Should You Invest in Dividend Paying Stocks?
I’ve mentioned that I tend to gravitate towards dividend paying stocks before, so the subject of this post should be no surprise.
When investing, my aim is to continue to educate myself about how to become an intelligent investor and to avoid speculating in the market, and I recently came across an interesting discussion on Reddit about why focusing on dividend stocks can be a mistake.
I’ll come back to this discussion later, but first I wanted to talk about why I buy dividend paying stocks in the first place.
In general, I have two main reasons for deciding to focus on buying dividend paying stocks.
The first reason I like dividend paying stocks is that it allows me to capture a portion of the capital gains I get from holding the stocks I already own. I can then use those dividends to invest in other companies I don’t own.
This is critical to my strategy right now because my wife and I can’t afford to put much money into the stock market. I’m in the middle of my junior year of school, and money is tight, so small contributions to our portfolio are a fact of life right now.
In a sense, I don’t have the luxury of waiting until my holdings appreciate, I need to have a capital return so that I can continue to add new shares and diversify our portfolio.
Dividends allow me to reap the rewards of diligently putting away a few dollars a month towards our investments, even though that amount is small.
To illustrate this point, our portfolio currently produces enough dividend income to equal 3.2 months of our normal contributions.
In other words, I can invest 15 months of money into the stock market in only 12 months. For someone who must make a serious effort to make any contributions to our portfolio in the first place, this is a huge deal.
The second reason I’ve decided to concentrate our investments in dividend producing stocks is two small reasons combined into one.
I want to be able to have an income stream that will stretch from now until long after my wife and I have both passed away, benefiting us in retirement and our children and grandchildren after that.
I understand that there are other ways of producing an income stream like this, but those income streams are ones that are either inaccessible to me currently or that I don’t have faith will insulate me from inflation.
I also want to have an income stream that I can use to fund other business ventures or, if needed, use as a safety net to insulate me from Murphy’s Law.
Leaving corporate America and striking out on my own will be a lot less stressful for me, and especially for my wife, if our dividends are producing enough income to cover our necessities. In the meantime, the worry of being laid off, phased out, or terminated will be significantly reduced when we know our portfolio is producing enough income to support us if it needed to, without requiring us to sell any shares.
My two reasons for favoring dividend paying stocks are ones which, for now, are compelling for me.
The reason I began this post discussing them is that I want to draw attention to the idea that you need to have a compelling reason for your investing strategies, and you need to understand what you are, and importantly, are not, trying to accomplish when you get into the market.
If you don’t do that there’s a good chance that you’ll get excited by one new investment idea or the other and squander your opportunities. You need to be focused so that you get what you want, instead of getting what happens to you.
Why Dividend Stocks Are A Bad Idea
Now we get to the fun stuff. The Reddit discussion I mentioned earlier.
Like I said, I try to keep educating myself about investment in the stock market. As part of that, I will occasionally hop over to r/investing and see what people are talking about. Often, I disagree with a lot of the things people say because I have a different investment strategy than they do.
One of the things I’ve noticed is that r/investing is notorious for disliking the idea of dividend growth investing, to the point that the general attitude I’ve seen is that only the ignorant do so.
I’ve read a few arguments against dividend growth investing before, but I’ve never found one that made sense to me, because I’ve typically understood them from the perspective of the strategy I laid out above.
That said, I wanted to try and understand a little bit better why so many are so adamant that investing for dividends is a rookie mistake, so I searched for the term “why you shouldn’t buy dividend growth stocks” and quickly found a very good thread titled ‘The “free dividend” fallacy is a belief that seemingly runs rampant in this sub. It’s high time we took a closer look at whether investing in high dividend paying stocks makes sense.’
I won’t take the time to detail the entire thread to you, but I highly recommend you go over and see what it has to say.
The main thing I think you should learn from it is that if your aim is to maximize your total return, investing in high dividend paying stocks may, but often does not, make sense. The overall tension is that dividends are not earnings, they are an allocation of capital, and unless the company you are investing in cannot make better use of that capital by retaining it in the business, paying a dividend is actually detrimental to your total returns.
Perhaps the best lesson I learned from reading through this thread came when someone linked to the Berkshire Hathaway shareholder’s letter from 2012. Starting on page 19, Buffett discusses the impact that dividend payment can have on your total returns as an investor, and he makes a case for the alternative often mentioned in r/investing.
That is, instead of collecting a dividend, you sell a fractional portion of your investment every year.
As your investment appreciates that fractional portion will diminish, allowing you to continue to maintain an income stream while benefiting from the capital allocation that ensures the greatest total return for investors.
I highly, highly recommend you read what Buffett has to say, as he makes an excellent point and finally explained the concept in a way that made sense to me.
As a summary of this discussion, Buffett makes the following statement:
“For the last seven years, I have annually given away about 4 1⁄4% of my Berkshire shares. Through this process, my original position of 712,497,000 B-equivalent shares (split-adjusted) has decreased to 528,525,623 shares. Clearly, my ownership percentage of the company has significantly decreased.
Yet my investment in the business has actually increased: The book value of my current interest in Berkshire considerably exceeds the book value attributable to my holdings of seven years ago. (The actual figures are $28.2 billion for 2005 and $40.2 billion for 2012.) In other words, I now have far more money working for me at Berkshire even though my ownership of the company has materially decreased. It’s also true that my share of both Berkshire’s intrinsic business value and the company’s normal earning power is far greater than it was in 2005. Over time, I expect this accretion of value to continue – albeit in a decidedly irregular fashion – even as I now annually give away more than 4 1⁄2% of my shares (the increase having occurred because I’ve recently doubled my lifetime pledges to certain foundations).”
I agree with the point Buffett is making here, although I am not going to say that I think he is completely correct.
For instance, one of the assumptions of the argument that Buffett makes is that a company can allocate its capital more effectively by retaining it in the business and thus provide investors with greater returns.
This is, obviously, a simplifying assumption that doesn’t always hold true. Just look at the Edsel, New Coke, or anything Yahoo has done in the last decade. However, I think the lesson is that we should be aware that just because a company pays a dividend doesn’t mean that doing so is the best way for us to get a return on our investment.
The Bottom Line
After reading through the discussion on r/investing, and especially after what Buffett has to say about dividends, I agree.
In general, it’s probably not the best idea to focus primarily on buying stocks because they pay dividends, especially because sometimes companies choose to manipulate their economic results because they are attempting to woo dividend investors.
However, I still think that dividend investing can be a viable, and sound, investing strategy, provided you understand the why behind what you’re doing. If you’re chasing total returns, dividend growth stocks might feature in your portfolio, but probably shouldn’t be a major focus of it.
If, like me, you have other reasons for investing in dividend paying stocks, don’t let the loss of returns stop you. After all, as investors we have to make a decision between total return and income today.
If you’ve learned something from what I’ve had to say, or you’d like to contribute to the discussion, please let me know by getting in contact with me.