Debunking Dividend Myths: Part 2

This post is the second in a series exploring the myths and misunderstandings about dividend investing. The goal of the series is to argue that many investors following a dividend-focused strategy may be better off with broad-based index funds.

Dividend Myth #2: Dividend investors are successful because they select excellent companies and buy them when they are attractively priced.

Every morning Larry takes a brisk walk with his beloved German shepherd and then enjoys a Dole banana and a cup of nonfat Yoplait. He eats organic lunches at The Angry Vegan, and three times a week he visits The House of Pain, where he lifts weights, swims or does a spinning class. Larry follows this routine for decades (he goes through a few German shepherds) and remains spry and active into old age. One day, Larry’s great-grandson asks him for the secret to keeping so healthy. “It’s all about making good choices,” the old man replies. “Start by choosing a breed of dog that is strong and long-lived. Then buy only recognized brand names for your breakfast foods. Finally, always patronize restaurants and fitness clubs that are well managed and highly profitable.”

When I hear dividend investors talk about their success, I think of Larry. Because like my fictional fitness buff, these investors often achieve their goals without appreciating why. They save regularly and put their money to work in the equity markets, which have delivered better long-term returns than any other investment. They avoid high-fee mutual funds, keep their trading costs low, and carefully manage their accounts to minimize taxes. They hold their stocks for the long run and show strict discipline by not panicking when markets tumble. These factors probably determine 95% of their fate. Yet when dividend investors reflect on their wealth, they’re inclined to say, “I owe it all to my ability to choose excellent companies with good yield, and to buying them when they were attractively priced.”

The real reason dividend investors succeed

The most important factors affecting investment success are boring. When was the last time you bragged to a friend about how few trades you made last year? Or regaled your family with stories of your preauthorized RRSP contribution? Try as I might, I just can’t seem to get my hockey buddies interested in asset-class correlation.

By contrast, the hunt for dividends is exciting. People genuinely enjoy analyzing businesses, building their stock portfolios one company at a time, feeling smart when their picks do well, monitoring the markets for buying opportunities and, perhaps most of all, getting those cheques in the mail. This is clear from the zeal of dividend investors, which isn’t matched by people using any other strategy. There are no blogs called “Think Bond Ladders” or “The Capital Gains Ninja.”

There’s nothing wrong with this — indeed, people who enjoy investing are more likely to be successful than those who find it a chore. Anyone who tells a dividend disciple that they should switch strategies has failed to understand that investing isn’t only about earning the highest possible return. As Meir Statman has argued, investing has genuine expressive and emotional benefits.

However, because many dividend investors devote so much time and enthusiasm to identifying great companies at good prices, they mistakenly believe that this is the essence of the strategy. On the contrary, I think that dividend investors achieve their financial goals because they do everything else right. Their wealth comes despite stock picking and market timing, not because of it.

Beating the market is still a loser’s game

Dividend investing is a successful and enjoyable strategy. The problem is that it’s often extolled as a way to beat the market. This is the dangerous part of the myth, and a claim that should be challenged.

The fact is, dividend investing is simply a form of active management. I’m not going to rehash the whole active-versus-passive debate here — many books have been devoted to the topic, and the matter has been settled by academics. Suffice it to say that likelihood of any investor beating the market over a lifetime is extremely low. It’s probably higher for dividend investors than it is for mutual fund managers, who have much greater costs to overcome, but it’s still a long shot.

There is no shortage of data showing that dividend-paying stocks outperformed the overall market during many periods in the past. The problem isn’t that these data are wrong, it’s simply that they are backward-looking and have no predictive value. Stocks that pay consistently high dividends over the next 20 years probably will outperform the market between now and 2031. The problem is no one has figured out how to identify those companies today.

Companies that have grown their dividends in the past are no secret to anyone, and screening for these stocks in no way guarantees outperformance. (Does anyone buying Fortis think that its widely known record of rising dividends isn’t baked into the price already?) Identifying undervalued stocks is far more difficult than many people admit. Surely amateur investors cannot truly believe that they have special talents in these areas when nine out of ten professionals cannot outpace their benchmarks.

Dividend junkies have a solid track record, and no one should suggest they abandon their strategy if it works for them. However, all investors should remain skeptical of anyone’s ability to consistently pick stocks and time their purchases. It’s always been a loser’s game. Instead, we would all do well to emulate the discipline, cost consciousness and other good habits of dividend investors. No matter what strategy you use, if you can get that part right, you’ll reach your financial goals.

Other posts in this series:

Dividend Myth #1: Companies that pay dividends are inherently better investments than those that don’t.

Dividend Myth #3: Dividend-paying stocks are a substitute for bonds in an income-oriented portfolio.

Dividend Myth #4: You can beat the market with common sense: just focus on blue-chip companies with a competitive advantage and a history of paying dividends.

Dividend Myth #5: It’s easy to build a well diversified portfolio of Canadian dividend stocks.