Obsessed With Income
When you buy a share in a company, there are two ways that you can make money:
The share prices goes up; and/or
You receive an income in the form of dividend payments.
Both of these two elements combine to give you the total return on your investment.
As we know, share price moves are inherently unpredictable in the short term. Day in and day out, stock prices move by seemingly random amounts based on the aggregate demand of investors globally. Just last week, the share price of the second biggest company on the planet rose 7% in a day because a man did a presentation.
Due to this (natural) day to day volatility in share prices, a lot of investors like to focus on investing in companies that pay good dividends to their shareholders.
Companies that pay dividends, usually continue to do so. This gives these investors comfort that they can expect at least some of their money back from their investment in the form of an income yield.
Such an approach can seem particularly appealing to folks who are living off their assets, maybe in retirement, as it feels lower risk. They can point to the dividends that they are receiving and say with a degree of confidence that not only will they continue to receive this income stream into the future, but that it will likely rise (as dividend payments tend to rise alongside company earnings). Moreover, if they choose to only live off their income, these retirees can take comfort from the fact that they will never touch their capital - a sure fire way, if there ever was one, of never running out of money.
However, I am a firm believer that what we should all be focussed on are total returns (capital growth, plus income) rather than focussing on just looking for income. This is especially the case for those in retirement.
Why? Well…
Dividends Get Cut All The Time
To begin by stating the obvious, if you buy a stock just because it pays a chunky dividend and that dividend gets cut, you could be in for a world of pain.
Back in 2020 you might remember that the market had a bit of a whoopsie. One of the cheery side effects of the pandemic, and the subsequent temporary mothballing of the global economy, was that demand for oil evaporated to the extent that oil prices went negative. Not great news for the companies who sell the stuff.
In response to the crisis, dividends for shareholders in Royal Dutch Shell were cut for the first time since the end of the Second World War. As you can imagine, investors did not take this news well.
Source: Yahoo Finance. The blue line shows the performance of Shell shares from 1/1/20-31/12/20.
No Chief Executive of a listed company wakes up and hopes that their shares will be yielding 12%1. For a double digit dividend yield tells us one of two things about a stock - either the shares are too cheap, or that dividend is getting cut.
Receiving a dividend from an investment is no bad thing, and one of the reasons that we invest in equities at all is that they offer us access to a rising income stream over time.
But it is also the case that often companies with optically high dividend yields are companies that are in bother. The irony therefore of investing based solely on pursuing high income, is that you can put yourself at risk of loss through major drawdown in the capital value of your investment.
You Can Miss Out On The Winners
As a rule of thumb, I am against anything that restricts an investor's scope of potential opportunities. If our process has the effect of meaning that we only buy a certain kind of stock, then we leave ourselves open to fairly major opportunity cost.
History shows us that, over the long term, the overall returns for the market come from a narrow band of extreme "winners". Diversification not only offers our means of managing risk, but also of ensuring that we are in these winning names.
The past decade offers a really good illustration of the dangers of solely fishing in the “dividend payers” pool. The below chart shows the ten year performance of two Vanguard funds - one (in blue) that adopts a strategy of only investing in high dividend paying stocks, versus one that invests in the broad market as a whole (in red).
Source: FE Analytics. The chart shows total return for each investment, without dividends being reinvested. Fund charges are included, but advice and custody charges are not. None of this is investment advice.
If you had lobbed £10,000 into the higher dividend yielding strategy, yes you would have received a higher income each year - but you would have missed out on just over £7,500 of overall return, largely because you weren’t in the winning stocks.
If you think about the best performing stocks over the past decade, they are mainly companies that paid out little to no dividends. Instead they reinvested their profits into the business to innovate, enter new markets, release new products and with it grow their earnings (and market cap).
Even if you are about to retire or have just retired, you are likely to still have a twenty to thirty year investment horizon. Would you rather put your money into a company that is able to reinvest its profits to add further momentum to its growth, or a company that can’t think of anything better to do with its money than to return it to shareholders?
To reiterate, there is nothing wrong with buying stocks that pay a dividend - but not at the expense of reducing your investable universe. By remaining open to buying everything we give ourselves the best chance possible of a great outcome.
Dividends Are Not “Free”
Back in 2016, Samuel Hartzmark and David Solomon wrote a paper on the “free dividend fallacy”. They found that, on average, investors were erroneously mentally accounting for the dividends that they were receiving.
The above video sets out their point in detail, but the executive summary is this - most investors seem to incorrectly think of dividends as additional bonus payments, received on top of the return that they would have otherwise had.
When a company pays a dividend that money has to come from somewhere, namely the profits the business. We see the effect of this on the day that a stock goes ex-dividend2 - all else being equal, the share price falls by an equivalent amount to the dividend per share being paid.
By investing in a stock that pays a dividend therefore, we are choosing to take an element of our share price return and turn it into income.
“So what?” you might think. The total return is going to be the same regardless of whether I take it as income or capital growth.
Well, not exactly…
Generating Returns Through Capital Growth Is More Tax Efficient Than Through Dividend Yield.
At the moment, tax rates charged on capital gains made on share sales are much lower for higher and additional rate taxpayers than the equivalent rates charged on dividends.
For all taxpayers, the amount that one can receive “tax free” from capital gains is also larger than for dividends (currently £3,000 versus £500).
None of this matters of course if you are holding the relevant shares in an ISA or a pension where returns are not taxed at all, but how you receive your return matters an awful lot if you are a higher rate taxpayer holding these investments in a taxable account. If, as we have seen above, dividends and share price appreciation are simply different sides of the same coin, why would I choose to receive my return via a means that is taxed so much more punitively?
Over the years I have observed that people hate paying Capital Gains Tax (CGT). I reckon that this is because they think of it as a “voluntary” tax. Not voluntary in the sense that you don’t have to disclose or pay it of course, but voluntary in that it only becomes payable if you choose to transact by selling an investment. If you don’t sell, you don’t need to pay.
But paying a wee bit of CGT never did anyone any harm. It is the price of a profitable investment, and while rates are less than half of the equivalent dividend and income tax rates for higher and additional rate taxpayers3, that price is hardly punitive.
You Could Be Spending More
As I alluded to above, there are behavioural benefits to adopting an investment strategy that focusses solely on income generation.
If I build a portfolio, and pledge to only spend the income that that portfolio generates, then that is a simple and sure fire way of avoid running out of money in retirement. It is a plan that is easy to understand, monitor and, I suppose, is “low risk” in its own way.
The downside to this strategy of course is that you could be spending more money. Once we have accumulated enough money to last us for the rest of our lives, we broadly have three choices as to what to do with it:
Spend it on ourselves;
Consciously spend it on others (through gifting) while we are alive; or
Unconsciously spend it on others (potentially via the state) when we are dead.
There are a number of studies that show that retirees are not spending as much as they could be. For what it is worth, this aligns with my own professional experience too.
An obsession with income, combined with a strategy of only spending what is coming in each month, can ultimately result in the biggest opportunity cost of all - regret that we didn’t enjoy ourselves more.
Have a great weekend.
As ever, none of the above is intended to constitute advice to any individual. Moreover, past performance is not indicative of future returns.
Investing involves the risk of capital loss. Income from any investment is not guaranteed.
When discussing dividends, investors will often point to the dividend yield of a stock. The dividend yield is calculated by dividing the dividend paid per share, by the share price.
So, on the face of it, a stock with a higher dividend yield would appear to be a more attractive investment. But, as we shall see, a really high dividend yield might not be all that it’s cracked up to be.
When a stock goes “ex dividend”, all of the names on the shareholder register are entitled to receive the next dividend paid by the company. If I hold a share in a company that has gone “ex dividend”, and then sell it to someone else before the dividend is paid, I will still receive the dividend as I was the registered shareholder on the “ex dividend” date.
And let’s be honest, these are the folks who are far more likely to be realising capital gains in excess of the annual exempt amount anyway.
It's true that dividends could get cut. I wouldn't say "all the time." Companies are reluctant to cut them because a cut affects the stock price negatively. But for me, the most important point is that public companies have limited control over their stock prices and absolute control over their dividends. If you're afraid of getting a divvy cut (like me), pick a dividend ETF. 100+ dividend-paying stocks are your insurance against shit happening. Even if one or two companies decide to cut their divvies, that will hardly affect your payout.