When Does a Dividend Strategy Make Sense?

Dividend investing is perhaps more popular than it has ever been. There are two obvious reasons for its increased appeal. First, many people have lost faith in the growth prospects for equities and see dividend payouts as more reliable than share-price increases.  Second, the low rates on bonds and GIC rates have made dividend yields even more attractive to income investors. But if the emails and comments I’m receiving are any indication, many investors have flocked to dividend investing for the wrong reasons, without understanding the risk-reward trade-off.

When dividend investing may be best

Let me stress something before we go any further. I am not suggesting that building a portfolio of dividend stocks is a bad strategy. Many savvy investors have done so successfully for years, and it would be supremely arrogant for me or anyone else to tell them they’re wrong. Indeed, there are at least three situations in which focusing on Canadian dividend payers may well be superior to a global indexing strategy:

You rely on income from a non-registered portfolio. Dividends from Canadian companies can provide significant tax advantages. An Ontario resident with $65,000 in taxable income would pay only about 10% tax on eligible dividends, compared with more than 30% on interest income. If you’re making regular withdrawals from a non-registered account, the tax advantages of Canadian dividend stocks can make them superior to other types of investments.

You buy discounted shares directly from companies. Many investors have enjoyed great success using share-purchase plans (SPPs) and dividend reinvestment plans (DRIPs). SPPs allow investors to buy shares directly from the issuing company without brokerage fees, while DRIPs reinvest all dividends in new stock (including fractional shares), often at a significant discount. Investing this way is for the serious DIYer only. However, if you’re buying all of your shares at a discount and with no trading commissions, the rewards can be enormous over time.

You cannot imagine yourself as a passive investor. While the academic research is clear that indexing is likely to provide the highest returns, that assumes people have the discipline to stick to the strategy. Most people don’t: they either believe they can beat the market, or they accept the theory behind indexing but find it too hard emotionally. If you know you could never buy and hold index funds, but you’re prepared to be rigorously disciplined with a portfolio of dividend-paying stocks, then you should certainly do the latter. The best investment strategy is always the one you’ll stick to over the long term.

Dividends are not a free lunch

That said, I believe that many investors have bought into myths and misunderstandings about dividends. Many believe that choosing individual stocks based on their yields gives them a high probability of outperforming the broad equity markets. Others think that dividend stocks can take the place of bonds or GICs in a portfolio. Perhaps most alarming, some even refer to dividends as free money or a free lunch.

Dividends are an extremely important part of investment returns, but there is nothing magical about them. If you’re still in the accumulation phase of your life — that is, if you’re not drawing on your portfolio for income — then you should focus on total return, whether it comes from dividends, capital gains or interest. And the optimal vehicle for maximizing total returns is a globally diversified, passively managed portfolio, not one based around dividend funds or individual stocks.

I’ll kick off the series tomorrow with Dividend Myth #1: Companies that pay dividends are inherently better investments than those that don’t.

Congratulations to Michael and Echo, who won the draw for free copies of Meir Statman’s new book, What Investors Really Want. Thanks to everyone who entered by posting their thoughtful comments about their own behavioural biases.