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This show is a proud member of the Retirement Podcast Network. Dividend investing helps your mental health by not caring as much about market volatility because you're getting reliable and rising cash payouts every three months. Dividend investing is a no-fail strategy that makes investing easy and allows you to earn income while you sleep, golf, relax, and travel. Dividend investing can make you money while you sleep.
These are just a few of the countless claims from well-followed people arguing that dividends are the solution to our investing problems. And it's not just limited to financial influencers on social media. The last quote was the actual title of an article published by CNBC earlier this year.
The misleading claims are getting louder, more extreme and reaching more people than ever before. I get it. Yield and predictable income and making money while I sleep is appealing, much more appealing than spending from my diversified portfolio of stocks and bonds.
While dividends are a normal and natural part of the investing process, their role in a retirement portfolio is often misunderstood. In fact, one academic study concludes that reducing exposure to dividend stocks can actually boost your long-term returns.
Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte, and today I'm very excited to kick off a multi-part series on dividend investing. Once and for all, you will have a clear understanding of how dividends work, the role they play in the investing world, why some companies issue them and some don't, the pros and cons of this investment approach, and an underrated alternative to companies paying a dividend.
To grab the links and resources from today's episode, just head over to youstaywealthy.com forward slash 217. When a company is profitable, it can choose to invest those profits back into the business to fuel future growth, or it can pay eligible shareholders a cash dividend. Yes, technically there are a few other options that a company has, but we'll push those aside for now and just keep it simple.
So that's all a stock dividend is. A dividend is a portion of a company's profits being paid out to eligible shareholders. The company that you invested in made some money and in turn, they've decided to give you a shareholder and partial owner some of the money that they made.
Naturally, you might be thinking, hey, that's great and all, but why would a company do this? Why would they voluntarily commit to giving some of their cash to me on a regular basis? Well, one popular reason is that it signals to investors that the company is healthy, which can increase demand for the stock.
As we all know from the GameStop saga, more demand from investors to buy a stock will, in turn, increase its price. According to Investopedia, quote, paying dividends sends a clear, powerful message about a company's future prospects and performance. And its willingness and ability to pay steady dividends over time provides a solid demonstration of financial strength.
People invest in companies because they want to participate in their growth and the value that they create. And to some investors, receiving a consistent quarterly dividend provides certainty about when they'll realize a return on their investment or when they'll participate in some of the value that's being created. Without a consistent dividend, some investors might feel like there's more risk and uncertainty about when they'll benefit from the investment that they made.
But is that really what's happening? Do dividends really signal financial strength? Do they actually reduce risk and provide more certainty about an investor's return? To find out, let's talk about my birthday. My birthday is next week. And while I don't have much of a sweet tooth, I do love a good ice cream cake, a peanut butter ice cream cake to be exact. So if on my birthday, I eat three slices of peanut butter ice cream cake, which is highly likely, I think we can all agree that there will be three fewer slices available.
But there's also my three-year-old daughter who could unpredictably grab a handful of my cake when I'm not looking, further reducing the amount of my cake.
Believe it or not, this birthday cake example is analogous to stock dividends. Let me explain. We already established that a dividend is a distribution of company profits. It's literally a slice of the company's value being removed from the company and distributed to shareholders. It's not magically created out of thin air. If a company makes some money and they want to give some of that money to its shareholders instead of holding onto it or reinvesting it, the company will have less money as a result.
Because of this, because a dividend is a cash distribution of company profits, a company's stock price is typically reduced by the amount of the dividend that's paid. I'll say that again. A company's stock price is typically reduced by the amount of the dividend that's paid.
For example, let's say your favorite stock is trading at $50 a share and the company declares a 50 cent dividend per share. In other words, for every share of the stock you own, the company will send you 50 cents. If you own 100 shares, 50 bucks is headed your way.
However, on the day this dividend payment is paid, the share price of the stock will typically adjust accordingly. In this example, the share price might adjust to $49.50. It's reduced by 50 cents, the exact amount of the dividend paid. So instead of owning 100 shares at $50 a share, you now own 100 shares at $49.50 plus the 50 cents per share given to you in cash.
Mathematically speaking, you're financially in the same exact position, especially if you choose to immediately reinvest the dividend payment that you received right back into the stock that paid it. However, if you spend the dividend payment, like I plan to eat a few slices of birthday cake, you will have enjoyed a nice tasty dividend, but the total value of your investment portfolio or the total amount of cake will be smaller as a result.
But wait, there's more. Just like my unpredictable three-year-old daughter who might swipe some additional cake from me when I'm not looking, the stock market might do some unpredictable things to you at the same time your dividend is being paid. In addition to the share price being reduced by the amount of the dividend being paid, other market factors could further reduce the price of the stock on the same day. In fact,
Dimensional Funds recently conducted a study evaluating the 10 largest companies in the S&P 500 High Dividend Index.
From 2018 to 2023, the average dividend paid across the 10 largest companies in this index was $1 per share. However, on the dates the dividends were reflected, the average share price between all 10 of these companies dropped by $1.15 per share. In other words, the average share price for these 10 companies dropped slightly more than the amount of the dividend paid to shareholders.
Even with the dividend in hand, investors ended up with less money. This is the stock market's version of my unpredictable daughter swiping some extra cake from me, where the stock share price not only drops by the amount of the dividend being paid, but it can drop even more due to other unpredictable factors in the market on the same day.
The study only examines 10 companies in one index over a short five-year time period, so it doesn't necessarily provide robust evidence that investing in dividend-paying stocks will result in a poor outcome. In fact, while not as common, unpredictable market factors can also push the stock higher at the same time the dividend is paid. So while I won't argue that this study proves that dividends always lead to poor outcomes...
I will argue that it highlights the importance of measuring the total return of your portfolio and not just the yield or dividends being paid by the underlying securities. More on that later, but first, two quick things before we go any further. Number one, if you want to see how this dividend payment and corresponding stock price adjustment plays out in real life, you can head to a site like Yahoo Finance.
Enter a dividend paying stock ticker into the quote box at the top there, and then click on the button that says historical data. For example, if you check out Chevron's price history, the ticker is CVX, you'll see that the stock closed at $151.01 on February 14th of this year.
But then you'll want to take a look at the next column over labeled the adjusted close. The adjusted close for Chevron on that same day was $149.38, a $1.63 reduction in the price of the stock. Want to take a guess how much the dividend being paid the next day was? $1.63. Investors received a nice dividend, but they woke up the next day to a lower share price as a result of that dividend.
And as we talked about, the math isn't always perfect like this due to other market factors at play, including investor sentiment and trading activity around the same time of the dividend. Sometimes those unpredictable market factors push the stock down more than the dividend, and sometimes they bump the share price up.
The second thing to mention here is that everything we've talked about up to this point is applicable to pooled investment products like mutual funds and exchange traded funds, a.k.a. ETFs. I'm using individual companies here to explain the basic mechanics, but a dividend paying mutual fund or dividend paying ETF really isn't much different.
Instead of just one stock, it's a basket of stocks behaving in the same exact manner, collectively issuing dividends and collectively, on average, reducing the share price of the fund by roughly the amount of the dividend being paid out.
Of course, buying a fund that owns hundreds or even thousands of dividend paying stocks certainly reduces risk and reduces the chances of a catastrophic loss in your portfolio. However, as we all know, reducing risk will also reduce your portfolio's yield and expected returns.
As always, you can't have your cake and eat it too. Okay, okay, I promise no more cake analogies. Let's recap where we're at so far. First, a dividend is simply a portion of a company's profits being paid to shareholders. When a dividend is paid, the company's stock price typically adjusts by the same amount of the dividend. Investors will own the same number of shares, but the total value of their investment will be lower unless they immediately reinvest their dividend and don't spend it.
Evaluating the total return of your portfolio is more appropriate than evaluating the yield or dividends being paid by the underlying securities. And then finally, while taxes, risk, and the timing of dividend payments might differ, dividends affect individual stocks and funds like ETFs and mutual funds in the same way. Just like a stock price typically adjusts for the dividend being paid out, so too does a mutual fund or ETF.
So hopefully we now have a good handle on what a dividend is, why companies pay them and how they affect investors. Also, hopefully it's now clear that there's really nothing special about a dividend. A dividend is not created out of thin air and it does not represent an additional amount of money added to your investment account. You did not make extra money while you were sleeping. The company you invested in
made some money. And instead of reinvesting that money back into future growth or holding onto it, they returned some of it to you and the price of their stock adjusted accordingly.
The day the dividend is paid, you, the investor, more or less remain in the same place financially unless you spend the dividend or other market factors further influence the stock price. So dividends aren't special. In isolation, they aren't the magical solution to generating consistent, predictable income in retirement.
Conversely, at a high level, it's important to note that dividends are not necessarily the enemy either. In fact, 75% of companies in the S&P 500 pay a regular dividend. They are a natural and normal occurrence in the global financial markets. While dividends are not the enemy, using the dividend yield of a fund or a stock as a guide to construct your portfolio can certainly be problematic. It can potentially lead to higher taxes, higher investment risk, and lower returns.
In addition, evaluating the performance or health of your portfolio based on the dividend yield alone can also be problematic and maybe more importantly, misleading.
Before we dissect those aforementioned problems with focusing on dividend yield to build your portfolio, let's first briefly discuss what I believe to be an appropriate way to evaluate investments and determine what should or should not be included in a portfolio. In other words, if dividend yield should not be used as a guide to building a portfolio, well, what should be the guide? What should the process be and where do dividends fit into that process?
To start, if I build an academically sound portfolio, it will pay regular dividends. Again, three out of every four large cap U.S. companies pay a regular dividend. So my portfolio will naturally pay some regular dividends. However, the dividend yield after I go through this process, the dividend yield is irrelevant to me.
Said another way by the wonderful folks at Cambria Investments, quote,
Valuation matters. With investing, the price which you pay for an asset has a significant influence on the return or lack thereof that you'll get.
Since we now know that dividends are not special and a dividend payment does not change the total value of our investment, Cambria's comments should hopefully resonate. It should make sense that we want to focus on buying quality investments at a good value instead of just buying an investment because of the dividend yield. A stock might be paying an eye-popping 10% dividend yield, but if Warren Buffett's analysis concludes that the company is wildly overvalued, he's not touching it.
that 10% yield is meaningless if the stock price falls off a cliff. He and other smart, prudent investors would prefer to buy a quality, wildly undervalued company with high future expected returns, even if the dividend yield was only 1%.
With all of that in mind, if I really simplify the portfolio construction process for the equity part of your portfolio, it might look something like this. Step number one, leverage evidence and academic research to influence what equity asset classes belong in your portfolio. As a very simple example, this step might lead you to include a mix of U.S. stocks, international stocks, and real estate.
Next, step number two, using your preferred valuation metric, determine what companies or segments of those broad asset classes that you identified in step one have attractive valuations and higher future expected returns.
For example, you might use something like the Shiller PE ratio to conclude that small cap value stocks are undervalued and large cap growth stocks are overvalued. As a result, you may decide to overweight small cap value stocks in your portfolio and underweight large cap growth.
In other words, to improve your future expected returns, you might decide to own a higher percentage of the undervalued asset classes and a lower percentage of the overvalued asset classes.
Finally, step number three, once you've identified your target asset classes and the corresponding asset allocation weightings for each, this final step is to implement your portfolio to determine what investment solutions or products are best to use to invest in each of these asset classes. You might implement your portfolio through individual stocks, mutual funds, ETFs, or maybe a combination of all three.
Regardless, the ultimate goal is to ensure that you're getting the desired exposure to your chosen asset classes at the best cost. For example, let's say you've decided to include small cap value stocks for a portion of your portfolio.
Through your research, you might conclude that the Vanguard small cap value ETF is low cost, but then you dig a little bit deeper and you determine that it's actually not capturing the desired asset class appropriately, that the construction of that specific small cap value fund is not actually giving you the exposure you're looking for.
Conversely, maybe something like the Royce small cap value fund might be capturing the desired asset class appropriately, but you conclude that the higher than average fees being charged by the fund are eating into your expected returns. Heck, you might not consider funds at all. You might attempt to implement your desired portfolio by buying individual stocks.
This approach keeps costs low and allows you to get perfect exposure to your targeted asset classes. But as you explore further, you might conclude that the time it takes to manage and maintain all of these individual positions takes you away from other more important things that you want to be doing. These are the decisions that you have to make as you go through the portfolio construction process, and especially here in the final step when you go to implement.
So to quickly recap this intentionally oversimplified three-step process, first step number one is to identify what asset classes belong in your portfolio. Then step two, determine what segments of those asset classes you want to overweight and underweight using your desired valuation metric. And then finally, lastly, number three, implement your portfolio in the most efficient way, giving you the correct asset class exposure at the best price.
You can, of course, do all of this on your own or with the help of a financial advisor. Either way, at the end of this process, you will have or should have a low-cost, academically sound portfolio with attractive future expected returns. You'll also have a portfolio that pays regular dividends, but the fact that your investments pay a dividend did not influence your decision to include them in the portfolio.
Okay. We covered a lot in today's episode, but there's so much more to explore and discuss on this topic. So next week in part two of our dividend investing series, I'm going to dive deeper into the problems created when using dividend yield to build a portfolio. I'm also going to share an interesting research study that shows how avoiding dividends in your process can actually boost your long-term after-tax returns. For
From there, we'll continue on by talking about evaluating your portfolio based on the total return versus yield, an underrated alternative to companies paying a dividend, and the right way to invest in dividend stocks if you are inclined to use yield as a driver for portfolio construction.
Once again, to grab the links and resources mentioned in today's episode, just head over to youstaywealthy.com forward slash 217. Thank you as always for listening, and I will see you back here for part two next week. This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.
