The pros and cons of dividend investing

One of the more controversial investing topics confronted by near-retirees once they pass the age of 60 is the efficacy of dividend investing. One school of thought is that once you are near the stage of needing to draw income from portfolios, every investment should pay interest or dividends. That would rule out non-dividend-paying stocks you hope will rise in value, which generate only capital gains.

In his book You Can Retire Sooner Than You Think, author and financial planner Wes Moss makes the case for retirees age 60 or older having 100% of their portfolio in income-generating vehicles: whether interest, dividends, rental income from REITs or other securities: “Everything should be paying you an income from age 60 on.”

But there is a “total return” camp that argues total returns on your investments are what count, whether generated by capital gains, or cap gains combined with a growing stream of dividend income. In his series of “stop doing” blogs, Toronto-based Chartered Financial Analyst and advisor Steve Lowrie argues investors should stop chasing dividends.

Investors seeking a reliable income stream for retirement “should stop building their investment strategy around dividend-paying stocks (or higher-interest-yielding bonds) in isolation, without considering them in the context of their total wealth management,” Lowrie wrote. Total-return investing considers a more meaningful question: “What will optimize your ability to generate a reliable retirement cash flow today AND maintain or increase the value of your investments for future goals?”

Lowrie says the temptation to chase high dividends is similar to what fixed-income investors face with low GIC yields. “People don’t realize they are taking on extra risk when they start selling bonds to add to their dividends.” In market downturns, you often see the phenomenon of “accidental high yielders” when the stock price falls so much the dividend yield appears to spike. But “a 4% yield doesn’t do any good if the stock falls 40%,” Lowrie notes.

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Also in the total-return camp is PWL Capital portfolio manager Benjamin Felix, who tackled this in a Q&A column where a young Gen Y investor asked how he could create an all-dividend portfolio so he could retire early. Felix has said dividend investing is “one of the most romanticized ideas in personal finance”—citing a 2013 study by Dimensional Fund Advisors (DFA) that found 60% of U.S. stocks and 40% of international stocks don’t pay dividends, plus the fact that Warren Buffett declared dividends should not matter in making great investments. So, he concluded, an all-dividend approach would lead to “poor diversification.” Felix also dispelled the misconceptions that dividends are a guaranteed source of returns, offer protection in down markets, and that companies that grow their dividends necessarily beat the market.

He went on to say that the reader would be better off investing in broadly-based index funds (which would include dividend payers but not consist of them exclusively): “I would argue there is effectively no difference between receiving cash dividends and creating your own dividends by selling off some shares.” Felix elaborated on this theme in his Common Sense Investing video, where he asserted, “dividends do not matter” and that corporations can return money to shareholders either through paying dividends or through buybacks from shareholders, known as share repurchases. For investors, it shouldn’t matter which.

For years, fee-only financial planner Robb Engen described in his Boomer & Echo blog how he believed in investing exclusively in dividend stocks, preferably consistent dividend “aristocrats” with a long record of paying and raising their dividends. But four years ago, he reached a personal epiphany in favour of pure indexing. In a blog, he related how he sold 24 individual dividend-paying stocks and replaced them with just two Vanguard index funds.

Today, Engen is keen on the new asset allocation ETFs pioneered by Vanguard, BMO and iShares. For retirees looking to generate income (dividend or otherwise), he is partial to the classic 60/40 stock/bonds mix of the Vanguard Balanced Portfolio ETF (TSX: VBAL). A major reason is that “it handles the rebalancing for you. No need for a retiree to be in 100% equities, so VBAL is completely appropriate and gives some market exposure, while smoothing out the volatility in case markets tank.”

Another consideration is the tax levied on dividends and capital gains in non-registered portfolios. Both are taxed less than interest income, assuming the dividends are from Canadian issuers that qualify for the dividend tax credit. But Vancouver-based portfolio manager Adrian Mastracci, of Lycos Investment Management Inc., cautions investors to make the investment decision based first on logic, and only then on tax-friendliness. “I focus on the total asset mix to pursue for each family. That allows me to find the appropriate balance between value and growth investing. I don’t dwell just on dividends,” he says.

Finally, the retirement of the Baby Boom generation needs to be factored in. In a recent blog, Dale Roberts of Cut the Crap Investing said retiring boomers are unlikely to crash the market by selling stocks en masse. “It’s a continual theme…that many of these retirees ‘live off of the dividends.’ They’re not selling shares; they are simply collecting and spending the dividends. They will not put sell pressure on the markets.”

Comforting words. Personally, in addition to employer and government pensions, I plan to live on a combination of interest and dividend income and an ever-decreasing allocation to capital gains as I gradually take profits from some winners, preferably with offsetting losses, and move more money to cash.

Jonathan Chevreau is the founder of the Financial Independence Hub, author of Findependence Day and co-author of Victory Lap Retirement. He can be reached at [email protected]

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About Jonathan Chevreau

As MoneySense’s Investing-Editor-at-Large, he is also author of Findependence Day and co-author of Victory Lap Retirement. Reach him at [email protected], where he is the founder of Financial Independence Hub.

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