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Chapter 08: High Dividends for Sure Income

Chapter 8 image

“To ensure retirement income, I’ll just invest in high-dividend stocks.”

 

LONGEVITY KEEPS INCREASING—and only will continue in the future. (See Chapter 2.) Which means folks are likely to spend longer in retirement now than ever—maybe much longer than most anticipated. Getting enough cash flow to fund retirement is often a top concern for many investors.

No one wants surprises in retirement—particularly not the sort of surprise that requires a sudden spending downshift. So how can you increase the odds your portfolio kicks off a level of cash flow you expect for the totality of your time horizon?

A near-ubiquitous myth is funding retirement is easy and predictable with a portfolio heavy in high dividend-yielding stocks and/or fixed income with high coupon rates. Whatever that yield is (so goes the belief) you can safely spend—maybe without ever touching principal! Many investors—including professionals—believe this is a safe (there’s that word again) retirement strategy.

Don’t count on it. This myth could cause potentially very costly errors. Ones that can force you to ratchet down your future spending—and make for awkward conversations with your spouse.

There are a few problems with the high-dividend myth. First and most simply, this confuses income with cash flow. Yes, dividends (interest payments, too) are technically income. You report them as such on your tax returns. And there’s nothing wrong with either as cash flow sources—dividend-paying stocks and fixed income may well be appropriate for you to some varying degree, depending on your long-term goals and financial profile. I can’t tell you how much is appropriate for you because I don’t know you. But if you rely on them solely or primarily, you could be selling yourself vastly short.

Finance theory is clear: After taxes, you should be agnostic about the source of your cash flow. It doesn’t matter whether you get cash flow from dividends, a coupon or the sale of a security. Cash is cash is cash! Instead, what should concern you most is remaining optimally invested based on a benchmark (i.e., long-term asset allocation) appropriate for you. And a portfolio full of high-dividend stocks may not do it. Why?

All major categories of stocks come in and out of favor—including high-dividend stocks. Value and growth trade leadership, as do small cap and big cap. All major sectors rotate—Energy, Tech, Financials, Materials, etc.—going through periods they lead and periods they lag, always and irregularly. And high-dividend stocks are just another equity category. They aren’t better performing or less volatile. Sometimes they do well, sometimes they do middling and sometimes they do dreadfully. (More on this in Chapter 9.)

Some investors believe with their very souls a dividend is a sign a firm is healthy. And shouldn’t you want a portfolio of just healthy stocks? But there’s nothing inherently better about a firm that pays a dividend—it’s just a different way of generating shareholder value.

Some firms choose to generate shareholder value by reinvesting profits. They may believe investing in new capital equipment or research or buying (or merging with) a competitor or complementary business will make investors bid up the value of their stock. Other firms may decide reinvestment won’t yield much additional growth (either because of where they are in a market cycle or because of the nature of the firms’ business or some other reason). So they may generate shareholder value by paying dividends. You see this as a shareholder. When a firm pays a dividend, the share price falls by about the amount of the dividend, all else being equal. After all, the firm is giving away a valuable asset—cash.

Because high dividend-paying firms tend to see more value in giving shareholders cash rather than reinvesting profits, there is some overlap in high-dividend categories and value stocks. Whereas growthier firms tend to pay low or no dividends (generally—this isn’t a hard-and-fast rule). In general, when value is in favor, high dividend-paying stocks are, too. And when growth outperforms value, high-dividends similarly underperform.

Let me say that again: Value isn’t a permanently better category—it trades leadership with growth. No one category leads for all time (which we discuss more in Chapter 9).

No Guarantees!

So high-dividend stocks aren’t permanently better and don’t have materially different expected volatility or return characteristics over time. As important: Dividends aren’t guaranteed. Firms that pay them can and do and will cut the dividend. Or they may kill it altogether! PG&E, a utility with a long history of paying dividends, stopped for four years while its stock fell from the low $30s to around $5 between 2001 and 2002. Banks (and plenty of other firms) slashed their dividends during the 2008 credit crisis.

Another myth is the mere existence of a dividend is a testimony to the health of a firm. If a firm pays a dividend, it must be awash in cash and very healthy, right? And the bigger the dividend yield, the healthier the firm must be, right?

Nope. While PG&E experienced its aforementioned price fall, its dividend yield rose—but because dividend yield is a function of past payments and current stock prices. A higher dividend then was just a symptom of a falling stock price (and then PG&E suspended the dividend altogether). Now-defunct Lehman Brothers paid a dividend in August 2008—just weeks before imploding. Dividends don’t signal sure safety.

What about bond interest? If you rely wholly or partially on interest from bonds, you might end up with a too-large fixed income allocation that isn’t appropriate for you, which could impact the likelihood you achieve your goals over the long term.

Then, you can’t forget about interest rate risk—as discussed in Chapter 3. What happens when you have a 10-year bond paying a 5% coupon maturing in 2012, and a recently issued bond, similar in all ways—term, risk profile, etc.—yields just 1.6%? As I write in 2012, bond yields are and have been historically low. Unless you buy junk-rated bonds (increasing your portfolio risk, which may or may not be appropriate), you probably aren’t getting much yield. There’s nothing wrong with getting cash flow from dividends or bonds, but you shouldn’t assume they’re risk free. And you shouldn’t be shackled to them only.

Homegrown Dividends

So if you need cash flow from your portfolio, and you don’t want to be stuck in an inappropriately large allocation of high-dividend stocks and/or fixed income, what can you do? You don’t want to sell securities, do you?

Sure! Why not? That’s what they are there for!

I call this tactic homegrown dividends. The term is mine, and it just means harvesting your portfolio however appropriate while remaining optimally invested.

And to do that, you can sell securities. You can! Folks often say, “But I don’t want to sell principal.” But buying and selling individual securities is incredibly cheap—there’s little impediment to keeping your portfolio optimally invested based on your benchmark and selling securities now and then to raise cash.

Raising homegrown dividends also lets you do some tax planning, if appropriate. You can sell securities at a loss, if you like, to offset some gains. Some years you might not be able to do that, but even so, selling stocks with a long-term capital gain results in a relatively small tax liability. And maybe you have loss carry-forwards to mitigate some of that.

And a well-diversified portfolio will likely always include some dividend-paying stocks, so you’ll likely still have some cash flow from dividends. But you needn’t be hamstrung by just those with higher yields. And depending on your goals and time horizon, you may have some bonds kicking off coupon payments—but depending on your benchmark, that may not be a requirement.

Whether in retirement, approaching retirement or 40 years out, investors should care more about total return—i.e., price appreciation plus dividends—rather than just dividend yield. That allows you to pick a benchmark based on your goals and time horizon, not just on a dividend yield. Focusing solely on dividend yield can mean badly lagging what you would have gotten otherwise as high-dividend stocks go out of favor or watching dividends periodically shrink or get cut. Not a great strategy.

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This excerpt from Little Book of Market Myths is distributed by permission of Wiley & Sons and is subject to copyright laws and other restrictions imposed by the provider of the information.

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