtues of investing in what they call “high quality, dividend-yielding securities.” Often, their interest is spurred by the recent high performance of these stocks. According to one paper by Gregg S. Fisher, published in the Journal of Financial Planning, the FTSE High Dividend Yield index of U.S. stocks returned a whopping 26 percent between the period of Jan. 1, 2011 and Sept. 30, 2012. During the same period, the Standard & Poor's 500 index fell short, returning 19 percent.
There are many myths on the benefits of investing in these stocks. Here are some of the most common ones:
Myth No. 1: Dividends hold up in bad markets. There is a perception that dividend-paying stocks will hold up better when the market declines. If that were the case, you would think the stock of General Electric, a member of the Dow Jones Industrial Average, would help prove that point. GE paid a quarterly dividend of $0.31 per share in 2008. In 2009, during the global recession, GE cut its dividend to $0.10, commencing in the second quarter of 2009.
GE was not alone. In 2009, a whopping 57 percent of dividend-paying companies, located in 23 developed markets, either reduced their dividends or eliminated them altogether.
Myth No. 2: Dividend-paying stocks outperform the market. From 1991 to 2012, the simple average annual returns of dividend-paying stocks and the market were both 9.1 percent. During the same period, stocks not paying dividends had a simple average annual return of 11.1 percent, though the higher returns came with greater volatility.
Myth No. 3: Dividend-paying stocks provide adequate diversification. If you focus only on investing in dividend-paying stocks, you are ignoring 39 percent of the global companies that do not pay dividends. An investor who invests only in dividend-paying stocks is sacrificing diversification. Approximately 53 percent of global small-cap stocks pay dividends. If your portfolio is made up entirely of dividend-paying stocks, you are excluding 47 percent of global small-cap stocks.
Myth No. 4: Dividends are a reliable source of future income. A change in tax policy can dramatically affect future payment of dividends. In the U.S., dividends are taxed favorably compared with ordinary income tax rates. For individuals in an income tax bracket that not exceeding 35 percent, dividends are taxed at only 15 percent. However, there isn't any assurance this policy will not change, or that foreign countries will not alter their tax policy toward dividends.
Myth No. 5: Dividends are tax efficient. Dividends are more tax efficient than ordinary income because they are taxed at a lower rate. However, they are less tax efficient than capital gains, because you are taxed on dividends in the year in which they are paid, but you are not taxed on capital gains until you sell the stock.
Myth No. 6: Buying dividend stocks is a prudent way to obtain exposure to value stocks. Fisher's analysis of more than 30 years of high dividend-yielding stocks compared those stocks' returns with the broader stock market. The paper concluded that it wasn’t the dividends associated with high-yielding stocks that drove performance. In fact, the author, Gregg S. Fisher, concluded that the “ ... yield factor associated with high dividend-yielding stocks actually detracted from performance.”
If dividends didn’t account for the returns, what factor did? It was the value factor, which refers to the purchase of stocks that have low prices compared with earnings or other metrics (like book value). The study concluded there are better ways to get exposure to value stocks than buying high dividend stocks. It recommended simply tilting your portfolio toward value stocks.
Myth No. 7: Dividend-paying stocks are a substitute for bonds. Some investors believe they can improve their yields, without taking additional risk, by dumping bonds from their portfolio and substituting higher dividend-paying stocks. This analysis is incorrect on several levels.
First, dividend-paying stocks are (obviously) stocks. They have significantly greater risk than high quality, short-term bonds. Comparing the returns of these two investments doesn't make any sense.
Second, there is a better way to increase expected returns. You can do so by increasing your allocation to stocks. The purpose of bonds is to lessen periods of volatility. You should take a total return approach to investing. The stock portion of your portfolio is where you should take risk. You should not take any meaningful risk with the bond portion.
Third, if the market drops, the value of the stocks of dividend-paying companies would also likely decline, and the dividends could be reduced or even eliminated. Proponents of buying dividend-paying stocks often dismiss or ignore these risks.
Dan Solin is the director of investor advocacy for the BAM Alliance and a wealth advisor with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books. His next book, “The Smartest Sales Book You’ll Ever Read,” will be published March 3, 2014.